Querin Law: Fannie, Freddie And The Future (Part Two)

iStock_000010654155Small“…the Obama administration may represent “Peak Left” in American politics, and what we are getting from the left these days is a mix of bewilderment and anger as it realizes that this is as good as it gets. America is unlikely to go farther to the left than it went in the wake of the Iraq War and the financial crash, and while that wasn’t anywhere near enough of a shift for left-leaning Democrats, the country has already moved on.” ~Walter Russell Mead writing online for the American Interest, Dec. 19 [as quoted in the Wall Street Journal’s Notable & Quotable: ‘Peak Left’ for Democrats]

Fannie and Freddie [collectively “the GSEs”[1]] are the two major players in the secondary mortgage market, whose role is to purchase qualifying residential loans made by banks to homebuyers.  In that way, the banks get money back to make more and more residential loans.

When the GSEs were making money hand-over-fist, they were the darlings of Wall Street.  But that ended abruptly in 2008, when the financial crisis nearly bankrupted them, resulting in the feds stepping in and taking them over.  For several years thereafter, while on life support, the GSEs were costing the American taxpayer billions. Since then, Fannie and Freddie have been regarded by some as pariahs.

Of late, Fannie and Freddie are no longer in ICU, and have been spinning off billions of dollars in dividends, which the federal government has gratefully taken for its own coffers.[2]  While there is no question that the GSEs were a major player in the lead-up to the financial crisis and Great Recession, it should not be forgotten that Fannie and Freddie did not act on their own; they were following the political directives of various politicians to lower the credit bar under an affordable housing mandate.

Now that the dust has settled, and we’re moving away from backfilling the gaping holes in the economy, attention is now being focused on what to do with the “toxic twins,” as they were called in a recent Wall Street Journal op-ed piece, titled “Life Without Fannie and Freddie.”

The Congressional Budget Office (“CBO”) recently addressed the GSEs’ future.  An interesting discussion of the issues is found at www.valuewalk.com [“The CBO Takes On Fannie Mae, Freddie Mac Reform”]

According to the article, the GSEs’ future will follow one of four courses:

  1. A single federal agency that guarantees the mortgage-backed securities[3] sold to large private investors;
  2. A hybrid system whereby private investors and the federal government share the risk with private investors in the “first loss” position;
  3. A “mostly private” secondary mortgage market with the government assuming “the role of guarantor of last resort” when it is necessary to do so “…to prevent the housing market from collapsing”; or
  4. An entirely private market “with no federal involvement.”

In the Journal’s “Life without Fannie and Freddie” article, it is clear their editorial board would like to see the government entirely out of housing, subject only to possibley retaining the FHA programs, which would still have government backing.

Under the scenario sketched out by CBO, as the toxic twins disappear, private investors could once again take a leading role in the market. But the Federal Housing Administration would still exist to subsidize first-time home buyers and CBO figures they would soak up a portion of the business that used to belong to Fan and Fred. So the taxpayer wouldn’t be entirely out of the woods.

CBO estimates that, under current policy, FHA loan volume over the next decade will be more than $2.2 trillion for single-family mortgages, and more than $3 trillion if Fan and Fred are phased out. But if that transition succeeds, why couldn’t private investors also replace taxpayers in the FHA market segment?

The housing lobby likes to pretend that 30-year fixed-rate mortgages would hardly exist without a federal guarantee, or would only be available to borrowers at extremely high prices. CBO’s report makes it much tougher to sell that fairy tale.

This could be helpful to Rep. Jeb Hensarling and other Republicans who want to put Fan and Fred out of our misery in the new Congress. Such an effort will be difficult given the housing lobby’s hooks into both political parties, but the reformers have the evidence on their side. Even the Keynesian economists who run CBO recognize that the U.S. can have a vibrant, affordable housing market that better protects taxpayers against the systemic risks known as Fannie and Freddie.

Conclusion.  Now that the Republicans will control both houses, 2015 may be a pivotal year in shaping Fannie and Freddie’s future.  My take is that in order to secure buy-in from the left, the result will be a blended federal/private system, with the private market, take the “first loss” position. For more this topic, see my post here. ~PCQ

[1] “GSEs” stands for “Government Sponsored Enterprises.”  They were private corporations specially created by the federal government, and due to this provenance, have been regarded as having the implicit “guarantee” of the government should they fail.

[2] The sub rosa story here is that private shareholders have been completely shut out.  See WSJ article here.

[3] These consist of the mortgage loans bought by the GSEs, then bundled into securities and sold in pieces to large pension funds, and municipalities, and others.