“I believe that our housing system should operate where there’s a limited government role and private lending should be the backbone of the housing market.” – President Obama, August 2013
In last week’s Insight, we walked through the history of Fannie Mae and Freddie Mac to better understand how they grew into behemoth companies and why they were socialized under the umbrella of the US taxpayer back in 2008. This week we will look at the bill being debated in the Senate and publically endorsed by the President proposing the eventual shut down of both Fannie Mae and Freddie Mac. The new bill being offered up by Republican Senator Bob Corker and Democratic Senator Mark Warner proposes a plan to shut down Fannie and Freddie over the next 5 years while still maintaining a reduced role of the federal government in mortgage finance. The embedded video below is a recent Bloomberg interview with these two gentlemen discussing their proposed bill.
Under the current system, Fannie and Freddie buy mortgages from underwriters (e.g. banks) and then bundle the mortgages into securities with a 100% guarantee of principal and interest payments. The companies make money on the spread between what they actually collect on the mortgages and what they pay out to their investors which hold their securities. During periods of time when the housing market is stable and default rates are within “normal” bounds, these companies can be extremely profitable, which happens to be the case at present. The problem arises when things don’t go according to plan like they did back in 2007 and 2008 when default rates skyrocketed due to an overinflated housing market (bigger payments for borrowers) and reduced lending standards as we outlined last week. With the 100% guarantee, Fannie and Freddie couldn’t simply pass these losses along to their investors and were on the hook for the difference between what they were actually collecting and what they promised they could pay. With banks and other mortgage investors still licking their wounds from the crisis, the burden of “greasing the wheels” for the US housing market by facilitating the issuance of new mortgages now rests almost entirely on the US taxpayer (via Fannie and Freddie).
Under the new proposal, a new entity modeled after the Federal Deposit Insurance Corp (FDIC) will be created to replace Fannie and Freddie. This new entity would guarantee a portion of the principal and interest on the mortgage backed securities (MBS) they issue but require that the first 10% of principal losses on any security be covered by private capital. The private capital could come from banks, hedge funds, private equity funds, or any institutional investor that feels they are being fairly compensated for the default risk they are incurring. The new entity would collect insurance premiums from the industry and maintain an insurance fund in order to cover claims that exceed the 10% loss threshold. A 10% threshold may not sound like much, but according to the bill summary this private capital buffer “could have prevented taxpayer assistance following the housing crisis” if it had been in place at the time.
Some might ask, why not simply get the government out of the mortgage market altogether? This is a valid question as other countries have fully functioning housing markets without government assistance or subsidies like we have here in the United States. Or one could argue that the jumbo mortgage, which is too large to be purchased by Fannie or Freddie, is a perfect example of the banking system operating without a government guarantee. In most cases, a jumbo mortgage carries a higher interest rate than a conventional mortgage to compensate the private capital investor for the added risk of default. This is basic supply-and-demand, free markets at work.
In the long-run, a completely privatized mortgage market may be the best solution, but at present it is an unrealistic dream at best. The US banking system is in the process of recapitalizing its balance sheet, which is a fancy way of saying they are still recovering from the losses they experienced during the credit crisis and are stockpiling cash and other no/low risk securities. In addition, the new capital constraints put in place by the Dodd Frank Act would make it almost impossible for banks to absorb the entirety of the US loan volume. Therefore, the most viable solution is most likely one that weans the mortgage market off government support by involving private investors in the underwriting of mortgage credit risk. In a recent blog post explaining a new security which Freddie Mac is issuing to test out the waters of transferring some of the mortgage default risk to the private sector, the author states:
Pulling the government "guarantee" plug from the GSEs at this stage will destroy the housing market - potentially plunging the nation into another recession. To do it gradually however will take years in order for the private sector to absorb some of this risk…
The end of a government backed mortgage market would probably mean some big changes would be coming down the pipe. Mortgage rates would be set by supply and demand meaning that borrowers who put down a large down payment would most likely get a lower rate than those who do not (a novel concept to say the least). Right now, the most distorted market is probably mortgage insurance programs backed by the FHA to help first time homebuyers buy a house. The average down payment for loans of this nature is around 4%, which obviously wouldn’t fly in a free market system unless the buyer was willing to pay a much higher rate to compensate the investor for the added risk.
With so many moving parts, it is hard to say what is best for the US mortgage market. Rock the boat too much and we could be heading into another recession. Maintain the status quo and we run the risk of history repeating itself. The current bill being debated in the Senate is a good mix of both with bipartisan support, which is nice to see for a change. It may be just the right compromise to keep the present housing market afloat while still taking a long-term view on what is best for this country and its citizens.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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