What Should Be Done With Fannie Mae and Freddie Mac?

December 18, 2013

Actually, that is the easy question. There seems to be an almost universal consensus that the agencies should be phased out, and there are many different ways to do this. Perhaps the cleanest would be a gradual but preset reduction in the maximum size of loan that the agencies are authorized to purchase.  

The reason that this phase-out plan, or any other, has not been adopted is that we need the agencies to keep the housing and mortgage markets from collapsing. The tough question is not how we phase out the agencies but how we replace the market support they now provide.  

Right now, there is no game plan for replacing them. We are just drifting, one more example of Federal Government dysfunction. Unless we develop an effective game plan for replacing them, Fannie and Freddy will be with us indefinitely.   

We lost our chance to do it the easy way. A phase-out of the agencies before the financial crisis would have been matched by a self-generating phase-in of the private sector. The fixed-rate mortgages that the agencies could no longer purchase would have been sold into the then-thriving private secondary market. The overflow of adjustable rate mortgages would have been placed in the portfolios of the major depository institutions, who viewed them as prime assets with manageable interest rate risk and cross-selling potential.  

Both of these outlets, which would have required nothing of Government, are now effectively shut. The private secondary market remains traumatized by the heavy losses sustained on private mortgage securities following the crisis. The depositories remain traumatized by the heavy losses they have sustained, and are still sustaining, from being held legally liable for misdeeds committed prior to the crisis.  

In its zeal to punish those considered responsible, the Federal Government has fundamentally altered the risk/reward calculus of those institutions going forward. They now view home mortgages as carrying high political risk. They will not be fund sources in the new housing finance system that must emerge to replace Fannie and Freddie. 

The other mortgage lenders in our system today are mortgage companies that originate to sell. They will continue to be needed to originate conventional loans for sale to Fannie and Freddie, and FHA loans that are sold to issuers of GNMA securities. Because they do not have permanent funding capacity, they cannot fill the void left by a phase-out of Fannie and Freddie. However, they could convert themselves into mortgage banks of the type described below, which would give them permanent funding capacity. 

One of the benefits of a financial crisis is to reveal the types of institutional arrangements that are not sufficiently robust to weather the storm, and those that are. Fannie and Freddie fall in the first group, while the Danish system of mortgage banks belongs in the second. These banks, privately owned but regulated by the state, have existed for several hundred years. They originate mortgages and fund them with mortgage bonds for which they retain full liability.  

While Denmark was subject to a housing bubble, and a subsequent collapse in home prices similar to that of the US, there was no crisis there and no breakdown in the market for mortgage bonds. During the worst phases of the financial crisis in the US, it was business as usual in the Danish mortgage market. Indeed, there has never been a default on a Danish mortgage bond.

The reason the Danish mortgage bond system weathered the crisis and the private mortgage-backed security system in the US collapsed is not difficult to understand. A Danish mortgage-bond is a full liability of the bank issuing it. This means that if the pool of mortgages supporting one bond experiences a high default rate, all the resources of the issuing bank are available to protect the investors who hold the bonds issued against that pool. Hence, all the bonds issued by one bank stand or fail together, and they never fail.

In contrast, every private mortgage-backed security (MBS) issued in the US had “credit enhancements” designed to allow it stand on its own feet. If nine MBSs had more credit enhancement than they needed and one had less, that one would fail. The surpluses from the nine good securities could not be touched, and the issuer of the security with a deficiency had zero liability.

The Dodd/Frank legislation passed after the crisis took a swipe at this problem by stipulating that under some circumstances mortgage security issuers had to retain 5% of the issue. If that had been done 10 years earlier, it could have had an enormous impact, but to have any impact today more powerful medicine is needed.

Specifically, we need a new system of nationally-chartered mortgage banks, similar to those in Denmark. They could be regulated by the Federal Housing Finance Agency, which currently regulates Fannie and Freddie. Depository institutions would be encouraged to charter mortgage bank affiliates, and existing mortgage companies would be encouraged to convert. Such encouragement might include some temporary Federal assistance in raising the capital that full-fledged mortgage banks require.

This is not the only possible game plan for replacing Fannie and Freddie, but I have not seen any that have been as thoroughly tested as this one. 

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