What will happen to Fannie Mae and Freddie Mac, and What Could it Mean?

Image Source: National Public Radio

Over the past several weeks, countless reports have emerged focusing on the fate of the government-created private loan securitization companies, the Federal National Home Mortgage Associate and the Federal Home Loan Mortgage Corporation, colloquially known as Fannie Mae and Freddie Mac.  The former is, famously, a product of the New Deal, finding its birth in a 1938 amendment to the Roosevelt Administration’s Housing Act, passed four years earlier.  At the time, the organization’s primary function was to inject capital into local, main street banks, which could in turn issue more mortgages, almost all of which were insured by the Federal Housing Administration, also established by the 1934 Act.  This resulted in an increase of home-ownership at a time when it was desperately needed, as well as the creation of a major market for secondary mortgages. Fannie stayed intact after the Depression ended, and the proportion of American home-owners rapidly increased, which perhaps paved the way f or the contemporary notion that owning a home constitutes some fundamental facet of what’s known as the “American Dream.”

Fannie only grew from here—the government opened the company to private investors in 1954, and in 1968, in order to accommodate the expanding market for secondary mortgages, the government split Fannie into two.  Freddie came about in 1970, in an effort to provide competition in the secondary mortgage market, which would ultimately lead to more accessible loans.  In time, Fannie and Freddie gained the ability to purchase and issue securities, leading to the development of the paradigmatic thirty-year fixed rate mortgage. They have been the focus of targeted policy efforts (i.e. the Clinton initiative to expand loans to low-income Americans), and they’ve shouldered considerable blame for purportedly encouraging the financial crisis.

This latter point has been vigorously debated along partisan lines, with folks on the right criticizing the organization for overseeing the expansion of easy credit, which, they argue, tipped the economy over the edge.  Those on the left level the blame on the financial industry, for their relentless practice of utilizing exotic new tools in order to securitize bundled mortgages.

No doubt, politics, one way or another, helped feed the Obama Administration’s desire to phase out these two giant entities.  While the Administration’s plans remain complex and difficult to follow, the New York Times, in a recent editorial, delivered a brief summary of each of three proposals released by the Administration:

The first option, for a system that is virtually all privatized, would result in the highest mortgage rates. It could imperil the availability of traditional, 30-year fixed-rate mortgages, which currently exist only because of federal backing. It would also curtail the government’s ability to mitigate a credit crisis — leaving taxpayers exposed to protracted downturns and possible bailouts.

The second, which involves a partial federal guarantee, raises similar cost and access problems. Theoretically, it would give the government a way to keep credit flowing in a crisis, but it would be difficult to shape a program that is small in good times and expands in bad.

Under the third and most promising option, losses on mortgages and related investments would be covered by capital set aside by banks and insurers or by other private institutions in the mortgage chain. On top of that, the government would provide reinsurance — essentially catastrophic coverage — but only for mortgages that met strict underwriting criteria and at a cost that would cover future claims.

As a someone who decisively is not an expert, my lay person’s reaction is that in it’s current setup, these governmental institutions serve to propel a financial industry (whose recklessness has been demonstrated) by continuing to back their activities in the form of government insurance.  As for option number one, which the Times implies to be the worst, numerous banks—the very same ones whose names became infamous for catalyzing the crisis—have already offered their own proposals to “Buy Pieces of the Fannie-Freddie Pie,” which by extension suggests their desire to not only continue but increase the industry’s practice of privatizing and trading complex securities backed by other people’s mortgages.  Even the “most promising” option proffers a way for the government to continue backing such “investments.”

I wish there was more talk about the fact that it doesn’t make sense to place calculated bets–“investments”–on pieces of other citizens’ mortgages, the way it wouldn’t make sense to purchase a fire insurance policy on your neighbor on your neighbor’s house.  But clearly, the Obama Administration, first and foremost, must grapple with realities of politics, as these proposals indicate.