Given the task of producing a plan to develop a new housing finance system after the crisis of 2008 and the failure of both Fannie Mae and Freddie Mac—a task that everyone agrees will be extremely complex—the Obama Administration decided to punt. Rather than one detailed plan, it produced brief summaries of three very different ones, leaving the nation to wonder what the Administration really wants.
The report clearly supports ending both Fannie and Freddie, but what happens next is very unclear. The three proposals for the future after Fannie and Freddie deal with the role of the federal government in providing housing finance. Of them, the first essentially calls for no role at all, leaving the matter in the hands of the private sector. This is clearly the best proposal of the three. In their words, it “would minimize distortions in capital allocation across sectors, reduce moral hazard in mortgage lending and drastically reduce direct taxpayer exposure to private lenders’ losses” (page 28).
However, the Administration signals that it really does not like this option, claiming that it will cause mortgage rates to increase, make traditional 30-year mortgages “more difficult for many Americans to afford,” and make it harder for smaller financial institutions to compete with larger ones.
This criticism is somewhat valid, but misrepresents the facts. No matter what, mortgage costs will go up as interest rates rise, and a return to proper underwriting standards simply means that people without sufficient assets or income to pay their mortgages will not get one.
Another key point often conveniently left out of the discussions is that while in the past, mortgages appeared to be cheap, when the $150 billion in taxpayer dollars needed so far to pay for losses at Fannie Mae and Freddie Mac and the severe drop in home value because of the 2008 crisis are factored in, the actual cost to homebuyers and taxpayers is much higher than what appeared on their monthly mortgage bills.
Obama’s other two options for the world after Fannie and Freddie take the wrong approach. One calls for a backstop federal facility that would provide mortgage credit in an emergency, while the other calls for a continuing government presence in the mortgage finance market that is very similar to what Fannie and Freddie do now. Neither is a viable option, and the ultimate result would likely be yet another bailout in a few years.
Inasmuch as the Administration punted with its presentation of three different options, it does tip its hand about the preferred road when it says, “As Fannie Mae and Freddie Mac are wound down, we must design a transition that allows for continued support of the housing market, so that Americans continue to have the ability to take out a mortgage to buy a home or refinance their existing mortgage” (page 23). These are steps that all policymakers must guard against.
The one bit of good news is that the Administration proposes measures that will “ultimately wind down” both Fannie and Freddie using practical methods. It appears that their goal is to complete the process in five to seven years, which is achievable and gives the private sector time to replace them while avoiding any immediate change that could shock the still-weak housing market.
The report makes it very clear where the fault for Fannie and Freddie’s failure lies, saying that “as their combined market share declined—from nearly 70 percent of new originations in 2003 to 40 percent in 2006—Fannie Mae and Freddie Mac pursued riskier business to raise their market share and increase profits. Not only did they expand their guarantees to new and riskier products, but they also increased their holdings of some of these riskier mortgages on their own balance sheets” (page 7).
In addition to the three options for Fannie and Freddie, the report includes several other needed housing finance reforms. Many of these are already being implemented, so their inclusion here is more a reminder than a call to action. These include better underwriting standards for mortgages to reduce the possibility that low-quality mortgages will again contaminate mortgage-backed securities and improved consumer protection designed to ensure that workers are not sold mortgages that they ultimately cannot afford.
In addition, the Administration proposes to return the Federal Housing Administration (FHA) to its traditional role as a targeted provider of mortgage credit for low- and moderate-income workers. Since 2008, the FHA has played a much larger role in housing markets, and it is likely to sustain higher losses as a result. However, Congress should use this as an invitation to reassess the role of the FHA and its place (if any) in the housing finance system of the future.
Finally, the report brings up the 12 Federal Home Loan banks, which have structures that are very close to those of Fannie and Freddie and are likely to sustain major losses in their mortgage investments. The Administration proposes to refocus the 12 banks to assisting smaller financial institutions and to reduce their portfolio investments. These steps do not go far enough; instead, policymakers should use this as an opportunity to close them down in an orderly fashion.
Of course, the real question is in the details, and for the three future alternatives that the Administration proposes for housing finance, all of them are lacking. Eliminating Fannie and Freddie is a major step in the right direction, The real question is what the Administration would replace them with—the private sector or some clone of the failed government subsidized system that caused so much of the 2008 crash. Congress should ensure that the future housing finance system contains no more Fannie Maes, Freddie Macs, or anything similar.