President Obama unveiled an ambitious new plan this week to overhaul how America finances home mortgages.
If the president’s plan is enacted, the likely result will be slightly higher interest rates and a more stable financial system.
If a hard-right rump in the House prevails (which it probably won’t), the likely result will be shorter-term mortgages at adjustable rates and a less stable financial system.
And if nothing happens at all—a very real possibility—then interest rates and financial stability will be unaffected; the budget deficit will be a bit lower; and U.S. government debt, which today stands officially at $17 trillion, will actually be more like $23 trillion (an outcome that isn’t necessarily dire).
At issue is the continued existence of the government-created Federal National Mortgage Association, commonly known as Fannie Mae, and Federal Home Loan Mortgage Corporation, commonly known as Freddie Mac. These so-called “government sponsored enterprises” buy home mortgages, package them into securities, and then sell them to investors. For some obscure reason these enterprises tend to have nicknames straight out of Li’l Abner (Fannie Mae, Freddie Mac, Sallie Mae for student loans, Farmer Mac for agricultural loans).”
By securitizing mortgages, Fannie and Freddie make it possible for banks to issue mortgages on what would otherwise be, when you think about it, great terms for the borrower but lousy terms for the lender (30 years? At fixed interest rates? To a borrower who might turn out to be a deadbeat?). Indeed, the 30-year mortgage didn’t exist before President Franklin Roosevelt created Fannie Mae during the Great Depression. When people bought houses, they typically took out two or three mortgages, each at a higher interest rate than its predecessor, and these mortgages had to be paid off or renegotiated within five or six years. That limited severely the home buyers’ market, and when the crash came in 1929 the highly-leveraged housing sector fell especially hard.
Roosevelt invited the financial community to create a secondary mortgage market within the private sector, but there were no takers. So in 1938 he created Fannie Mae as a government-owned corporation that packaged home mortgages into bonds. Thirty years later Congress made Fannie a private corporation, and two years after that it created Freddie Mac to give Fannie a little competition. In 1977, a young Salomon Brothers trader named Lewis Ranieri created mortgage-backed securities, a more lucrative alternative to bonds in the secondary mortgage market, and pretty soon they were being packaged in enormous volume by Fannie, Freddie, and the banks.
In 2008 this market crashed, bringing the entire U.S. financial system down with it. Conservatives try to blame Fannie and Freddie, which had been directed by the federal government to broaden the market for lower-income homeowners. But in fact the culprits were banks and mortgage companies, which had grown steadily more reckless in bundling so-called “subprime” mortgages issued to unwary low-income people who were bad credit risks. Also culpable were the big three credit rating agencies (Standard & Poor’s, Moody’s, and Fitch), which yielded to financial pressure from their clients the issuers to inflate ratings for these subprime mortgage-backed securities.
For a long while Fannie and Freddie stayed away from the subprime market, even as the government enterprises were expanding loans to more creditworthy low-income people. But eventually Fannie and Freddie yielded to competitive pressure to market subprime mortgage-backed securities too, and when the crash came they entered into government receivership, where they remain today as the de facto property of the U.S. government.
Nobody wants Fannie and Freddie to be revived as private organizations. As “government-created enterprises,” they were always presumed to have the implicit backing of the government, a guarantee that became explicit after the 2008 crash. This translated into what was in effect an unfair (and much-resented) subsidy.
Fannie in particular hired executives based less on their banking knowhow than on government connections they could translate into lobbying stroke to preserve their privileged place in the market. Fannie spun that advantage into excessive shareholder returns and made small fortunes for its executives. It was the worst of both worlds. The public presumed, correctly, that Fannie Mae had government backing, but the government had little control over its operations.
Some conservatives propose eliminating Fannie and Freddie and leaving the secondary mortgage market to the private sector. That’s the approach favored by House Financial Services Committee Chairman Jeb Hensarling, a Texas Republican, in a bill that narrowly cleared the committee on July 24.
