Beyond Fannie and Freddie
Homeownership may be the American dream, but lately it has been an expensive one for taxpayers. The deduction for mortgage interest cost about $80 billion in lost revenue in 2009, and a tax credit for home buyers in this year’s stimulus bill will add $15 billion to the tab. Taxpayers have provided Fannie Mae and Freddie Mac, two giant, troubled mortgage finance companies, nearly $100 billion that they have little chance of recouping. Mounting defaults also threaten the Federal Housing Administration, the agency that guarantees many home mortgages, raising the odds for yet another multibillion-dollar federal bailout. Meanwhile, the Federal Reserve has effectively been printing money to reduce mortgage interest rates, using the new dollars to buy more than $860 billion in mortgage-backed securities.
Nevertheless, some in Washington want to offer even more help to home buyers, arguing that a rebound in sales is crucial to the recovering economy. With the home buyers’ tax credit due to end in November, Sen. Johnny Isakson (R-Ga.), a former Realtor, introduced a bill to continue the subsidy for one year, raise it from $8,000 to $15,000 and make even wealthy buyers eligible. The estimated revenue loss: up to $100 billion.
There are economic and social reasons to support Isakson’s proposal -- home purchases spur other spending, and converting renters to owners leads to more stable neighborhoods. Those benefits evaporate, however, if people take on mortgages they can’t afford. The gains in homeownership may prove to be evanescent too. Federal subsidies helped push the rate from less than 44% in 1940 to more than 67% in 2000, and nearly 70% in 2004. The rate has fallen since then to where it was before the housing boom. Rather than increasing subsidies for buyers who may not be able to afford a home, Washington should be planning for a slow but steady diminution of its role in the market, especially when it comes to mortgage finance.
Fannie Mae and Freddie Mac are government-sponsored but privately owned companies that buy mortgages and related securities from lenders and Wall Street. They also package the loans they buy into mortgage-backed securities. This secondary market has provided a steady supply of money that banks can lend to home buyers. The financing provided by the companies lowers mortgage rates while shielding banks from much of the risk of the mortgages they issue, as long as the terms comply with Fannie’s and Freddie’s standards.
One of the problems for Fannie and Freddie has been trying to maximize profits for shareholders while also carrying out their government-assigned duty to finance homes and rental housing for lower-income Americans. When competitors on Wall Street gained ground by selling securities backed by subprime and exotic loans that didn’t meet Fannie’s and Freddie’s standards, the companies changed course and jumped into those markets -- and soon faced losses they couldn’t cover. Regulators seized control of the companies a year ago but left them in private hands.
The companies’ troubles demonstrate that the mix of public mission and private ownership is too combustible to be sustained. The federal sponsorship and duties convey an implicit governmental guarantee against failure, which gives the companies an incentive to take excessive risks as they compete for market share. And grabbing the biggest possible share of the $10-trillion U.S. mortgage market works for shareholders, but it only increases the consequences for taxpayers if the companies go belly up. The private sector has shown in the past that it can sustain a secondary market for mortgages. The government should give it the chance to do so again after the wave of foreclosures has passed, either by cutting its ties to Fannie and Freddie or by dismantling them.
That’s no easy task, given that the two companies hold about $5 trillion worth of mortgage-related investments. Withdrawing the government’s backing would result in less low-cost capital flowing into mortgages, leading to higher interest rates and, consequently, lower property values. Although it’s hard to quantify the potential effect, such an adjustment in the market may be beneficial over the long term. After all, the sustained low interest rates earlier in the decade contributed mightily to the boom and bust in the housing market.
Pulling out of Fannie and Freddie, however, does not mean the government should abandon the public side of the companies’ missions. Instead, it means Washington should find a better way to accomplish them. Recent research by the Fed suggests that Fannie and Freddie didn’t significantly increase the availability of mortgages in minority and lower-income neighborhoods. If the government decides to do more to support those borrowers, it can do it more directly through the FHA and the Government National Mortgage Assn. (better known as Ginnie Mae). But promoting affordable housing should not be confused with weakening lending standards. As John Taylor of the National Community Reinvestment Coalition has pointed out, the subprime fiasco stemmed not from loans to low- and moderate-income borrowers in underserved neighborhoods but from irresponsible lending to better-off borrowers who took on more debt than they could repay.
Perhaps the best argument for the government’s continued sponsorship of Fannie and Freddie is the cushion they provide when credit markets stop working. With private investors still spooked about mortgages, as much as 90% of home loans today are issued or guaranteed by Fannie, Freddie or a federal agency. Nevertheless, Fannie and Freddie are not indispensable. The Fed can increase the availability of credit by using its emergency authority to buy mortgage-related securities. And in Europe, a type of security called covered bonds has enabled banks to raise the capital for mortgages without the help of government agencies. Covered bonds also penalize banks more tangibly for the bad mortgages they sell to investors, giving them an incentive to issue loans that are likely to be repaid. Fannie and Freddie helped eliminate that incentive in the United States, to the detriment of borrowers and taxpayers alike. It’s a mistake we can’t afford to repeat.
