Over the last few weeks, more attention has been put on dismantling Fannie Mae and Freddie Mac and designing a replacement. Why? Because FNMA and FMAC have been singled out as one of the main causes of the national housing meltdown. Is that true? Since they were the recipient of one of the largest government loans after the crisis it stands to reason that many would question their viability. Additionally, the federal government has said repeatedly that they want to get out of backing mortgages.
The current solution suggested by the legislative branch currently has all the earmarks of replacing a working model that had a major hiccup (because of political intervention) with a questionable economic model that would force mortgage standards that private industry does not want.
Before continuing further, if you are unfamiliar with Fannie Mae and Freddie Mac, or just need a refresher, take a look at the Independence Voice blog entry from August 16, 2013, “Meet Fannie & Freddie”.
During the early days of the financial crisis, the federal government had to step in and take control of these two mortgage financiers and set them up in a conservatorship. Starting with the bailout, the two companies required roughly $150 billion in taxpayer support to stay solvent, while the government was able to keep the housing market afloat by backing more than 95 percent of all home loans made in the United States. At the time of stepping in these two mortgage giants handled 60-65% of all mortgage business. Today, it is over 95% of all mortgages.
Since the bailout, the mortgage giants have now been turning a profit. U.S. taxpayers have recouped all of the $187 billion they gave mortgage giants Fannie Mae and Freddie Mac in one of the most expensive bailouts of the financial crisis. So, if they’re profitable, that means that they are near paying off their debt, because the profits go back to pay their bailout, correct?
It turns out they don’t. The chief beneficiary of FNMA / FMAC’s profits is the federal government—the same entity that bailed it out at the height of the financial panic nearly five years ago. The payback was not set up as a loan, with debt payments towards paying off the initial debt as most notes are done. Part of the agreement was that the government took senior preferred shares of the company. Fannie Mae / Freddie Mac now have to pay nearly all of its profits, save a small capital cushion, to the government in dividends. This doesn’t pay back the draw; it is just a dividend. In turn the federal government decides where the money should go. This does not necessarily go to paying off the original debt.
This last March, housing finance reform legislation by the two most senior members of the Senate Banking Committee was proposed in efforts to chart a path beyond Fannie Mae and Freddie Mac. Senator Johnson and Senator Tim Crapo’s 442-page bill would create a new regulator, the Federal Mortgage Insurance Corp., to provide an explicit government backstop for certain mortgage-backed securities. Private firms would be permitted to buy mortgages and sell the securities after putting up 10% in first-loss capital. Meanwhile, a new small lender mutual cooperative would aim to provide members with access to the secondary mortgage market through a cash window and securitization services.
With so much dissension and partisan gridlock, any legislative / administrative proposal with significant bipartisan sponsorship would be praised and supported if it simply did not produce a policy worse than the where we currently are.
Yet one of the stumbling blocks of the new legislation is the politicization of the allocation of mortgage credit beyond the level that was possible with FNMA and FMAC and any private equity currently. In establishing the proposed Federal Mortgage Insurance Corporation (FMIC), the bill broadens affordable-housing goals by requiring “equitable access” to mortgage credit for all eligible borrowers. The government would determine the definition of all eligible borrowers. This bill forces borrowers and lien holders with good credit to subsidize those with bad credit. This bill proposed by Sen. Tim Johnson (D., S.D.) and Sen. Mike Crapo (R., Idaho) manages to make the affordable-housing provisions of current policy worse.
Under the new guidelines, an “eligible borrower” is someone who meets the standards for a loan under the qualified-mortgage standard promulgated by the Consumer Financial Protection Bureau under Dodd-Frank. In an August 2013 proposal for a new risk-retention rule, six federal agencies noted that mortgages meeting the qualified-mortgage standard had a 23% default or serious delinquency rate between 2005 and 2008. Even Fannie and Freddie were never forced to set their mortgage standards that low.
The plan has received widespread attention in part because it appears to address the most evident problems of Fannie and Freddie. Yet on deeper examination, this seems not to be true.
To satisfy those who want low-priced mortgages on terms that private markets would in practicality never endorse, the plan makes explicit the government guarantee on debt which had been implicit for Fannie and Freddie. This would lower the interest rate on high-risk loans, while hiding the cost of what should be a higher priced, higher down payment subsidy.
To address the concerns of those analysts who worry that this in turn would leave the government stuck with mountains of dud loans, a 10% capital cushion must be provided by investors to absorb initial losses. A fee of 0.1% would be charged on all mortgage-backed bonds, with the proceeds going to three funds, two pre-existing, that will provide subsidies for housing. An as-yet undetermined insurance charge will be levied on top. The result, said Mike Crapo, the ranking Republican senator on the committee, “would be a strong step forward” to fixing “our flawed housing system”.
When the plan was announced, the price of shares in Fannie and Freddie, which account for about two-thirds of the mortgage market, did not budge at first. Then they tanked quickly– because investors reached page 387 of the 442-page text and found written in the legislation an earlier 2012 order by the Treasury that expropriated from private investors all profits made by Fannie and Freddie.
The move is unlikely to help attract the private money needed to supply the 10% in equity underpinning bonds issued under the new plan. Although there is need for ‘affordable financing’, legislated financing will not attract private equity. The language in the proposed law points to the fact that lending decisions would be based on political rather than credit criteria. “The result”, says Edward Pinto of the American Enterprise Institute, a think-tank, “will be risky lending for those least able to cope.”
Throughout the proposed law are words such as “affordable”, “equal access” and “underserved communities”, it tries to reconcile two conflicting goals: protecting the financial system and providing low-cost housing loans to favored groups. History has shown that a better approach would be to handle these goals separately and explicitly.
If the legislative branch wants to subsidize affordable housing it should authorize a subsidy program and fund it through appropriations instead of placing parameters for financing subject to political concerns as the legislation currently seems to be written as. A transparent program to subsidize low-income housing is a reasonable price in resetting the standards of housing finance. But to force ‘higher risk financing’ to ease Congress’s conscience is not a sound economical answer. Particularly when the new proposal contains the ‘historical remnants’ of higher risk subprime loans of the previous financial crisis.
What can you do? Contact your legislative representative and question the current proposal. If you don’t then we will face another financial crisis sooner that wanted or expected.
I would suggest that we leave FNMA / FMAC in place with stronger borrower and credit standards. The low entry equity and qualifying programs have proven to be problematic to say the least. Look at what parameters are acceptable to private equity without forcing bad credit on them. The debate should continue, then focus, on safety and soundness protections and whether a federal loan guarantee is necessary. The outcome could be a better housing-finance system for America.