On Friday February 11, the Obama Administration unveiled its plan to reform housing and wind down Fannie Mae and Freddie Mac. The timing was interesting since over the weekend the President released the 2011 budget which includes budgetary items regarding housing and the cost of loans. Although the passage of the budget is currently a matter of debate, there is no question that we are about to see the greatest remaking of the U.S. mortgage system in 70 years.
The stated goal of the Obama Administration's Housing Plan is to:
"1. Pave the way for a robust private mortgage market by reducing government support for housing finance and winding down Fannie Mae and Freddie Mac on a responsible timeline.
2. Address fundamental flaws in the mortgage market to protect borrowers, help ensure transparency for investors, and increase the role of the private capital.
3. Target the government's vital support for affordable housing in a more effective and transparent manner."
This is a common, recurring theme throughout the document--Fannie and Freddie must be "wound down" in an orderly, responsible manner and we must have "robust private" capital supervised carefully through government oversight. At the end of the paper, the Administration details three possible scenarios for how to effectively accomplish this goal with the pros and cons for the implementation of each, and then invites discussion and in put from Congress and industry participants.
First, however, there is the matter of killing the mortgage giants, which the administration acknowledges must happen gradually over a period of several years to avoid a complete disruption of the housing market. Remember that Fannie and Freddie are providing about 70% of mortgages in the U.S. right now. And the Administration acknowledges that as underwriting has tightened over the last two years, the quality of loans being originated by Fannie and Freddie have improved considerably, so the losses on their books mainly stem from riskier loans taken on between 2006 and 2008.
So let's look at the plan to phase out Fannie and Freddie:
1. Increase the guarantee fees to make conforming mortgages less competitive and reduce the market advantage that Fannie and Freddie have. In other words, conforming mortgages need to become more expensive so that they are not the most attractive option for homebuyers. Remember that one of the suggestions from the think tanks last week was to add a 1% fee to all mortgages originated by Fannie and Freddie to pay into a reserve fund. Typically, these fees are priced into the interest rates and show up as a higher rate to the borrower. With interest rates on the rise anyway, we can expect to see rates for mortgages secured by Fannie and Freddie increase a lot. The Administration's plan states that although the "pace of these price changes will depend significantly on market conditions, such changes should be phased in over the next several years." However, Fannie and Freddie announced a fee increase in January ahead of the Obama Administration's plan, which can lead us to believe that this increase is the first of many.
2. Increase private capital ahead of Fannie Mae and Freddie Mac guarantees. This will come from insurance from private investors, and higher down payments from homeowners. Although the housing plan states that they want loans secured by Fannie and Freddie to have at least a 10% down payment, we know that in reality the FDIC chairwoman Sheila Bair has already given us a strong indication that the new "qualified residential mortgages" which are exempt from risk retention rules will require at least a 20% down payment.
3. Reducing conforming loan limits. Under the Obama Administration's Housing Plan, the higher loan limits established by Congress in 2008 (super conforming mortgages) which allowed borrowers to refinance and purchase homes with mortgages up to $729,000 in high cost areas should be allowed to expire in October of 2011 and the previous loan limits should be reinstated. The previous loan limit was $417,000, and in areas that were not designated "high cost areas" that loan limit remains in place. However, the Administration says that, "We will work with Congress to determine appropriate conforming loan limits in the future, taking into account cost of living differences across the country." That indicates to me that we can expect to see the conforming loan limit drop below $417,000 back to $330,000 or possibly lower as Fannie and Freddie wind down. The purpose of this is to force the larger loans for the more expensive homes to be funded through private markets.
4. Wind down the investment portfolio. The Administration's goal is to wind down the portfolio at a pace of 10% a year. To accomplish this, they need to impose tougher underwriting standards and higher fees. "As the market begins to heal and private investors return, we will seek opportunities, wherever possible, to accelerate Fannie Mae and Freddie Mac's withdrawal." One suggestion from the think tanks was to limit Fannie and Freddie loans to those for primary residences only, leaving second homes and investment properties outside of the portfolio. I think we expect to see new guidelines limiting conforming loans to primary residences in the near future.
What is most interesting to me about this is that the Administration insists that private capital should be able to fill the void left by Fannie and Freddie, while at the same time touting the need for all the restrictions that the Dodd Frank Act puts in place and blaming the entire mortgage community, from originators to servicers, for the problems with the housing market. But the Administration and the authors of the housing plan seem totally unaware of the relationship between risk and reward as part of the free enterprise system. For example, as part of the preamble, entitled "Housing Finance from the Great Depression to the Great Recession" the Housing Plan gives the short history of Fannie Mae, which started in the 1930s and Freddie Mac, which started in the 1970s to compete with Fannie Mae. "Initially, Fannie Mae and Freddie Mac were largely on the sidelines while private markets generated increasingly risky mortgages. Between 2001 and 2005, private label securitizations of Alt-A and subprime mortgages grew fivefold, yet Fannie Mae and Freddie Mac continued to guarantee fully documented, high-quality mortgages. But 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."
In other words, Fannie and Freddie were becoming irrelevant in a mortgage climate with freedom and private capital and so to compete they took on more risk. But the reason that the private markets produced a lot of products was that they could expect a high rate of return for those products. This was capitalism at work. No rules were in place that originators had to retain 5% of the risk of most kinds of mortgages. The government did not dictate what kinds of loans individual homebuyers could get--rather, the lending institutions decided how much risk they felt comfortable assuming. Loan officers and mortgage brokers got out and sold mortgage loans because they could earn a good living, lenders made those loans because they could earn a good living, and Wall Street packaged and sold the loans because they could earn a good living. And the American homeowner purchased the houses (and with them the mortgage loans) because they believed that housing was a good investment.
When the loans got too risky and the housing prices began to adjust, of course, the companies with the most exposure were going to go bankrupt. That is also capitalism at work. But by allowing those in trouble to fail, the government could have let the system correct itself. Rather than greatly expanding the loan offerings of Fannie and Freddie until we are again in a situation where they back about 70% of the loans in the U.S., both the Bush and Obama administrations should have said, "Freedom cuts both ways. You are free to succeed and free to fail. Right now you are failing. Deal with it." That is the way to find private market solutions to private market problems. But by taking Fannie and Freddie into conservatorship and making them the primary providers for loans, the government has set the entire housing system up for a collapse when they are gone.
Today, the federal government is writing the suitability standards for mortgage lending, setting the compensation packages for the originators, and setting the rules for the servicers of those mortgages. To tell the private markets in this climate that they need to step up and provide the capital to back the mortgages in the U.S. under these rules is a little like Pharaoh ordering the children of Israel to produce their normal quota of bricks without government-issued straw. The Adminstration's incessant chiding of businesses to get back in the game is both extremely unreasonable and unlikely to be heard. And at the end of the day, when private markets do not respond to this new formula of risk with little reward, we will hear that this is just another failure of capitalism.
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