Keep Fannie and Freddie

Housing is America’s biggest industry, contributing to gross domestic product (GDP) in two basic ways: through private residential investment and consumption spending on housing services.

Historically, residential investment has averaged roughly 5 percent of GDP while housing services have averaged between 12 pecent and 13 percent, for a combined 17 percent to 18 percent of GDP.   The industry employees millions of people, not just in construction but in brokerage, mortgage financing, home improvement, insurance and other businesses.  Indeed, one of the reasons the economy is growing at a snail’s pace today is because housing starts, despite recent gains, remain well below pre-recession levels.  What’s more, the home ownership rate in the U.S. has fallen each year since 2008 and is now down to 65 percent of all households, the lowest rate since 1995.

{mosads}Obviously, home ownership depends on the availability of mortgage financing.  And the ability of community banks to offer mortgages to prospective home buyers depends on a reliable and liquid secondary market, since most of their originations are quickly resold. Since the 1930s, much of this liquidity has been provided by two government sponsored enterprises (GSEs) with private shareholders: Fannie Mae and Freddie Mac.  The mission of both of these entities is to stabilize the nation’s residential mortgage markets, expand opportunities for homeownership, and provide liquidity and affordability to the U.S. housing market.

Because private capital has not returned to the housing market in a significant way, Fannie and Freddie have become even more important to mortgage financing.  Last year, they provided support for 68 percent of the $1.9 trillion in single-family mortgages originated in the U.S.  What’s more, the government guarantee that accompanies purchases by Fannie and Freddie has helped sustain the availability of the 30-year fixed mortgage, the mainstay of housing finance.

In the mid-1990s, political pressure was put on both Fannie and Freddie to underwrite more affordable housing.  Consequently, the quality of their portfolios declined as more “sub-prime” loans were added to the mix.  When the Great Recession hit in 2007, and unemployment grew to 10 percent, many borrowers were unable to make their payments, putting Fannie and Freddie on the hook for their loan guarantees to the mortgage originators.  Worried that the entire U.S. housing market might go into freefall, as well as thousands of community banks, Congress authorized a $188 billion bailout of Fannie and Freddie in 2008.

Since 2008, both institutions have been conducting operations under a conservatorship directed by the Federal Housing Agency (FHFA). Under the conservatorship, the U.S. Treasury acquired 79.9 percent of the GSE’s stock and mandated a 10 percent annual dividend payout.  Because the financial health of Fannie and Freddie has improved markedly over the past two years, the entities have already repaid $132 of the $188 billion they received in the bailout, and the rest should be paid off by the end of 2014.

Fannie and Freddie clearly weren’t innocent victims of the financial crisis.  Evidence is mounting that the two agencies lacked proper control processes for credit, market and operational risk, often requiring no verification of borrower income or assets.   Consequently, some members of Congress want to put them out of business.  Sens. Mark Warner (D) of Virginia and Bob Corker (R) of Tennessee have proposed replacing the two GSEs with a mortgage insurance fund similar to the Federal Deposit Insurance Corporation (FDIC). Congressman Jeb Hensarling (R) of Texas, chair of the House Financial Services Committee, has introduced a bill that would dissolve Fannie and Freddie and rely on a privatized housing finance system. 

Before Congress decides on a course of action, it must first assess whether enough private capital is available to fill the gap if Fannie and Freddie go away.  Given the $4.5 trillion in mortgage-backed securities currently guaranteed by the GSEs, this seems unlikely.  Second, what happens to the private investors in Fannie and Freddie, in particular community banks and insurance companies?  Will they be made whole if the GSEs are dissolved?  If dissolution is the path chosen, Fannie and Freddie should go through a structured bankruptcy process as opposed to simply adding $4.5 trillion to America’s already escalating public debt.

On the other hand, if Congress decides to continue the franchises of Fannie and Freddie, the two GSEs must be allowed to rebuild their capital.  Under a 2012 directive whereby Treasury replaced the 10 percent dividend requirement with a “net worth” sweep—tantamount to capturing all of the dividends as well as increases in net worth—it will be impossible for Fannie and Freddie to attract private investment.

Just as General Motors, Chrysler and AIG have repaid the government for their bailouts, Fannie Mae and Freddie Mac are on course to do the same.  Let’s keep Fannie and Freddie but return them to private ownership with stronger government oversight, remembering that home ownership is still part of the American dream.

Weinstein is an adjunct professor of business economics in the Cox School of Business at Southern Methodist University in Dallas, a fellow with the George W. Bush Institute, and a former mortgage banker.