Firing Fannie and Freddie

Five years ago, the U.S.  government took over the Federal National Mortgage Association and Federal Home Loan Mortgage Corp. in a $175 billion bailout during the height of the financial crisis. Now, “Fannie Mae” and “Freddie Mac,” as they’re known, respectively, are back in the black.

The two government-sponsored entities (GSEs) buy mortgages on the secondary market, pool them and sell them as securities to investors. They posted their sixth straight profitable quarter this past summer. In total, Fannie and Freddie’s surprisingly robust performance already has translated into more than $75 billion in dividend payments to the U.S. Treasury.

Profitability doesn’t equate to stability, however. That is why calls to reform Fannie and Freddie, which began in earnest after the 2008 housing bust, continue to resound on Capitol Hill.  Fannie and Freddie were key players in the subprime mortgage crisis because of lax risk standards for borrowers and investors.

“No one ever assumed that these entities were going to remain in permanent conservatorship — that was always supposed to be a temporary solution,” explains Democratic Sen. Mark R. Warner of Virginia. “Right now, you still have virtually no private capital behind mortgages. If there were another downturn in the housing market, the American taxpayer would bear the full brunt.”

Of course, there are a lot of opinions on what a new, permanent solution should look like. A conservative contingent in Congress, led by Republican Rep. Jeb Hensarling of Texas, chairman of the House Financial Services Committee, wants the government to get out of the housing finance business altogether. He has introduced a bill that would liquidate Freddie and Fannie and replace them with private capital.
Still others, including Fannie and Freddie preferred shareholders, believe the structure of the GSEs is basically sound and should continue as is.

Warner, Republican Sen. Bob Corker of Tennessee and eight other lawmakers have drawn up a bipartisan compromise that would replace Fannie and Freddie with a mix of private and public backstops against future bailouts. This solution already has gained tentative support from many in Virginia’s mortgage industry.

“I think everyone recognizes that Fannie and Freddie are in a somewhat untenable position long term, so any motion towards bringing clarity and establishing a new framework for the secondary market is a step in the right direction,” says J.G. Carter, president of Suffolk-based TowneBank Mortgage. “Because at the end of the day, the secondary market does need to be structured in some way that provides liquidity to the market so that lenders like us can still offer a full range of mortgage credit that’s sustainable. What that level of intervention on the government’s part should be is obviously a subject of fierce debate, and I see the bill as a great starting point for that debate.”

A new order
The bill introduced by Warner and Corker in June, the Housing Finance Reform and Taxpayer Protection Act, sets up various layers of capital to protect the taxpayer in an unexpected downturn. The structure mandates that private financiers take a first-loss position on the first 10 percent of any mortgage-backed security.

In addition, Fannie and Freddie would be transitioned out over five years. Replacing them would be a new government-owned and -operated reinsurance entity, the Federal Mortgage Insurance Co. (FMIC), which would guarantee the next level of losses. FMIC also would take over certain Fannie and Freddie functions such as qualifying securities investors. The organization would be similar to the Federal Deposit Insurance Corp. (FDIC) in that its funds would be financed through user fees.

Under this structure, a taxpayer bailout would be necessary only when all other options are exhausted, according to Warner. “The idea is that we move the government guarantee further to the back so that it’s a catastrophic backstop, rather than being the first place you turn when things go wrong,” he explains.

Some industry observers, however, have doubts about the Senate bill. “Basically what the proposal calls for is a non-Fannie Mae and a non-Freddie Mac institution that’s going to look just like Fannie Mae and Freddie Mac,” says William W. Sihler, the Ronald Edward Trzcinski Professor of Business Administration at the University of Virginia’s Darden School of Business. “The only real significant change is that they are charging the private sector with an insurance premium, which is essentially Uncle Sam charging to guarantee the mortgages. That is different, but you could do that with Fannie Mae and Freddie Mac or maybe you get rid of the idea of having two GSEs and just have one.”

Moving ahead carefully
Lenders and other frontline participants in Virginia’s mortgage industry refer to the Warner-Corker bill as a good starting point for a conversation on how to undertake the colossal task of reforming a national housing finance system — but it’s hardly the last word.

The effort to put in place long-term housing reforms would not be a panacea for current challenges to the still-struggling housing market, says Brian Holland, president of the Virginia Mortgage Lenders Association and president of the Atlantic Bay Mortgage Group. Passage of the Warner-Corker bill initially would result in a bump in the cost of mortgages as lenders pass their premium costs on to consumers, for example. The mortgage application process also will remain challenging, thanks to stringent documentation, compliance and underwriting rules lenders now have to follow under the Dodd-Frank Wall Street Reform and Consumer Protection Act and rules set by the Consumer Financial Protection Bureau. The bureau’s Qualified Mortgage (QM) and Qualified Residential Mortgage (QRM) rules are set to take effect in January.

Nonetheless, because the Warner-Corker bill requires government involvement in home financing, the legislation would ensure the continued availability of the 30-year mortgage for U.S. homebuyers, keep interest rates relatively low and continue to provide even troubled communities with access to the credit market, Holland says.

“I’m definitely a pro-business person, but there are certain places where the government has to play a role, and housing is one of them,” he states. “Imagine if in 2008, when the credit markets basically turned off, there had been no Fannie and Freddie, no GSE. The market that we saw would have been tremendously worse, catastrophic really, because there would have been no financing available, no access to credit.”
Bruce Whitehurst, president and CEO of the Virginia Bankers Association, likes Warner’s proposal in its current form.  The bill not only retains a federal backstop, he notes, but it also provides safeguards to smaller lenders, like community banks and the small independent mortgage companies, to ensure they have equal access to the secondary market and the same pricing as the largest mortgage providers do.

“With sweeping change of any kind, the devil is in the details in terms of managing against unintended consequences,” Whitehurst says, adding that the bipartisan nature of the Warner-Corker bill bolsters its credibility and chances for eventual passage. “We’re talking about a national housing finance infrastructure, so there are certainly risks in terms of making massive changes, because if the transition doesn’t really go well, where does that lead you? That has to be weighed by our political leaders against their perception of the risk of not doing anything or not doing much or just tinkering around the edges.”

Carter believes that any national housing reform legislation must address the nature of the government guarantee of mortgage-backed securities. If the Warner-Corker bill can bring certainty to that issue, it will go a long way toward enabling a healthy housing market and more private investment, both in the short term and the long term, he says.

“An outcome you wouldn’t want to see is one where there remains ambiguity about whether it’s an explicit or an implicit guarantee and at what level that guarantee exists,” he says. “They need to define that in black-and-white terms, not gray, because with that type of clarity and certainty, you can assign risk and manage risk accordingly. That would make for a more efficient market and I think it also would facilitate the return of private capital.”