The Fannie Mae-Freddie Mac morass

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The time is drawing near: Washington is gearing up to figure out how to deal with wards-of-the-state Fannie Mae and Freddie Mac. I’ve been reporting a homeownership piece for the magazine, so I’ve been thinking a lot about the U.S. system of mortgage finance, and I’ve come to a firm conclusion about what should be done with the GSEs.

Just kidding! If I’ve learned anything in recent weeks, it’s that people who make it seem like the answer is obvious or easy to implement are either naive or have an agenda. Government involvement in the housing market is heavy stuff. And we’re not just talking about whether folks can get a mortgage at 5% or 5.25%.

The very existence of the 30-year fixed-rate mortgage derives from government’s presence. Until the 1930s, we all had short-term mortgages that had to be refinanced every few years. That worked out pretty well—at least until property values collapsed and no one could roll over their loan any more. (Sound familiar?) The Roosevelt administration invented  the 30-year fixed rate mortgage, a much more consumer-friendly product, with the creation of the Federal Housing Administration (FHA) in 1934, and increased its reach with the birth of Fannie Mae 1938.

And, oh, by the way, the Feds didn’t originally intend to create Fannie Mae. Here’s a little piece of forgotten history I came across courtesy of a 1966 government report on the history of Fannie Mae. The whole idea of the FHA was to inject confidence into the battered banking system. Once a bunch of loans had a government guarantee, the thinking went, private industry would step in to create a secondary market, thereby moving mortgage capital around to where it was most needed and establishing more equable national interest rates. But that never happened. So, in 1938, the government did it itself.

Now, that doesn’t mean this function can’t be accomplished by private industry in the future. We had a pretty good private securitization market going on before the real estate bust, after all. In a panic, all that private capital tends to run for the door—consider the past couple of years—but in such situations, even without a Fannie or a Freddie, we’ve still got the Federal Reserve as a lender of last resort (at least that’s the argument Raj Date makes).

The bigger question, I think, is what would happen to the good, old 30-year fixed rate mortgage if we didn’t have the government setting the market’s terms. Only one other country in the world comes even close to the U.S. in terms of how often 30-year fixed rate mortgages are written (Denmark!), which makes one wonder if such steady, long-term loans—a great deal for consumers, but a headache for lenders—would largely go away if the government stopped playing such a major role in the market. Check out this chart, courtesy of San Diego State University’s Michael Lea:

That’s certainly not an argument for going back to the old system. I think we’ve all learned that private, profit-seeking companies with implicit government guarantees are a disaster waiting to happen, the classic heads-shareholders-win, tails-taxpayers-lose scenario. But we should keep in mind that were we to expunge the government from the mortgage markets in the most severe way imaginable, there could be ramifications for what sort of loans homeowners would be able to get.

Could America survive on medium-term fixed-rate loans with prepayment penalties? Canadians and plenty of Europeans manage to. And could the government encourage mortgage market liquidity without holding onto massive investment portfolios (a big part of the reason Fannie and Freddie imploded)? Government loan-guarantee agencies in Korea, Japan and Canada came through this storm intact—as did the U.S.’s Ginnie Mae.

The bottom line is that there are plenty of ways to reinvent mortgage finance in the U.S. The way the world works, though, is if you gain something—less government involvement, less taxpayer risk—you tend to give something up.