Fannie and Freddie Fact vs. Fiction: What Will the Wind-Down Do?

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Andrew Harrer/Bloomberg via Getty Images

Fannie Mae and Freddie Mac — just the companies’ names sound like characters out of a Brothers Grimm fable. But their financials from the last few years read like something from Stephen King. Here’s a look at what will and won’t happen in a Fannie/Freddie wind-down.

These private companies were strange, hybrid Government Sponsored Enterprises (GSEs), backed by the federal government. Their mission was always to foster homeownership, but over the last couple of decades, their methods evolved, so their primary activity became buying, packaging and reselling mortgages originated by private lenders, empowering those lenders to always have money on hand to lend. Both companies insured the loans they resold against default.

And because the federal government explicitly backed Fannie and Freddie, their loan packages — mortgage-backed securities — had the implicit guarantee of Uncle Sam (that means you and me).
[time-link title=”(Read more about the Obama administration’s housing plan)” url=http://swampland.time.com/2011/02/25/obamas-cautious-housing-plan/]

Problem was, when millions of those packaged-and-resold-by-Fannie-and-Freddie mortgages did the unthinkable and defaulted, they had to pay up. By default, that meant taxpayers had to pay up in the form of a federal 2008 conservatorship (read: bailout) to the tune of $150 billion and counting.

These days, virtually everyone agrees that the prognosis for Fannie and Freddie is terminal. In February, the Treasury Department formally recommended that the GSEs be wound down, i.e., put to rest, over the next 5 to 7 years. House Republicans responded with a bill objecting to euthanizing the companies so slowly. Even last month’s publication of Freddie Mac’s relatively positive Q1 financial report (in the black by $676 million) failed to renew anyone’s hope that the companies might survive — especially when considered alongside Fannie Mae’s $8.7 billion loss in the same three months (and with the government’s estimate that the bailout will run around $259 billion before it’s all said and done).

The highly likely prospect of a Fannie/Freddie wind-down has caused a veritable proliferation of urban legends — some true, others less so — about what will happen when the mortgage giants are gone. Usually, the more horrific scenarios are posited as an argument against the wind-down, even though staunch advocates of a wind-down see it as a bitter but necessary pill.
[time-link title=”(Read about how fixed mortgage rates have dropped for two straight months)” url=http://www.time.com/time/nation/article/0,8599,2076650,00.html]

Let’s take a look at what will and won’t happen for Fannie and Freddie.

Fiction: Minorities won’t be able to buy homes.
Fact: Higher down payment requirements could reduce the minority homeownership rate, but the increased market stability will serve these communities well.

Numerically speaking, it is possible, that Fannie and Freddie’s elimination might cause this to happen to at least a small degree. But chances are slim, especially given the prevailing proposal to replace the GSEs with a larger number of similar companies specifically to ensure that access to homeownership is preserved. But, even if this fiction were fact, rather than it creating a knee-jerk reaction against Fannie and Freddie’s elimination, there are a number of other hyper-linked concerns that it should pop open.

First off, Fannie and Freddie were never intended to provide an affirmative action system for mortgages. Expanding the homeownership opportunities available to lower-income communities is, however, a mandate of the Federal Housing Administration, which will almost certainly continue to exist and carry out that mandate with low-down payment options like the 3.5 percent down payment loans that are currently en vogue (and being used by buyers of homes as costly as $729,950, in high-cost areas, by the way). In fact, Fannie and Freddie-backed loans already have higher down payment requirements than FHA loans.

Secondly, Fannie and Freddie’s facilitation of the subprime mortgage market — and the resulting housing market meltdown — had a dramatic impact on minority communities. The Center for Responsible Lending published a report that revealed that during the housing crisis “17 percent of Latino and 11 percent of African-American homeowners have lost their home or are at imminent risk of losing their home, compared with 7 percent of white homeowners.” Empowering minorities to buy homes with unsustainable mortgages is vastly more egregious than imposing a market-stabilizing fix that would minimize taxpayers’ current overexposure to mortgage market risks, even if it might reduce the numbers who can buy. (The federal government went from backing 30 percent of mortgages before the recession to 90 percent of loans currently being originated.)

