Fannie and Freddie: Implications for Consumer Policy?

The news from Wall Street just keeps coming. I have been drafting thoughts on current events and then constantly revising them as more information comes out. It looks like AIG will have access to an infusion of public capital, but at a cost to shareholders and management, much like Fannie Mae and Freddie Mac. But the issues are very different.

Fannie and Freddie - the government sponsored enterprises (GSEs) - were created as a public-private enterprises. They have historically played a key role in buying whole mortgages from banks, allowing banks to make more mortgage loans. This secondary market function was an innovation and has helped the banking system overall.

The public part of the GSE mission has been widely debated for years. Investors always believed there was an implicit government backing for Fannie and Freddie. Investors behaved like GSE securities were 'almost' like Treasury securities. This gave the GSEs access to lower cost capital and ultimately allowed for lower interest rates on mortgages. How much lower? There have been several studies. The most objective study (arguably) is from the Fed (in the Alan Greenspan era) and suggests about 25 basis points lower interest rates on conforming mortgages. That is one-quarter of 1 percentage point of interest. Not that much for a consumer to notice, really, but it is something from the view of capital markets.

The other function of the GSEs that is less discussed is as a 'backstop' in the capital markets for mortgages available to the middle class. A few years ago many argued banks had direct access to Wall Street and the GSE function was outdated. But as we have just seen, investor capital moves globally in seconds. As confidence in mortgages and financial institutions weakens, investors pull out rapidly. For some lenders there would be no more capital to make another mortgage loan without access to a stablized secondary market. A consumer who is in need of cash to pay for an unexpected expense might not be able to take out a home equity loan. Someone moving might not be able to sell their home because no cash buyers exist. It gets ugly fast.

There has been widespread criticism of how the GSEs have been treated. This summer's announcement that Treasury has the power to take over the GSEs, but no one at Treasury thought they would need to use it had a destabilizing effect. Investors were not comfortable with being in limbo- "maybe the government will take over and maybe that means shareholders are wiped out." In a market with extremely low tolerance for uncertainty, investors ran from Fannie and Freddie. As these firms had losses on the lending side they needed capital, but no investor was willing to go there. In the end Treasury had no choice. Fannie and Freddie shares still exist, but are worth just pennies.

So now what? With all the news about Lehman and AIG, we have not heard much on Fannie and Freddie the last few days. Key staff are heading for the exits, and that is troubling. But the GSE market function is still working. Mortgage rates are somewhat stable. Local lenders can still operate.

How will the GSEs look in the future? We don't know how Treasury will proceed. The clean-up alone will take a while. One view is to spilt them up into 5-6 smaller secondary market firms to buy loans. The Federal Home Loan Banks played a bit of this game a few years back. It is not clear more smaller firms helps overall, and there will always be returns to scale such that consolidation could make economic sense. Firms could specialize by type of loan or region, but that presents problems in terms of concentrated risk.

Regardless of the institutional structure, the public-private GSE structure needs review. The government guarantee needs to be priced and made into legal contracts. The affordable housing function of the GSEs should continue at least as long as the GSEs have some federal support and probably longer. If banks are required to make lending balance deposits under the Community Reinvestment Act, then there must be a vibrant secondary market to support this function. It is hard to imagine a completely private mortgage secondary market. In fact the 3rd GSE - Ginnie Mae - is essentially a department of HUD and facilitates the secondary market for mortgages insured by FHA/VA mortgage insurance. This is going to be complex to sort out.

Unfortunatelty election year politics are caught up in all of this. Most policymakers don't have a full understanding of the issues involved. Career staff at Treasury and HUD, as well as the Fed, will have their hands full for quite some time. Consumer advocates need to be as well informed as possible and make sure lending markets are stable and capital keeps flowing especially for the market segments least well served by the financial market--working families in older urban areas and rural markets--as well as immigrants and minorities with no connections to the financial sector. These consumers are going to continue to be first-time homebuyers, especially as home prices come back down to more affordable levels.

A recent survey I helped run in California and Illinois shows moderate income renters are as interested in buying a home as ever. They see prices coming down and want to own a home. But they also see the risks, and want to be well-educated how to buy a home and find a mortgage loan (in fact they tend to substantially over-estimate the risks of foreclosure--we'll save that for another post). The majority have doubts any lender will offer them a loan. Reading the current press and watching the media, no wonder.