Winding down FNMA and FHMA

Where are thirty year home loan rates going?

I get this question weekly. If I knew, I would have gotten lot better grades in quantitative math (confession: I never took quantitative math). Since the QE3 announcement nearly three weeks ago, rates have fallen. The average rate for a conforming loan (a conforming loan is home loan that conforms to FHA and FNMA guidelines) last week was 3.4%, while a jumbo loan went for 4.1%.

Given all the current economic issues, rates will probably keep falling – but not all rates. As you’d expect, the spread between conforming and jumbo loans has again widened – the Fed is buying securities backed by conforming loans, not jumbo loans.

Remember two things when thinking about rates on home loans. The first is that QE3, or “QE Unlimited” involves the purchase of agency securities, not jumbo, Alt-A, or portfolio. The second is that at some level a bank, or other investor, will not want to own a 30-year security yielding next-to-nothing. Everyone should remember when S&L’s were earning low rates on their investments but were having to pay out higher rates to depositors. That is a no-win situation. This was one of the reasons for the demise of that whole industry, for those of us under the age of 35 that are reading this.

So what will happen to FNMA and FHMA?

The administration is planning to wind down Fannie Mae and Freddie Mac over time (the next five to seven years) and replace their functions with new regulation and private sector capital. The U.S. Treasury in August (8/15/12) revamped the bailout of Fannie Mae and Freddie Mac to curb chances the giant mortgage finance firms could emerge from government control as the powerful, profit-driven corporations they once were. The Treasury said it would require the companies, whose massive losses threatened the financial system after the housing bubble burst in 2007, to shrink their investment portfolios more quickly and turn over any profits to taxpayers.

Previously, the companies, which buy mortgages from lenders and repackage them as securities for investors, were required to make a ten percent dividend payment to the Treasury. At times, they had to borrow from the Treasury just to make the payments. Now, they simply won’t be able to retain any profits. The new terms mark the latest step in Fannie Mae and Freddie Mac’s fall from grace. The two companies were highly profitable and politically powerful as the U.S. housing bubble built. Now, most officials think they should be dissolved.

Fannie Mae and Freddie Mac were seized by the government at the height of the financial crisis in 2008 as mortgage losses threatened their solvency. Since then, they have drawn a total of $188 billion in taxpayer funds to stay afloat, while paying more than $45 billion in dividends.

At the start of next year, the unlimited support the Treasury extended to the two companies will expire. After December 31 2012, Fannie Mae’s bailout will be capped at $125 billion and Freddie Mac will have a limit of $149 billion.

The companies’ corporate debt price rallied over the past year as the new policy alleviated the need for Fannie Mae and Freddie Mac to borrow from the government just to make dividend payments, putting them in a better position to service their debt. However, their preferred shares lost more than half their value in heavy trading as investors saw the plan as undercutting the ability of either company to ever emerge from government conservatorship as profitable entities. Their common shares also fell.

With the U.S. housing market showing signs of improvement and Fannie Mae and Freddie Mac reducing their portfolios of loans with poor credit quality, the government-controlled companies posted strong profits in the second quarter of 2012. The Treasury said the altered bailout terms would ensure that “every dollar of earnings that Fannie Mae and Freddie Mac generate will be used to benefit taxpayers for their investment in those firms.”

Although the Treasury said the changes would accelerate plans to eventually shut the companies down, the announcement did little to address how that might be achieved or how the government’s footprint in the mortgage finance market might shrink. Fannie Mae, Freddie Mac, and the Federal Housing Administration finance nine out of every ten new home loans.

Early last year, the administration proposed three options to reshape the housing finance system, ranging from privatizing the market almost entirely to allowing the government to insure certain mortgages. But the administration has never provided detailed plans on how to move forward. While all parties agree on the need to reduce the government’s role in housing finance, they disagree on how sharply it should be scaled back.

The announcement contains some short term surprises that will impact real estate consumers and the housing economy within the next year. Plans from the Treasury Department are for the two government-sponsored enterprises to cease to exist (and with them a legacy of eighty years of direct federal support for housing finance). In addition to marking the official end of the era of ‘everyone should have the privilege of home ownership’ of many previous administrations (where increasing the level of home ownership was a national priority), the document contains a recommended regulatory overhaul of the Federal Housing Authority (FHA) as well as Fannie Mae and Freddie Mac (together known as Government Sponsored Enterprises “GSE’s”) that intends to bring the share of government owned home loans from the current 95% to 40% over the next five to seven years.

Most of their current functions in the marketplace will largely be absorbed by private lenders and investors. These steps are likely to mean higher borrowing costs and more limited access to home loans for consumers. Most of the changes described in the plan require Congressional review and approval before they can take effect. Some are scheduled to take effect in the next twelve months and their impact will be market-wide. Let’s take a look at some of the potential effects.

