MORTGAGE MARKETS
After Fannie & Freddie
September 15, 2008
Treasury Secretary Henry M. Paulson has announced that he is placing Fannie Mae and Freddie Mac in conservatorship. This action effectively nationalizes these two companies formed by the federal government to create and develop the modern secondary market for residential mortgages while also generating profits for their shareholders. It is all but certain, however, that Fannie and Freddie will exit their conservatorship in one form or another: perhaps retaining some of their hybrid public/private structure, perhaps as fully privatized companies, perhaps broken up into smaller companies that can spread the risk of future crises more broadly. As these two companies cease to exist in their current forms, it is worth thinking about what the post-Fannie and Freddie future of the American mortgage market should look like.
First, we should remember that the two companies can play a role in stabilizing the secondary mortgage markets, particularly in the short term. As the credit crisis unfolded, their share of the residential mortgage market grew to be almost half of that market — a market measured in the trillions of dollars — as they became the lenders of last resort. Their own growing instability, of course, has now undercut the stabilizing role that they initially played.
Providing genuine stability
Thus, the federal government must plan for other ways to provide genuine stability for future crises. For instance, the federal government could rely on targeted mortgage guarantees, mortgage-backed securities purchases, access to the discount window for key loan originators or other mechanisms to ensure that the mortgage market continues to function during a financial panic. Whatever the chosen mechanism, the government needs to make clear how far it is willing to go to stabilize the secondary mortgage market and then follow through expeditiously to quell credit crisis hysteria.
It is also important to remember that Fannie and Freddie reduce mortgage rates for conforming borrowers by between 0.22% and 0.60%. If Fannie and Freddie were phased out, homeowners would pay slightly higher interest rates for their conforming mortgages. For instance, a homeowner would pay an additional $68 a month in interest, assuming an increased 0.41-point spread (the average of 0.22% and 0.60%) on a $200,000 mortgage.
Nonetheless, if Congress determined that this increase were too high, it could simply modify the deduction for mortgage interest so that homeowners would be in the same financial position as they are under the existing Fannie and Freddie regime. The increased burden on the federal budget caused by the loss of tax revenues would be quite manageable, particularly given that the government would be relieved of the contingent liability of its implied guarantee of Fannie and Freddie's obligations. This is because making good on that contingent liability could lead to higher taxes or reduced services if they federal government had to pony up hundreds of billions of dollars as part of a future bailout.
Maintaining best practices
Finally, Fannie and Freddie, because of their origins as government-created enterprises and their market dominance, have imposed pro-consumer terms on much of the residential mortgage market. For the same reasons, Fannie and Freddie have also imposed a variety of best practices on secondary mortgage market players, such as loan originators, that helped cut back on some of the worst behavior in the residential mortgage market. These practices would need to be maintained through legislation or regulation as part of any initiative that ended the special relationship that the two companies have had with the federal government. This would be necessary to ensure that the worst instincts of the consumer finance industry, as exemplified in the subprime market, are kept under check going forward.
Those worst instincts led to the extension of credit to those who could not pay it back from the moment that the loan was made. They led to exotic mortgages that were affordable in the short term, but not in the long term. They led to outrageous fees that stripped away the equity that homeowners had built up over many years. And, of course, they led to the default and foreclosure crisis that extends from coast to coast and threatens to swamp our entire financial system.
Today's Fannie and Freddie are dead in their current incarnation but are certain to rise again in some new form, one that is likely to reduce their public role and make them more like traditional profit-seeking enterprises. Given that they outlived their original purpose of creating the secondary mortgage market, this could be a very positive development. But the good that they continue to do must be identified and protected because it is also clear that the unregulated pursuit of profit in the consumer finance market poses its own horrible dangers to the American public.
David Reiss is an associate professor of law at Brooklyn Law School. His research focuses on the secondary mortgage market.
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