The chief objection to Hensarling’s privatization plan is that it would likely mean the end of the 30-year fixed-rate mortgage. Hensarling has denied it would have that effect because:
1.) “Fannie Mae and Freddie Mac have never made a 30-year fixed rate mortgage” (true but irrelevant; Fannie and Freddie made it possible for banks to offer such mortgages);
2.) Thirty-year fixed-rate mortgages existed previously “without a government guarantee” (untrue; as noted earlier, the guarantee was presumed rather than explicit, and eventually the government made good on it);
3.) Homeowners can still “receive a 30-year fixed rate mortgage through the Federal Housing Administration” (true, but irrelevant; the agency has limited funds, requires an above-market interest rate, and serves a comparatively small number of mainly low-income and first-time buyers who need to minimize their down payment).
Some conservatives (and even a few liberals) have questioned whether the 30-year fixed-rate mortgage is worth saving. Writing in Slate, Matthew Yglesias points out that other, comparable industrial democracies seem to do fine without it. Some of these (the United Kingdom, Belgium, Italy) even manage to have higher homeownership rates than the U.S. But Barry Zigas, director of housing policy for the Consumer Federation of America, answers that these other countries’ housing policies must be understood in the broader context that they have more generous social-welfare policies. Absent such policies in the U.S., the impact of not having 30-year fixed-rate mortgages would be greater on America’s middle class than it has been on other countries’ middle class. To put it in a way that Zigas never would: Yes, delivering social welfare through the broad housing market probably isn’t the best way, but absent any reason to believe the U.S. would deliver it any other way, we’re probably better off sticking with we’ve got.
Hensarling’s weak case for his bill (which he will presumably repeat on Aug. 13 in an address at the George W. Bush Presidential Library and Museum) did not win over two of his own committee Republicans, and seems unlikely to prevail.
President Obama’s plan essentially endorses a bipartisan bill introduced by Sens. Mark Warner, D., Va., and Bob Corker, R., Tenn., that would eliminate Fannie Mae and Freddie Mac and replace it with a Federal Mortgage Insurance Corporation (FMIC) modeled after the Federal Deposit Insurance Corporation. Instead of insuring bank deposits, the replacement entity would insure mortgage-backed securities as a third line of defense (the first being the securitizing bank and the second being a private reinsurance market). The president’s plan—really a broad set of principles—emphasizes that private capital must bear more of the risk in the secondary market and that the 30-year fixed-rate mortgage be preserved.
The success of such a plan would depend on how successfully government regulators were able to limit mortgage-backed security risk at the front end. Peter Wallison, a conservative housing expert at the American Enterprise Institute, is skeptical on this point. As a reinsurer rather than a securitizer like Fannie and Freddie, FMIC would provide less financial support to the secondary mortgage market, and as a consequence interest rates would be somewhat higher. In a Wall Street Journal op-ed, Wallison argued that these higher rates would meet political resistance, and “Congress or the administration or both will pressure the FMIC to lower its insurance fees.” Result: an unstable, overheated market and, when the next crash comes, an underfunded FMIC that requires a huge taxpayer bailout.
A third option, favored by almost no one except economist Dwight M. Jaffee of Berkeley and Dean Baker of Washington’s left-leaning Center For Economic and Policy Research, is to let Fannie and Freddie remain part of the federal government (as Fannie was prior to 1968). Somewhat to the embarrassment of all concerned, the federally-run Fannie Mae has turned into a cash cow for the federal government, generating profits for the past six quarters, earning $10,1 billion in the last quarter alone. Keeping Fannie and Freddie part of the federal government, some housing advocates say, would limit the financial innovation necessary to sustain and enlarge the housing market. But after 2008 and the subprime fiasco, is innovation what the housing market really needs? (There’s already some disturbing evidence that the credit rating agencies are up to their old bank-pleasing tricks.)
Another objection is that Fannie and Freddie add $6 trillion in liabilities to the U.S. Treasury. But given the conservative nature of mortgage lending today (Fannie and Freddie, with their fuddy-duddy risk management, have since the 2008 crash completely dominated the secondary mortgage market), those liabilities don’t seem a major concern.
Still, an officially federalized Fannie and Freddie (they aren’t technically part of the federal government today) would be a hard political sell. Neither Democrats nor Republicans want the government’s debt figures to go up, even if Fannie and Freddie simultaneously bring the deficit down by delivering profit to the U.S. Treasury. Too bad, because it might be the best solution.