Fannie and Freddie: GSE reformers keep their options open


Louise Bowman
Published on:

Range of options mooted; Wind-down on the cards

To be called "the biggest disasters of all time" really takes some doing. But when JPMorgan chief executive Jamie Dimon thus described US government-sponsored mortgage companies Fannie Mae and Freddie Mac in his testimony to the Financial Crisis Inquiry Commission last October he was not accused of exaggeration.

total Federal funding for Fannie and Freddie to date
 total Federal funding for Fannie and Freddie to date
The firms have soaked up more than $150 billion in federal aid so far and have been deserted by their senior management.

Freddie Mac is under investigation by the SEC (for a second time) over its disclosures to investors, the firm’s chief financial officer committed suicide in 2009 and its chief operating officer resigned last month. "[The GSE crisis] was an accident waiting to happen," Dimon said last October. "We all knew about it, we all worried about it, no one did anything about it."

Three options

"Doing something" about Fannie and Freddie is now a priority, and the Obama administration finally came out with its delayed recommendations for GSE and housing finance on February 11.

Projecting that they could need further federal assistance to the tune of another $73 billion until 2021, the Administration – perhaps not surprisingly – explicitly advocates that both Fannie Mae and Freddie Mac be wound down. Its plans laid out the three options that housing reform could take: very limited government support for the mortgage markets, government support in times of housing distress or government reinsurance for mortgage-backed securities as a backstop for private mortgage guarantors taking first-loss exposure.

"The menu of options in the report clearly indicates the administration is not interested in expending political capital on the issue," says Evan Thomas from political advisory firm Capstone LLC in Washington. "Moreover, it is not the style of the administration to offer a comprehensive plan to Congress, leaving details open to attack – the salient example being Health Care Reform. All signs point to the White House approaching this exercise as a legal requirement, punting the first pass at structural reform of GSEs and the mortgage market to congressional Republicans."

The first option of minimal government involvement would have the obvious downside of increasing the cost of mortgage lending.

"Wherever there is a government back-stop and the private sector is entrenched, there is the risk that it will be ‘heads the private sector wins’ and ‘tails the government loses’"

James Frischling, NewOak Capital

James Frischling, president and co-founder at NewOak Capital in New York


"The removal or downsizing of Fannie and Freddie will result in an increase in the costs and rates associated with mortgages," says James Frischling, president and co-founder at NewOak Capital in New York. "Wherever there is a government back-stop or guarantee and the private sector is entrenched in the market, there is the risk and maybe even the likelihood that it will be ‘heads the private sector wins’ and ‘tails the government loses’."

The GSE’s involvement would be reduced by raising the price of guarantees, larger downpayments and tightened qualification requirements. Analysts at CreditSights point out that this will put additional negative pressure on national housing prices.

"We cannot rule out that another leg down in prices could lead more borrowers to stop paying on their home equity loans, and force banks to take greater losses," they say.

The reforms will also target the FHA (Federal Housing Administration) assistance for low-income borrowers (which was historically around 10% to 15% of the mortgage market but is now 30%) by increasing the price of FHA mortgage insurance.

Unravelling the mess that Fannie and Freddie have become will be a long and painful process, and many believe it will be years before concrete change emerges. But the Administration is keen to emphasise the urgency of the situation.

"It is important to recognize if we do nothing, we don’t legislate, if Congress does not legislate, then we are left with an authority under, let’s call it HERA, that in many ways would recreate Fannie and Freddie," said Treasury Secretary Tim Geithner in testimony to the House committee on Financial Services. "This is something that Congress wants to do within the next two years," he said. "You don’t want to wait three to five years to do that."

Option three

CreditSights reckons that option three will be the administration’s preference as it is essentially a compromise between the private and public sectors, with mortgage securitizers buying 25% of the insurance on new issues from the private sector and 75% from a new government entity. But it leaves the government open to accusations that it is just recreating the GSEs in a new guise. Geithner firmly rejected the suggestion.

"Any proposal that is designed to keep them [the GSEs] in existence for the long term we will resist. Any proposal that carries the risk of increasing the ultimate losses to the taxpayer we will resist," he said.

But it seems inevitable that any reform will involve some degree of public support for the mortgage industry in order to prevent a sharp cost hike to borrowers.