Congress chartered Fannie Mae in 1938 as part of the New Deal and Freddie Mac in 1970. Although they were chartered by the federal government, the corporations were owned by private shareholders for the purpose of making homeownership affordable for lower- and middle-class and other underserved Americans.
In theory, GSEs purchase mortgages from lenders, guarantee them, and package them into mortgage-backed securities, which they either keep as investments or sell to institutional investors. Lenders are able to increase liquidity and lending potential by selling these loans to the GSEs, which in turn should increase availability of credit.
In practice, they have dominated the mortgage finance market, thus promoting homeownership. This domination is attributed to the ability of the GSEs to buy mortgages by borrowing at below-market rates based on the illusion of a government guarantee.
In the 1990s, they implemented housing initiatives to lenders to offer low-down-payment mortgages to low- and middle-income families and to loosen underwriting guidelines, both factors which contributed to the housing bubble.
In the early 2000s, Wall Street increased quantity of loans—often non-GSE, riskier loans that were securitized, another factor contributing to the bubble. By 2005, the GSEs, which were losing market share, loosened underwriting guidelines, taking on more risk without an increase in capital reserves.
As the bubble began bursting in 2008, some in Congress wanted the GSEs to take on more risk, but U.S. Treasury officials, alarmed by continued devaluation of GSE loan portfolios, GSE weak capital reserves, potential investor sell-off, and impact on global markets—against the GSEs, with their weak capital reserves—persuaded the GSEs to consent to conservatorship in September 2008.
The Housing and Economic Recovery Act (HERA), enacted in July 2008, created the Federal Housing Finance Agency (FHFA), the GSEs’ conservator since 2008.
Fannie and Freddie continue to dominate the secondary mortgage market: They currently have more than $5.6 trillion in obligations outstanding, an amount nearly 40 percent the size of the entire U.S. economy, and they owned or guaranteed about 61 percent of all new residential mortgage loans in the United States in 2012. Contrasted with private mortgage origination, only $5.2 billion in residential mortgage-backed securities have been issued without government support in the same time period.
Importance of GSE Reform
Freddie and Fannie received a $188 billion bailout from Treasury and had paid $146 billion back by September 2013, with two-thirds paid back this year. They continue to be profitable, while having increased lender fees and tightened underwriting guidelines, and, along with the Federal Housing Administration (FHA), which guarantees reverse mortgages to seniors, insure nearly 90 percent of all residential mortgages.
The costs beyond the direct infusion of the $188 billion bailout are much higher: an estimated $7.4 trillion loss in real property equity, for one.
The GSE "privatized gains and socialized losses" model remains firmly entrenched in housing, and, along with the mortgage-interest federal tax deduction, has been described as having evolved into an entitlement.
Both ends of our political spectrum agree GSE reform is required to minimize risk in U.S. housing markets. Methodology, however, varies depending upon the perspective of the GSEs, which promoted homeownership by loosening standards at the urging of politicians, or private investment companies, which securitized and sold riskier loans.
Sens. Bob Corker (R-Tennessee) and Mark Warner (D-Virginia) introduced a bill this past June that would replace the GSEs with federal reinsurance for mortgage-backed securities, similar to FDIC-insured bank deposits. This is thought to encourage private investors to take first losses on mortgages, knowing there is a backstop in economic downturns. President Obama has endorsed this approach in theory.
A government insurance program could assuage the concerns of consumer and trade groups, who prefer the status quo about availability of mortgages, and the ability and promotion of prospective owners to buy homes, the mission of Fannie and Freddie.
Most legal and residential mortgage banking and related professionals and industries advocate a thoughtful approach to reform, which would include some type of government guarantee or insurance. The U.S. housing market includes and affects untold numbers of homeowners and home occupants, who are served by a vast industry of professionals—all of whom value the intrinsic permanency of homeownership and solidarity found in our country based on our private real estate market.
While larger lenders may not like the competition of the GSEs’ rates, they benefit, as smaller lenders do, by the liquidity and pseudo-government guarantee offered by the GSEs. Smaller lenders do not want the GSEs to wind down because they cannot compete with the liquidity of the large banks.
On the other end of the spectrum are advocates of a free market system, with the government almost completely out of housing finance, except for, say, FHA/HUD first-time low- to middle-income buyer mortgages. They propose winding down the GSEs while legislating the definition of a prime loan (could the Consumer Financial Protection Bureau’s qualified mortgage definition be the foundation for this?) that would be the standard for a private finance market.
Free market advocates note that the stated purpose of the GSEs, to encourage and expand home ownership, has not been substantially accomplished. Since 1998, when the GSEs increased efforts, ownership only increased from 66 percent to 70 percent, and it is now back down to 1998 levels. When the economic and human expense is added to this paltry result, the GSEs are not sustainable, though Fannie vows to remain viable. These advocates point to the Western European housing markets, which operate efficiently with very little government involvement, but with respectable percentages of homeownership.
Almost everyone agrees that something needs to be done with the GSEs, and almost everyone recognizes that the “something” will be a complex undertaking in our housing and financial markets which are enmeshed with the GSEs, but we must be up to this task, we must be thoughtful about reform, avoid unintended consequences, and strike a middle ground between growing a private mortgage market and providing a government backstop.
On the Horizon
While there were housing reform hearings on Capitol Hill during the Congressional fall session, the topic is not on the House agenda and therefore is not a legislative focus compared to the current highlight on the debt ceiling and the Affordable Care Act.
Hill insiders predict substantive GSE reform would take many years. Financial services company analysts point out the current profitability of the GSEs, and as noted previously, community and large banks like the advantages they receive, in different ways, from the GSEs’ liquidity.
In fact, some hedge funds have heavily invested in the GSEs' preferred stock, and two of them, Perry Capital and Fairholme Funds, have sued the United States for devaluation of the stock based upon Treasury changes in agreements with the GSEs.
The same holding pattern exists for the Protecting American Taxpayers and Homeowners (PATH) Act, introduced in the House of Representatives bill rolled out in July, which seeks to return the FHA's market share to first-time, lower-income buyers. The best approach now or in future Congressional sessions is to recognize the interplay between GSE and FHA reform and the market shift between them due to reform.
Housing market reform is complex, topical, and looming on the horizon, if lessons from our recent history are heeded. Stay tuned for an always evolving and important dialogue on our nation’s housing market.