What happens if Fannie (FNM) and Freddie (FRE) disappear?

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What happens if Fannie and Freddie disappear?
Changes coming for agencies that stand behind most U.S. home loans

By Amy Hoak, MarketWatch
Last Update: 6:37 PM ET Aug 13, 2010

CHICAGO (MarketWatch) -- Fannie Mae and Freddie Mac may be effectively insolvent, but they're backing over half of all U.S. mortgages. That has some people worried.

The two government-owned enterprises stood behind 62% of new home loans this year, compared to 27% of new loans in all of 2006, when the private mortgage market still thrived, according to Inside Mortgage Finance. Add in Ginnie Mae and nine out of every 10 mortgages are supported by the government.

"Right now, the market is almost entirely dependent on Fannie and Freddie and also Ginnie," said Michael Lea, head of San Diego State University's Corky McMillin Center for Real Estate.

Why should you care? Since the government seized Fannie (FNMA) and Freddie (FMCC) in 2008, it essentially owns the two GSEs. If the economy deteriorates further and mortgage defaults rise again, taxpayers will be on the hook for the losses. At a time when government debt is rising, that worries a lot of people.

"Clearly, it doesn't benefit the housing system overall -- or the government -- to have a mortgage market that is almost exclusively government-backed. We have to talk about a way to bring the private sector back into the mortgage market," Cecala said.

Delicate balance

But if the government pulls back too quickly, it could trigger another housing crash -- just when this fragile market seems to be getting back on its feet.

The Obama administration plans to hold a conference Tuesday on how to reform the U.S. housing finance system, with Fannie Mae and Freddie Mac center stage. Legislators, academics and community activists will be looking to strike a delicate balance between reducing government involvement and preventing another market swoon. See related story on political wrangling over future of Freddie Mac and Fannie Mae.

Many scenarios are in play. The agencies could be disbanded in favor of new entities, or be split into two pieces -- a "public" securitization function and a "private" mortgage investment portfolio, said Keith Gumbinger, vice president for HSH Associates, a publisher of consumer loan information.

In the public-private scenario, the private component would become fully private over time, with the government slowly removing its support for that private portion, he said.

While many industry watchers believe changing the housing finance giants is necessary -- and that the federal government shouldn't play so large a role in the mortgage market -- they also agree that, given how shaky the housing market is, any major changes won't come immediately.

"We need to give some consideration before we pick up and disturb what has been crucial support of the mortgage market," Gumbinger said.

Given that there isn't much of a private mortgage securitization market, "the only thing you can do now is small, incremental changes that will get you where you want to be in five or 10 years," Cecala said.

For borrowers, that means any changes to Fannie and Freddie that would affect their pocketbooks likely would materialize slowly.

"We don't want to do anything that makes things worse," Cecala said.

Small steps

Although Freddie and Fannie are almost single-handily propping up the market, such government involvement in the securitization of mortgages isn't sustainable, Lea said. But right now, there's also not much choice, with investors still too jittery to trust paper that isn't backed by the federal government.

"There's not a lot of alternative credit out there," Lea said. "We're stuck with probably 90% [of mortgages] backstopped by the government for the next few years."

Many components of the new Dodd-Frank financial-reform law are aimed at restoring investor confidence in the mortgage market, particularly the non-agency market, Cecala said. Still, it's going to take some time before Fannie and Freddie can scale back from their current roles.

"At this point, no matter what we do to create a non-agency market, it's not going to get legs until investors are going to support it and believe the risks are gone," he said.

One small step that could reduce Fannie and Freddie's share soon: The government could reconsider current conforming loan limits -- still temporarily elevated due to the credit crisis -- and decide to dial those back, Cecala said. The loan limit is now up to $729,750 in certain high-cost areas.

Loan limits were temporarily raised to improve consumers' access to credit -- and lower the cost of credit -- in areas with higher home prices. A loan larger than the conforming limit is considered a jumbo mortgage, and not eligible for securitization by Fannie and Freddie. So jumbo loans cost more.

"Clearly, a first step would be to dial that high-cost loan level back, to allow it to expire at the end of this year," Cecala said. "It should be part and parcel of the housing finance debate -- what should the loan limits be. Those loan limits have defined how much a market share and how big a presence Fannie and Freddie are."

Higher mortgage rates

Mortgage rates overall may rise if Fannie and Freddie's role in the market declines, according to Radhakrishnan Gopalan, assistant professor of finance at Washington University in St. Louis.

That's because right now there's "almost full government support for all things mortgage and housing," Gumbinger said in an email. "When those supports diminish or disappear, private market entities will most certainly want to be compensated better for accepting the risks of investing in the housing market. Backed by taxpayers, the federal government may be able to run markets at a perpetual loss, but that's not how it works in the real world."

Tight underwriting?

Tighter mortgage underwriting currently espoused by Fannie and Freddie -- from credit score requirements to conditions for certain types of properties, especially condos -- might not budge much in the near term, many agree. Most mortgage money likely would remain reserved for borrowers with substantial down payments and sparkling credit histories.

"The irony is that if you're really concerned about the health of the housing market and want to see it recover for the broader economy to recover, you should be making it easier to obtain credit. We're doing the opposite," Lea said. "We're actually, in some respects, slowing or stifling the housing recovery by restricting the flow of credit. It's the classic closing the barn door after the horses are gone."

Still, from a historical perspective, current underwriting standards aren't that restrictive, Gumbinger said.

"You could call them overly restrictive, but they're probably only somewhat restrictive when you look over time," he said. "Go back to the '80s, the '90s, they're not that far off normal. If you're comparing to '06, when you could walk in and breathe on an application to get a loan, they're strict."