More Expensive Mortgages

The plan phases in increased pricing at Fannie and Freddie to end their capital advantages over private lenders to “help level the playing field for the private sector to take back market share.” The timing and impact of the increased pricing will depend significantly on market conditions, but the Administration recommends bringing Fannie and Freddie to a level even with the private market over the next five to seven years. The result will be more expensive mortgages for consumers in terms of rates (in today’s market, private backed money would be about 3/8 of a point higher) and larger down payments. However there is hope that once private enterprise is involved (and has a number of years tracking), rates would become more attractive.

Investors have a choice: they could either buy the Fannie/Freddie loans with the implicit guarantee or they could buy private label mortgages with no guarantee. Obviously investors prefer to be guaranteed and so money moved from private label to Fannie/Freddie. This dropped Fannie/Freddie rates somewhat, but it caused private label to rise by even more. It is also the reason that government backed enterprises (GSE’s) had captured over 95+% of the mortgage market.

Lower Loan Limits

Unless Congress steps in, the upper limits on loans that Freddie, Fannie and FHA will guarantee in high cost markets will fall from $729,750 for a single family home (the limit in effect since 2008) to $417,000. This parameters went into effect October of last year. Borrowers needing financing above that limit will be forced to turn to the privately financed jumbo market, where rates and down payments are higher.

Increased Down Payments

The plan phases in a 10% down payment requirement for any mortgage backed by Fannie Mae and Freddie Mac. This requirement will increase demand for private mortgage insurance. Shares of mortgage insurers jumped as high as 11% when the plan was released. The amount required down on a house will be dramatically more than we are used to over the last fifty years.

Higher FHA Insurance

“As Fannie Mae and Freddie Mac’s presence in the market shrinks, we will encourage program changes at FHA to ensure that the private sector – not FHA – picks up this new market share,” states the Treasury plan. In addition to the change in loan limits, the Administration will put in place a 25 basis point increase in the price of FHA’s annual mortgage insurance premium, which is paid in twelve monthly installments. FHA just increased the annual MIP payment to .85 percent last October. The new rate will be 1.1 percent. FHA currently accounts for 30-40% of all new purchase mortgages, and more than half of all mortgages taken out by first-time buyers.

Maximizing homeownership no longer a goal

For the first time since the Depression, the Treasury plan makes it clear that homeownership is no longer a policy goal. “The Administration believes that we must continue to help ensure that Americans have access to quality housing they can afford. This does not mean, however, that our goal is for all Americans to become homeowners. Instead, we should make sure opportunities are available for all Americans who have the credit history, financial capacity, and desire to own a home have the opportunity to take that step,” the plan states. There is concern that the demise of Fannie or Freddie will mean much for affordability.

The plan calls for stronger capital standards to help ensure that banks can better withstand future downturns, declines in home prices and other sudden shocks, without jeopardizing the health of the economy. It also supports several immediate and near-term reforms to correct problems in mortgage servicing and foreclosure processing. These include putting in place national standards for mortgage servicing, reforming servicing compensation to help ensure servicers have proper incentives to invest the time and effort necessary to work with borrowers to avoid default or foreclosure, requiring that mortgage documents disclose the presence of second liens and define the process for modifying a second lien in the event the first lien becomes delinquent, and considering options for allowing primary mortgage holders to restrict, in certain circumstances, additional debt secured by the same property (multiple liens).
Though it is specific on short-term changes, the plan falls short of describing what the federal role in the housing market will look like in future years. The report puts forward several choices for structuring the government’s future role in the housing market without advocating any particular option.

One question that needs to be asked

What would have happened to the U.S. economy had Fannie and Freddie not been in a position to offset the collapse in the private mortgage market? One possibility is that the price of housing would have collapsed. We know that people are still shell-shocked by the decline in housing prices, but while there was a dramatic fall, it was hardly a full scale collapse. Are even bigger collapses theoretically possible? If credit completely tightens then the market will turn to cash buyers and prices will fall to the point where cash buyers can meet forced sellers.

However, an alternative view is that reaching equilibrium faster reduces uncertainty (with the government backing, it has been a slower process than the late 80s/early 90s when values were decided quickly by the Resolution Trust Corporation). Without GSEs, there would have been a larger wave of strategic defaults, but that, on the other hand, would have meant a huge decline in the debt ‘hangover’ for consumers.
Would the private banking sector have been as easily saved without Fannie or Freddie? This we do not know. While it is important to resolve the inaccuracies of the current mortgage concerns, we need to consider the alternatives of no government backing. Without a mortgage lender of last resort, much larger crashes in housing prices are possible.

