Will Reform of Fannie and Freddie Kill the 30-Year Mortgage?
The sequester is all anybody wants to talk about. I get it: It’s the hip new crisis sweeping Washington. But remember Fannie Mae and Freddie Mac? You know, the once quasi-independent housing giants whose takeover by the federal government has cost taxpayers upwards of $190 billion thus far? Well, Fannie and Freddie are still owned by the federal government and, on top of that, are the only thing holding the U.S.’ badly battered housing-finance system together, as the Feds back 9 out of 10 mortgages issued today.
But Congress and the President have been so bogged down in their never-ending budget battles that we’ve heard little from Washington on this subject in recent months. Until last week, that is, when the Bipartisan Policy Center — a think tank formed by former Senate Majority Leaders Howard Baker, Tom Daschle, Bob Dole, and George Mitchell — tried to bring this very important issue back to the fore by releasing a 131-page report on the future of housing policy in America.
Their solution is to wind down Fannie Mae and Freddie Mac by slowly selling off their assets to the private sector as the economy improves. In their place, the government would create a public guarantor of mortgages, sort of like what Ginnie Mae does for FHA and VA loans now. This guarantor would not purchase mortgage-backed securities as Fannie Mae and Freddie Mac do now; rather it would simply insure mortgages in case of default, and charge a fee to do so. The BPC framework would also require issuers of mortgage-backed securities to purchase private insurance, so that the government guarantor would only have to step in in the case of a total real estate market meltdown, similar to the one we experienced in 2008.
This system is more stable than the one in place prior to the crisis because the government guarantees would be explicit, and be accounted for in the budget. Furthermore, any losses the government would have to take would be paid for in advance by guarantee fees paid by the issuing bank.
But this raises the question: Why does the government play a role in the housing market at all? After all, one of the causes of the mortgage market meltdown was quasi-governmental Fannie and Freddie taking on too much risk. And many Republicans, like House Financial Services Committee Chair Jeb Hensarling, want to completely privatize the housing finance system. Wouldn’t that make the most sense if the goal is to protect taxpayers from having to bailout out the mortgage industry again?
Not if we want to maintain the 30-year, fixed-rate mortgage that most American homeowners have come to know and rely on. According to the report, without some form of government backstop, those types of mortgages would be exceedingly rare. As was seen during the savings and loan crisis of the 1980s, long-term, fixed-rate mortgages are risky investments for mortgage lenders to keep on their books. A bank that makes such a loan has not only to deal with the risk that a borrower may not re-pay in full, but also the risk that interest rate fluctuations impose on the investment. When interest rates rise, a bank can’t pass that cost on to borrowers because the rate is fixed. On top of that, lenders have to deal with prepayment risk, the risk that a borrower will pay back the mortgage before its due, reducing the total return of the investment.
The BPC’s position is no government role, no long-term fixed rate mortgages. So what’s the alternative? Though it may come as a surprise to many Americans, the 30-year fixed-rate mortgage is actually very uncommon outside the U.S. For all the reasons listed above, banks just don’t like to make such long commitments without being able to adjust the interest rates they charge customers, or prohibiting prepayment. In Canada for instance, the most common mortgage is a five-year fixed rate loan. These mortgages are amortized over a twenty-five year period, but the interest rate must be adjusted every five years, and there is no cap on how much interest can be charged.
This sort of system probably seems strange to most Americans, who have grown used to knowing exactly what their housing payments will be over the long term. There surely is value in having this sort of certainty, but banks don’t give it away for free. Lenders charge a premium to cover the risk they are incurring by giving such stable terms. And while it may seem to Americans that the Canadian system is too unpredictable, Canadians themselves seem to get along just fine with it, as they have home ownership rates similar to ours.
So while you may recoil at the idea of having the government involved in the mortgage market, it appears government intervention is necessary unless we’re willing to introduce significant changes to the way the average American will finance the purchase of a home. And given how averse to change many voters in this country are, one can expect significant support for continued federal participation in housing finance for years to come.