A Crisis Wasted: Fannie-Freddie Reform Fades

• Congress has little appetite for reforming Fannie Mae and Freddie Mac.
• Government involvement in housing finance may be suboptimal, but it is firmly entrenched.
• Delaying a plan for reform risks a return to the status quo as markets recover and the crisis subsides.

A journey of a thousand miles, as Lao Tzu said, begins with a single step. Yet on the long road to reform of the nation's crippled housing finance giants, U.S. policymakers appear unwilling even to lace up their boots. Losses at Fannie Mae and Freddie Mac, formerly known as the government-sponsored enterprises, have been staggering. It’s also now clear that the GSEs' quasi-governmental status created conflicts that led to their downfall. Yet even with popular support, Congress was unwilling to touch the GSE issue in the recently passed financial reform legislation. Since there is no easy fix and any action risks disrupting the fragile recovery, the two mortgage giants won’t be going away any time soon.

The people’s republic of Frannie

The main impediment to action is the institutions' sheer size. Fannie, Freddie, and their cousins the Federal Home Loan Banks together hold or guarantee some $7.3 trillion in outstanding debt and mortgage-backed securities. If they were a single country, they’d have the third largest stock of outstanding debt in the world, behind the U.K.’s $9.1 trillion and ahead of Germany’s $5.1 trillion. Greece, for all of its problems, is far down the list at around $500 billion.

Given this backdrop, it’s little wonder that proposed amendments to the recently passed financial reform legislation, which called for the institutions' dissolution within 15 years, failed in Congress. The political risks were high if such a proposal disturbed already-anemic housing markets. Moreover, the economic gains from successfully resolving the GSE issue won’t be seen for at least a generation. It was simply too much risk for too little political reward.

Instead of taking the first steps toward GSE transformation, Congress will take another year to study the problem and propose a solution in 2011. But the GSE question is not new, and previous administrations have promised action in the past only to be distracted by other issues. This time is unlikely to be different.

A government-dominated mortgage market

Not only are policymakers daunted by the GSEs' size, but alternatives to the system aren’t obvious. At one extreme, dissolution of the mortgage companies sounds attractive, but current market reality doesn’t support it. Despite a small resurgence of private lender activity in the last few months, over 95% of all new mortgage originations are guaranteed by the government through FHA, Fannie Mae or Freddie Mac. Given this explicit government guarantee and Americans' preference for fixed-rate mortgages, private lending activity will remain muted, since no private institution with more restrictive capital requirements can compete with the government’s resources.

While government intervention has kept mortgage credit flowing throughout the crisis, it has come at a significant cost. Freddie Mac requested an additional $10.6 billion from the Treasury during the first quarter of 2010, while Fannie requested $8.4 billion to cover its losses. This brings total government funds injected into the GSEs to $140 billion. Losses at Fannie now exceed all profits recorded over its past 36 years of existence combined, making it extremely unlikely that taxpayers will be able to recoup their investment any time soon.

Despite rising losses, high levels of serious delinquency, and growing inventories of foreclosed properties, loss reserves at the institutions actually declined in the first quarter. This all but guarantees further Treasury injections will be necessary, with the total cost to taxpayers likely to approach the CBO’s projection of $400 billion by 2019.

During the worst of the financial crisis, it was appropriate for the government to step in and provide financing as a housing lender of last resort. Had the market been allowed to collapse, house prices would still be falling, and the economy would have been thrown into depression. But the system has now been stabilized, making it both possible and critically necessary to devise long-term plans for housing finance. While both Congress and the administration have punted for now, there is universal agreement that the firms’ large mortgage portfolios should be eliminated.

A good time to sell

Under the Housing and Economic Recovery Act of 2008, Fannie and Freddie were authorized to expand their retained portfolios for one year but were ordered to shrink their portfolios thereafter by 10% per year, to a level of $250 billion each by 2021. With the declines in origination volumes over the last two years, the firms’ retained portfolios have indeed been contracting, but this is likely to slow without a concerted effort to sell securities to private investors.

Debt fears in Europe and a dearth of new agency securitization have led to increased demand for the mortgage-backed securities in the agencies’ portfolios. Given this environment, it would seem an opportune time to sell some of their higher-coupon securities. The fact that this has not happened may be tied to the uncertainty around the institutions' future.

History repeats itself

The GSEs' size clearly poses a systemic risk, but dissolving them could merely shift their massive risk exposures to other "too big to fail" banks such as JP Morgan and Bank of America, rather than distributing the risks more broadly. In addition to the risk imposed by the GSEs' investment holdings, they are also exposed to nearly $5 trillion of credit risk in the form of guarantees to MBS investors for timely principal and interest payments. Shifting these credit guarantees to private institutions would be an even greater challenge than selling off the portfolios, given the increased capital requirements facing banks and insurers.

Completely privatizing the mortgage securitization business is another potential solution, but a number of legal and logistical issues stand in the way of reviving that market. Covered bonds or other vehicles could provide alternative sources of finance but would take decades to supplant the large and heavily entrenched system of agency MBS that foreign governments, pension funds and institutional investors now rely upon for liquidity.

Rolling back the clock

Given this backdrop, the government will continue to dominate the mortgage market well into the next decade. Nationalization of the GSEs is unlikely, as this would bring all their MBS and debt obligations onto the federal government’s balance sheet—a fiscal nightmare in the current environment. The most likely outcome is a return to the mortgage market of the 1980s and 1990s, with the private market gradually returning for jumbo home loans as house prices begin to rise and traditional lenders rebuild their balance sheets. The conforming loan limit will likely be held constant for a number of years, letting inflation gradually reduce the government’s share of financing.

Regulators will essentially outlaw the exotic mortgage arrangements such as Alt-A loans, as well as many of the subprime loans that had underpinned the majority of private-label MBS.

Losses at the GSEs will decline over the next few years as housing markets recover. The firms are likely to turn profits within five years as higher-quality loans originated over the last two years replace older mortgages and as house prices begin to rise again. If policymakers have not made a decision on the future of the GSEs by that point, pressure to reform will have waned, and the government-sponsored housing finance system will continue—much as it did for the 75 years prior to the meltdown.