'White, rich people'

One other potential question in the remaking of Fannie and Freddie: Whether they should have a public purpose to reach out to lower-income and minority borrowers, those underserved by today's broader mortgage market, Cecala said.

"If the government is going to support housing and mortgage finance, shouldn't the government be targeting the efforts to the people who wouldn't normally get it?" he asked. "Are we happy with a mortgage finance system that favors white, rich people?"

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Legislative battle on horizon for future of Fannie and Freddie
White House continues work on developing housing-reform proposal for 2011
By Ronald D. Orol, MarketWatch
Last Update: 6:27 PM ET Aug 13, 2010

WASHINGTON (MarketWatch) -- Now that the most sweeping financial reform bill since the Depression is law, Washington is finally getting around to dealing with the hard part: Fannie Mae and Freddie Mac.

But even as the Obama administration prepares for an Aug. 17 conference on the U.S. housing finance system, lawmakers on Capitol Hill are preparing to battle each other and the powerful housing lobby over the future of the mortgage-finance giants.

The goal of the conference is to come up with a system that would win the support of enough lawmakers on Capitol Hill to pass while also ensuring a fully functional housing market that doesn't rely on taxpayer backing -- even in a severe economic downturn.

It's a tall order. Many Republicans want to fully privatize the two entities altogether, while numerous Democrats want to enshrine a permanent government agency -- or agencies -- to buy and sell mortgages and mortgage securities.

"Conservatives are saying the government should be out of the business altogether and they should be privatized to compete in the private market," said Bob Kuttner, senior fellow at research and advocacy group Demos in Washington. "Democrats say if the government is going to run it, it should be a government agency and have set standards."

Treasury Secretary Timothy Geithner is seeking a middle ground where the government would continue to offer some type of federal guarantee of mortgage loans to ensure that U.S. borrowers can easily finance the purchases of homes. But he has yet to provide specific details. Read Geithner's comments.

Among the obstacles for any agreement are the mid-term elections, fresh fears that the economy will fall back into recession, and the still precarious state of the housing market fully two years after the onset of the credit crisis.

Still, the administration is working to develop a proposal with the aim of delivering it to Congress by early next year.

Crucial players
Practically all new U.S. mortgages are guaranteed by Fannie Mae (FNMA) and Freddie Mac (FMCC) and the Federal Housing Administration. Since the credit crisis began the Federal Reserve has purchased $1.1 trillion in agency mortgage securities as a means of propping up the market and keeping loan rates low.

As the financial crisis intensified in September 2008, Fannie and Freddie were essentially nationalized to avoid losses and stem the credit contagion. They were taken over by the government in a conservatorship. Roughly $145 billion in taxpayer funds have been used to cover their losses.

Before their downfall, Fannie and Freddie were hybrid government-sponsored quasi-private entities that purchased whole mortgages, mortgage securities and asset-backed securities from banks and other direct lenders, packaged them, and sold them back to private investors as mortgage backed securities. The system was designed to ensure that adequate capital was available to banks and other financial institutions that lend money to home buyers.

However, starting in the 1990s Fannie and Freddie dramatically raised the risk they took on their balance sheets, and eased their underwriting standards, at the behest of lawmakers seeking to make home ownership possible for less qualified Americans.

Their expansive purchases -- along with risky loans taken on by private mortgage investors -- helped drive the subprime boom and bust that took the economy to the brink in 2008.

Partial consensus
Despite the divergent views, lawmakers actually are moving towards agreement that Fannie and Freddie should stop borrowing heavily from the capital markets.

"There is a broad bipartisan mood to get rid of their portfolio activities and that was impossible seven years ago," said Mark Calabria, director of financial regulation studies at the CATO Institute in Washington. "The ground has shifted a lot."

Instead, Geithner and other Democrats seem to be moving in the direction of turning Fannie and Freddie into much smaller entities that buy individual mortgages, pool them and sell them back into the market to private investors who would pay a fee for a government guarantee of the security, argues Ted Gayer, fellow at the Brookings Institution in Washington.

It's that guarantee that lies at the heart of the debate over Fannie and Freddie's future.

Republicans who don't back a fully private market are likely to push for a government guarantee that is available for any corporate mortgage investor packaging loans, not just Fannie and Freddie.

"Are you going to say these are government agencies that package mortgages and sell them with a guarantee or are you let the government sell a guarantee to any institution?" Gayer asked.

Without such a guarantee, selling mortgage backed securities will be harder, if not impossible, and the flow of capital into the housing market will falter, crushing housing values again.

Calabria added that some sort of government guarantee is likely because of the influence of the housing lobby, including the Mortgage Bankers Association, the National Association of Realtors and the National Association of Home Builders, who have been pushing for some sort of government backstop.

However, he argues that any sort of government backstop is a bad idea because it would subsidize mortgage risk, leading to further taxpayer losses.

"The housing industry is dead set on having guarantees," Calabria said. "They will continue to have considerable sway among Republicans and Democrats."

Fighting efforts to keep a government guarantee in place, a small contingent of conservatives, led by Rep. Jeb Hensarling (R., Texas) are seeking to wind-down Fannie and Freddie to an eventual point where they are fully private sector companies competing "on a level playing field" with the private industry. So far, his bill, "The GSE Bailout Elimination and Taxpayer Protection Act," has attracted 21 co-sponsors in the House.

Other issues
The policy debate over Fannie and Freddie will also be intense over other issues including:

The quality of any loans Fannie and Freddie will still be allowed to buy

Whether mortgage investors should be charged higher guarantee fees for riskier pooled mortgages and lower fees for plain-vanilla mortgage securities

Whether the companies should be broken up into smaller units to minimize the impact to taxpayers and the economy of any one of them failing.