Hager: RIP, Fan and Fred
Feb. 16, 2011
C.J. Eisenbarth Hager, senior policy analyst
On Friday, February 11, 2011, Treasury Secretary Timothy Geithner took the patients off life support. While the invalids may continue to breathe for a few more months, they are effectively dead. Rest in peace, Fannie Mae and Freddie Mac.
Not that many will hold vigil until their ultimate passing. Fannie’s and Freddie’s bad reputations are well-deserved. Accounting scams misled us to believe they were a safe investment. This particular scandal was a two-fer for Fannie: the executives who orchestrated this fraud received more than $100 million in bonuses for their extraordinary leadership. Executives received favorable terms on their multi-million-dollar mortgages. And then there was that multi-billion-dollar bailout because Fannie and Freddie were careless on which loans they purchased. Meanwhile, it was a well-known secret that Fannie and Freddie held enviable sway on the Hill and within presidential administrations, regardless of which party held power. All of this was done while they wrapped themselves in the "implicit guarantee" that the U.S. government would protect and assist if ever a financial crisis touched them.
Fannie and Freddie are living their final days as hangers-on and painful reminders of the irrational exuberance of the 1990s and early- to mid-2000s. However, we need to keep in mind that they gained such power and prominence because they helped bring about a stable mortgage finance system that was virtually non-existent 70 years ago. Prior to the late 1930s, the U.S. mortgage finance system was entirely private, and failed to be germane to all but the wealthy. Interest rates were variable and high, maturity lengths were short and often punctuated by a balloon payment, and down payment requirements were steep. In short, mortgages were short term and expensive, and only available to the rich.
Fannie Mae – along with other financial reforms – was created during the chaos of the Great Depression. The country faced high foreclosure and unemployment rates, and falling homeownership rates (sound familiar?). Banks were closing because of the skyrocketing default rates. Congress created Fannie to buy mortgages from lenders in order to provide a more stable financial environment. By selling mortgages to Fannie, lenders were freed up to make more loans. Over time, Fannie – and 30 years later Freddie -- would package together thousands of these mortgages and sell them to institutional investors, such as pension funds, mutual funds, life insurance companies and foreign governments.
For decades, Fannie and Freddie were picky about the loans they purchased: mortgages were modest in size (no jumbo loans) and adhered to strict standards. Fannie and Freddie ushered in uniform and fairly transparent underwriting criteria, which in turn brought about an expansion of homeownership beyond the wealthy. Since the creation of Fannie and Freddie, the U.S. homeownership rate is among the highest in the world.
The past 15 years, however, saw Fannie and Freddie looking beyond their congressional charter to provide liquidity to the housing finance market. They were looking to satisfy shareholders that demanded a higher price per share. Not only were Fannie and Freddie a loosely attached creation of Congress, they were also publicly traded companies. Because of the vague relationship between Fannie and Freddie and the federal government, the investor community assumed the federal government was guaranteeing these loans. And it turns out, it was, but the feds had no cash reserve to pay investors when millions of mortgages went bad. Their demise was born out of tension – to serve the greater good of the American people, or to serve the profit motive. Unfortunately for all of us, the public mission and profit motive were not aligned.
Which brings us to Friday’s death cry. Geithner announced the Obama Administration’s much-anticipated plan of what to do with Fannie and Freddie, which now unambiguously are managed by the federal government. The Administration’s plan calls for a “winding down” of Fannie and Freddie, and letting the private market assume the void. As a nod to Fannie and Freddie’s role in increasing homeownership among low-income families, he said the feds would do what they could to continue to promote affordable housing options for the American people.
Unlike most, I am wistful about Fannie and Freddie’s passing. I have little doubt that I am a homeowner because of the radical transformation they brought about in the U.S. housing finance system; I expect most homeowners reading this blog are likewise beneficiaries. Perhaps Fannie and Freddie are poster children for an important role of government – to step in when the private market fails, engineer innovations and prove it can be done, and then let the private sector improve on these innovations.
However, in the current housing marketplace there are still many losers, those that the private market has failed. We look no further than the rental market, where the federal government has largely relied on the private market to provide affordable housing stock. Rental voucher holders have a tough time finding places that will accept a federal voucher for part or all of the rent; this is especially true in markets where rental housing is scarce or where rents are particularly high. In many communities families will be on the wait list for a rental housing voucher for years. The Low Income Housing Tax Credit Program – the main conduit through which affordable rental housing is produced – has been successful in increasing the number of affordable rental units, but the units are required to be affordable for only 15 years. Once that time expires, rents can be raised (and often are) to market-rate, thereby pricing out many low-income families.
And we know, the private market doesn’t have a sterling record on the residential mortgage side, as evidenced by the wrongdoings that led to Fannie and Freddie’s taxpayer financed life support.
While the private market will gladly assume a larger role once Fannie and Freddie are dead, there will still be losers. The Administration’s hope is for the Federal Housing Administration to pick up the secondary market slack by providing mortgage insurance for first-time and low-income borrowers. The plan admits that homeownership isn’t for everyone and that more needs to be done on the rental side, but offers few details and no concrete funding source. There are a number of gaping holes in their approach, and regardless of how we cut it, if you are poor or hope to purchase your first home, things have started to look a little less rosy for your housing future.
Rest in peace, Fannie and Freddie.