Overhauling the Giants: Fannie Mae & Freddie Mac

Can Fannie and Freddie Be Reformed?

As the Obama administration begins to think about how to ensure the future stability of the housing market, one thing stands out in everyone’s mind. Since Fannie Mae and Freddie Mac had an integral role in creating the instability, minimizing future problems within the mortgage industry should center on adjusting the way they do business. In the wake of the $111 billion bailout, will Congress change anything about how Fannie Mae and Freddie Mac operate in the long run?

President Obama has stated that his administration will begin to address the issue in early 2011. Many of those involved have agreed that it is best to wait until the Federal Reserve’s adjustments to their purchases of mortgage securities have run their course and the First-Time Homebuyer’s Tax Credit has expired. Once the market has somewhat stabilized and the aftereffects of recent changes can be analyzed, the government will be in a better position to form a more educated opinion of how Fannie Mae and Freddie Mac can be reformed and what role they should play in the future of America’s housing market.

The first task for the Obama administration will be to clearly define their goals for their reform of the mortgage industry. So far, several individuals and agencies have publicly announced their ideas for both the end goals and the methods by which to achieve them. Various think tanks are turning their attention to what might be reasonable and practical when it comes to changing the existing system. From a quick look at their suggestions, it will be a very interesting debate.

Hank Paulson, the man who orchestrated the government’s conservatorship of Fannie Mae and Freddie Mac, is in a unique position to have an intelligent opinion of what should come next for the two mortgage giants. The Wall Street Journal reports that his approach would be to shrink and/or combine the two, retain private ownership, minimize any government housing agendas, and create a commission to balance the activity between private and public concerns (similar to the system used by public utilities). Paulson’s opinion is rooted in his belief that the combination of public and private concerns became part of the housing market’s problem and encouraged risky activity at the taxpayer’s expense.

The Mortgage Bankers Association (MBA), with the goal of enhanced regulation of the housing market, proposes that the government break up Fannie Mae and Freddie Mac into smaller privately-owned companies with ability to issue government-guaranteed mortgage securities, while leaving the affordable housing mission to a separate government program. Designed with investor confidence in mind, MBA’s proposal requires that these smaller companies put money into a federal insurance fund which would guarantee interest and principal payments to bondholders in the event of each company’s default, but only in case of emergency, and backed by government funds. The proposal would also support the public utility model and prevent the new companies from holding large portfolios of mortgage securities.

Peter Wallison, in an editorial for the American Enterprise Institute, agrees that Fannie Mae and Freddie Mac should not be left in their original state. Unfortunately, he expects Congress to do as little as possible when it comes down to decision-making time. His Financial Services Outlook outlines four possible paths that Congress could choose from: nationalization (which would increase the federal budget and by extension the national debt), the public-utility structure (which would make rates difficult too regulate based on risk factors - and the budget would still be in trouble), restoration as government-sponsored enterprises (which won’t solve the corruption problem and the public/private combination problem), or privatization (which he says is the best and most unlikely of the four options).

However, according to the Wall Street Journal, the mortgage experts at Credit Suisse reacted to MBA’s proposal by publicly asking that Fannie Mae and Freddie Mac not be dismantled on the grounds that it would disrupt the mortgage market too much. Their solution would include leaving the loan portfolios in Fannie Mae’s and Freddie Mac’s hands for the most part, setting a cap of $500 to $800 billion for those portfolios, and creating a separate entity for absorbing toxic mortgage loans which are currently on Fannie’s and Freddie’s books. They do agree with MBA about a government guarantee for losses, but only above a certain amount.

The Center for American Progress has weighed in on the possibilities, but they have chosen to focus more on a list of financial principles that should guide the government in whatever reforms are undertaken. They say that a sound mortgage financial system should be based on:

• Access to credit and liquidity (with strong primary lending facilities, well-functioning secondary markets, careful but creative innovation, and adequate access to credit for all appropriate forms of housing)
• Countercyclicality (measures to ensure consistent access to credit and liquidity)
• Risk management and oversight (with a level playing field, robust and comprehensive regulation, strong underwriting standards, risk assessment, and capital adequacy)
• Standardization
• Transparency and accountability
• Systemic stability
• Enhanced consumer protection
• Equitable and fair access to credit for consumers and communities

Specific solutions from the Center for American Progress included eliminating lender incentives that are not in the consumer’s best interest, eliminating charter shopping, and implementing a system of fluctuating capital requirements which would increase during times of easy credit and decrease during times of deleveraging.

The National Association of Realtors proposes that Fannie Mae and Freddie Mac be converted into federally-owned non-profit corporations that would leave operations in general alone. Their proposal recommends that the federal government move from implied to explicit guarantees for certain mortgage-backed securities. The NAR would not recommend changes to affordable housing goals or Fannie’s and Freddie’s large investment portfolios, in spite of critics saying that these contributed to the poor decision-making that led to the housing crisis. They suggest that Fannie Mae and Freddie Mac reinvest their profits to be able to lend during lean times, converting them into self-funded institutions. Their proposal would also require that Fannie Mae’s and Freddie Mac’s executives serve fixed terms to keep politics out of the decision-making. The NAR warns Congress to watch for government overlap in FHA and GNMA functions.

The Wall Street Journal has said that the FHA is on the edge of financial losses from housing insurance as well, and is in need of better risk-management policies and better pay for people who know how to implement them. Fannie Mae and Freddie Mac together hold an interest in around 50 percent of U.S. home loans (around $5 trillion), and together with the FHA, that number goes up to 90 percent.

With Congress under pressure to make reforms, the theme seems to be “change the system, but don’t rock the boat”. Should the federal government continue to retain some ownership of the housing market? Should the market be completely privatized for the sake of the national debt? There may be some compromise involved, but until the government has a chance to review the big picture in depth, the proposals for the reform of Fannie Mae and Freddie Mac remain on the table.