Could Fannie and Freddie Disappear?

One year after the government officially took control over Fannie Mae and Freddie Mac, that is the question everyone is asking. The companies have racked up a combined $165 Billion in losses over the last couple years, and already burned through $100 Billion in taxpayer-financed aid. Altogether, the government now has $400 Billion exposure to Fannie and Freddie.

It’s quite clear that something has to be done. A new report by the Mortgage Bankers Association (MBA) recommends that the two companies be split into three smaller entities and continue to perform the same role that they do now. Under the proposal, the new firms would bear all of the direct risk from owning/underwriting mortgages, but would still enjoy some form of government guarantee. It’s not clear how this structure would facilitate stability, though it would probably increase transparency.

An unrelated report by the Government Accountability Office (GAO) examines the three options for Fannie and Freddie without actually offering an opinion as to which one is most advantageous. It is quite critical of the MBA proposal, arguing that “Creating ‘reconstituted’ for-profit government-sponsored enterprises, either publicly traded or owned by lenders, ‘could lead to even greater moral hazard. ‘ ” The alternatives – elimination, privatization, or full government takeover – however, are equally fraught with complications. Without Fannie and Freddie, it’s unclear how the mortgage markets would function, while a government takeover would probably result in a downsizing of their lending portfolios.

Before I continue, I want to stop and explain the role that Fannie and Freddie play in mortgage lending. Namely, the two firms act as liquidity providers, by using shareholders’ equity to purchase huge portfolios of securities mortgages (Mortgage-Backed Securities). And when I say huge, I mean it: “The companies, which own or guarantee about $5.4 trillion in U.S. residential debt and have accounted for about 70 percent of all new home loans this year.” By acting as the largest buyers, they enable mortgage lenders at the ground level to originate new loans, confident that they can be quickly repackaged and sold.

At this point, it seems the most likely scenario is that which was proposed by the MBA. It’s hard to understand how this represents a solution, but I guess it’s like the old joke about democracy: “It’s the worst system, except for all the others.” In other words, Fannie and Freddie have become the fulcrums of the mortgage lending industry, so their disappearance would be accompanied by a massive decline in new mortgage origination.

There are certainly analysts and policymakers that would argue this is a desirable outcome. The government has no business – explicitly or implicitly – playing with mortgages. If the government formally exited the mortgage lending industry (except to serve as regulator), it would probably lead to better risk management, since investors would have to assume the full risk of owning mortgage backed securities.

In addition, some of the slack caused by their disappearance would probably be picked up by private investors, since a portion of the capital currently invested in Fannie/Freddie would presumably be diverted to firms with similar interests. At the very least, it seems lending standards would tighten and interest rates would rise, but both of these phenomena have already started to obtain.

From the standpoint of current mortgagers, this won’t affect you much. Refinancing could prove more complicated, but it wouldn’t affect the terms of your current loan. For potential borrowers, it would most likely make it both more difficult and more expensive to obtain a mortgage. It’s tempting for me to urge you to preemptively go take out a mortgage lest the system changed tomorrow, but this is extremely unlikely, as the GAO estimates ” ‘potentially lengthy transition’ given their size.”

In other words, don’t let this affect your decision one way or another.