While You Were Watching Egypt… Obama Proposes To End Fannie And Freddie

Mubarak is ousted! Egyptian citizens saw the culmination of 10 years of mounting frustration of the rule of President Hosni Mubarak finally end last week. The protests in the streets by millions in Cairo and other major cities that started on January 18th came to a head on Friday February 11, 2011 with the resignation of Mr. Mubarak. While it took national riots and massive strikes in Egypt to end the 30-year rule of the country’s president; at home in the U.S. it appears that our own President Obama & Treasury Secretary Geithner will end the more tha
70 year domination of the mortgage market by the Federal government.

Idea so Great it was done twice. Fannie Mae (Federal National Mortgage Association) was started in 1938 under the Roosevelt administration and Freddie Mac (Federal Home Loan Mortgage Corporation) was created in 1970 under the Nixon administration. In short both were created with purpose of increasing the supply of money available for mortgage lending and increasing and especially to increase the money available for new home purchases. Each company implemented their mission by purchasing mortgages on the secondary market from various financial institutions, then pooling the loans together and repackaging them as a single security to be sold on the open (bond) market. However for the past two decades there have been mounting calls withi
Congress and beyond to revamp, reform, or outright end the two companies as each of them were mired in financial scandals that required the change in senior management and restating of their financial condition.

And of course as taxpayers we are all painfully aware that during the 2008 “financial crisis” the music stopped playing and these companies went into Federal Conservatorship at a combined bailout cost of more than $154 billion. Well on February 11, while the rumors of Mubarak resignation turned to truth the Obama administration announced sweeping plans to shut down both of the troubled mortgage giants by 2018 or sooner.1

When he met with the press, Treasury Secretary Timothy Geithner cited the “very broad consensus” that the government should play “a much smaller role” in the housing market. (That is the Treasury’s estimate.)2,3

The end of the housing market as we know it? Since moving into conservatorship on September 7, 2008, pundits, economists, politicians, bankers, and housing industry analysts have all opined what they think should happen to Fannie Mae and Freddie Mac. The Treasury Department’s report offers three proposals to Congress, with the hope of legislation emerging by 2014.1,2,4,5

• Optio
1. The government walks away from the mortgage market except for the FHA (Federal Housing Administration), VA (Veterans Administration) and a few other targeted programs designed to help farmers, low-income, and moderate-income homebuyers.
• Optio
2. The government offers a kind of downside protection. In addition to backing home loans via the entities mentioned in Optio
1, it would also provide “reinsurance” to guarantee private mortgages in the event of a real estate downtu
and/or recession. But the guarantee would only apply in a crisis.
• Optio
3. A variation of Optio
2 that would provide a “reinsurance” backstop for a range of mortgage investments already guaranteed by private insurers. The “reinsurance” would take effect if a private insurer couldn't pay (i.e., if its shareholders were wiped out).
The process. The Obama administration would like to see a five year to seven year orderly wind down of both agencies in a three-steps.2,6
• Step 1. Between now and 2014, the government gradually reduces its subsidy for the housing market. The conforming loan limit for Fannie and Freddie – now $729,000 in some metro areas – is scheduled to shrink to $625,000 in October. In addition, Fannie and Freddie would start to require 10% down for all loans and fees would rise for the government guarantee. This conceptually should price the government out of the market as privately financed mortgages should cost less than government sponsored loans.
• Step 2. Starting around 2013-2014, the federal government will “accelerate the pace of transition” (in Geithner ‘s words) to a mortgage market based in private capital with government intervention occurring only as needed.
• Step 3. This stage depends on Congress. The idea is that by the middle of this decade, legislation emerges spelling out Optio
1, Optio
2, or Optio
3 above in detail and a new law is passed.
The final outcomes, unintended consequences, and differing views. By the end of this decade, it could be considerably harder to buy a home. Once the government gets out of the mortgage market (or at least drastically reduces its role), a major influx of private capital needs to flow into the housing system to replace the federal subsidy, with a wide range of likely possible effects.
• The Treasury department believes that Optio
1 could reduce access to credit for some home buyers, and that it would leave the government without tools to intervene in a future crisis. 7
• The Wall Street journal has a counter belief if the Optio
1 scenario occurs. “If the government stands aside, it would open the way for alte
ative forms of finance, such as covered bonds, that now can’t compete in the U.S. because of government favoritism for the 30 year mortgage model. This would open options for borrowers by increasing the diversity of financing.” 7
• I would say that you could see considerably fewer Fixed Rate Mortgages (FRMs) and more Adjustable Rate Mortgages (ARMs) under Optio
1. In fact, you would probably see fewer FRMs even if Options 2 or 3 were chosen by Congress.
• A 30-year fixed rate mortgage could become significantly more expensive. How much more expensive? In early February, Credit Suisse projected that interest rates on a basic 30-year FRM could rise by up to 2% if Fannie and Freddie disappeared.8
• Big banks could grab a bigger chunk of the mortgage market. Which might place the country back on the too BIG to Fail track all over again?
• Higher mortgage rates could negatively impact home sales - and in turn, home prices.

Or…
To make homes “more affordable” we might see another upswing in various forms of ARMs issued by banks as we did during the 2003-2007 period, which as memory serves has not faired exceedingly well for many borrowers. For now we will all have to wait and see how this new creation takes its final form. Hopefully for better housing market!

Citations
1 – money.cnn.com/2011/02/11/news/companies/fannie_mae_freddie_mac_white_house_proposal/ [2/11/11]
2 – usatoday.com/money/economy/housing/2010-10-21-fannie-mae-freddie-mac-bailout_N.htm [10/22/10]
3 - cnbc.com/id/41529671 [2/11/11]
4 –blogs.abcnews.com/george/2011/02/the-end-of-fannie-mae-and-freddie-mac.html [2/11/11]
5 –nytimes.com/2011/02/12/business/12housing.html [2/11/11]
6 –finance.fortune.cnn.com/2011/02/11/fannie-mae-the-long-goodbye/ [2/11/11]
7 –http://online.wsj.com/article/SB10001424052748704657104576141891006477826.html
8 – cnbc.com/id/41533702 [2/11/11]