Before you think this is a done deal there are many groups who like the housing-finance system just the way it is – and are fighting hard to keep much from changing.

Home builders

The last few years have been the most difficult for home builders in the past half century. They are just beginning to recover and are begging and lobbying for a break. New home construction has obviously tanked over the last few years, with plunging sales creating high inventories of unsold homes.
In Texas, most of the volume done by the production builders is GSE business with higher leverage loans. Although mortgage rates remain low by historical standards, the consumer is ‘spoiled,’ expecting low rates. Mortgage rates have not helped builders in the last few months. Demand has been driven by rent versus buy. Also know that builders historically have had a 20% failure rate of mortgage applications. That has unfortunately moved up to a 50% failure rate due to the tougher mortgage guidelines. And as high as 80% for some builders and metros. The quality of applicants has not gotten worse – the underwriting rules are harsher do to the federal governments guidelines on banks. The demise of Fannie and Freddie would effectively reduce government subsidies for mortgages, lowering demand for new homes even more.


They too are looking for relief so they can start making sales again (here in Austin sales were are up 30+% with dramatic improvement the last nine months, but slower nationally). Higher costs for home buyers would harm realtors the same as home builders, by lowering demand for homes. For years, experienced realtors were able to prepare their consumers for the questions that would traditionally come up. This has changed over the last few years with all the changes from the big banks buying the mortgages to level the playing field, with megabanks undercutting them to grab market share. Small banks and credit unions have another powerful argument: Concentrating too much control of the housing market among a small number of huge banks makes the too-big-to-fail problem worse, not better.

Consumer groups

The Consumer Federation of America, for instance, has warned that a reduced government role in housing could cut off mortgages to many families and shift control to “Wall Street banks and investors whose previous missteps have already caused massive foreclosures and losses for consumers.” They may have a good point.
In some areas of the country, high balance conforming loans are plentiful. Every investor has a different policy about these loans, but generally since they can only make up a small percentage of any pool, the pricing is meant to limit production. And the Fed is, as best I can tell, not buying specified pools made up of high balance conforming loans. Some investors change their price or rate adjustments, and lenders should expect to see them continuing to widen out.

The Federal Reserve has done well with their monetary policy, but there is still a ways to go. If we look at QE3, it seems to have helped the overall mortgage rate market to varying degrees. When the Fed “eases”, it buys securities in the open market, reducing supply, thus increasing prices, and thus decreasing yields. Since the Fed doesn’t want to take much risk, they usually buy the safest of securities, such as Treasuries or agency mortgages. QE1 amounted to $1.75 trillion, and started in 2008. QE2 was rolled out in 2010 due to the high unemployment rate and lack of economic activity. But after this second round, our 10-yr hit a low yield of 1.38%, so it definitely had the effect of lowering Treasury rates. Under these programs, for this year alone in fact, the Fed has purchased roughly $360 billion in longer-dated maturities and now controls about 65% of the total gross issuance of all Treasuries available for these maturities. Again, one part of the government issues them, and another part buys them. There could be some fallacy to this thought process. And you can see why critics say this is ludicrous.

And now we have QE3, with the Fed buying $40 billion of agency loans per month. Depending on whom you ask, this is about all of, or twice, the amount being originated by mortgage companies per month. But if you’re a institutional investor, pension fund, or a community bank, where a sizeable percentage of your security portfolio is made up of MBS, this sharply reduces investment options. You’re in it for the spread. If you’re paying .25% on your deposits, and earning 3.25%, that is okay. But if rates slide higher, and suddenly you have to pay 1, or 2, or 3% to your depositors, owning a large amount of MBS paying 3.25% won’t work. Yes, some of this spread risk can be hedged (protected), but that can be costly.

Will banks become more interested in riskier assets to help generate revenue? In all likelihood, yes – but isn’t that what got us in this mess in the first place? Mortgage banks and community bankers are under severe pressure, given the significant cost of additional regulation, extreme competition, and the impact of changes on the industry (Dodd Franks, Basel 3 and not to mention a weak lending environment). Now, although many are still into MBS’s, they have to look at moving away from government backed securities toward structure, credit, or interest rate risk to generate a return. Unfortunately, there is no easy path when yields are stuck at such low levels in the market.

So, back to the original question – where will rates go? They should stay low for at least through 2015.

What happens to FNMA, FMHA, etc.? Politicians want them gone. This analyst is not so sure that is the prudent thing to do. Equity and investors have not stepped up to lend as the government wants them to do, so government backed entities will have to stay in the fight in some shape or form. What will happen? We will have to watch and see.