Perhaps some of the bailout funds that are currently going to cover the scores of foreclosed Fannie and Freddie-backed loans might better be used to promote homeownership in minority communities by providing them with access to quality education in two ways: the academic sort, which increases incomes and the ability to save up for down payments, and the financial literacy sort, which are the fundamentals that could leave these communities empowered to increase their savings and investments, their access to loans and their ability to build sustainable wealth.

The real concern for relatively low-income homebuyers is not the Fannie/Freddie wind-down, but rather the potential for a highly restrictive Qualified Residiential Mortgage (QRM) rule, which some say would ratchet interest rates on mortgages with 20 percent or lower down payments as much as 3 points higher than others. Of course, that wouldn’t just affect minority buyers — over 70 percent of all loans originated in 2009 would fall into what some say would be a next-generation version of subprime. But the QRM rule is still being hotly debated, so much so that it’s hard to parce realistic projections apart from hyperbole.

Fiction: Everyone will have to put 20 percent down.
Fact: Lower down payment options will always exist.

It’s true that the Treasury Department’s aim with winding down Fannie and Freddie is to minimize the federal government’s participation level in the mortgage markets which, in turn, might limit low down home loan options and require homebuyers and refinancing homeowners to put more of their own skin — be it down payment funds or home equity — in the game.

Consider this: the Center for Responsible Lending calculates that it would take an average U.S. household over 10 years to save for a 10 percent down payment and 2 percent closing costs. As a result, it will almost undoubtedly always be the case that the private lending market will step in to create mortgage products that are more accessible than those that require a 20 percent or even a 10 percent down payment, or they’ll be left with virtually no one to lend to.

Fiction: The homeownership rate will plummet.
Fact: The government will probably not be getting out of the mortgage business, so any declines in homeownership will be due to changes in consumer sentiment, not access to loans.

Even I originally suspected we would see a decline in the homeownership rate overall in the absence of Fannie and Freddie. But as time goes on, it doesn’t look like that will necessarily be the case. The most recent legislative proposal for how to wind Fannie and Freddie down is a bipartisan bill that proposes not to leave the mortgage market in anywhere near the dramatic fashion people suspect, but rather to replace Fannie and Freddie with some (perhaps alarmingly similar) private companies that offer federally backed mortgage bonds.

Between these GSE-replacement companies and the likelihood that the private mortgage market will seek to make some extra coin by charging homebuyers more for easier-to-get loans, the chances that there will be a drastic increase in the numbers of people who want to buy homes and can’t qualify for a mortgage after Fannie and Freddie are gone are somewhere between slim and none.

Fiction: High-end homes will become harder to buy.
Fact: Conforming loan limit changes will affect a small sliver of the market, a sector of housing consumers who can afford to get jumbo loans on the private market.

The first step of the Fannie/Freddie wind-down will be to let the 3-year-old “temporary” increase of the conforming loan limit from $625,500 to $729,950 expire on October 1 of this year. Some have expressed concerns that this will wipe out the high-end home market. Fact is, most of that market – homes above the current limit of $729,950 – is already required to find mortgage funds on the private market. And the vast majority of U.S. homes are still priced below the new, high-cost area conforming loan limit of $625,500, though it’s true that federally backed loan limits in some areas will come down even lower than this.

Most homebuyers in the price ranges affected can afford to pay a slightly higher down payment and interest rate to get a jumbo loan on the private mortgage market. Those who can’t might want to reconsider whether they can truly afford a home that pricey.

Correction: In the paragraph explaining the two companies’ financial reports, Freddie Mac’s Q1 report was mistakenly attributed to Fannie Mae. Fannie Mae’s $8.7 billion loss was mistakenly attributed to Freddie Mac.

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