Are We Nearing the End of Fannie and Freddie?

WASHINGTON – Talk of housing-finance market reform seems close to action as various proposals promise to move forward the national debate about the future of Fannie Mae and Freddie Mac.

Four decades ago, Congress set up Fannie Mae and Freddie Mac as government-sponsored enterprises (GSEs) – privately owned financial institutions established by the government to fulfill a public mission.

The two GSEs were created to provide a stable source of funding for residential mortgages, including loans on housing for low- and middle-income families. Fannie and Freddie fulfill that mission through their operations in the secondary mortgage market. The two companies buy mortgages that meet certain standards from banks and other loan originators, pool those loans into mortgage-backed securities that they guarantee against losses from defaults on the underlying mortgages, and sell the securities to investors.

Fannie and Freddie also buy mortgages and mortgage-backed securities – from each other and from private investors – to hold in their portfolios. Since their creation, the implicit government backing allowed them to fund their portfolio holdings at much lower interest rates than those paid by private finance institutions, which made it easier to make money by purchasing home loans. That meant generous salaries for executives and hefty returns for shareholders. Some of those benefits flowed to mortgage borrowers in the form of greater availability of credit and slightly lower interest rates.

The two companies dealt mostly with standard, 30-year, fixed-rate loans, which are common in the U.S. but rare elsewhere. But then in the mid 2000s, subprime lenders came on the scene, making loans to people with poor credit histories. As Fannie and Freddie began losing market share to investment banks, the two companies joined the subprime industry. They started accepting lower credit scores, stopped requiring proof of income from all borrowers, and invested in securities made up of subprime loans. A high percentage of these subprime mortgages had an adjustable rate. After U.S. house prices peaked in mid-2006 and began their steep decline, refinancing became more difficult. As adjustable-rate mortgages began to reset their values at higher interest rates mortgage delinquencies soared.

A couple of years later, Fannie and Freddie were on the brink of bankruptcy after the mortgage market came crashing down. The majority of Fannie and Freddie’s losses were a result of guaranteeing mortgages that defaulted during the housing crisis. The government seized them later in 2008 and pumped in approximately $187 billion in bailout money with the goal of eventually getting rid of them. The companies now back around 90 percent of mortgages in the U.S.

Recent housing finance reform proposals all suggest a greater role for private lending and finally putting an end to the two companies. The bill that the House will consider this fall proposes a housing-finance market primarily operated by the private sector. The Senate rival to the House bill keeps the government in control of housing finance but to a lesser degree.

In a speech in Arizona last month, President Obama joined the debate by proposing to wind down the two mortgage giants by rolling back the role of the GSEs in buying mortgages from lenders. He endorsed the bipartisan push of legislation from a Senate group that would phase out Fannie and Freddie over five years.

“For too long, these companies were allowed to make big profits buying mortgages, knowing that if their bets went bad, taxpayers would be left holding the bag,” the president said. “It was ‘heads we win, tails you lose.’”

The Senate bill, sponsored by Sens. Mark Warner (D-Va.) and Bob Corker (R-Tenn.), would shrink the portfolios of Fannie and Freddie and lose the implicit guarantee of a federal government bailout. It would create a new federal entity modeled after the Federal Deposit Insurance Corporation (FDIC) to provide a smaller share of government-backed securities than the current market.