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WorldJune 2 2014

Fannie Mae and Freddie Mac: here to stay?

Since their federal takeover in 2008, the fate of US mortgage underwriters Fannie Mae and Freddie Mac has hung in the balance. Politicians have jostled back and forth on the issue of winding them down, but without any workable and politically agreeable way to fill the void they would leave in the US housing market, it seems that the two institutions may be here to stay.
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Fannie Mae and Freddie Mac: here to stay?

It could be argued that settling the fate of Fannie Mae and Freddie Mac, the US mortgage underwriters, is an urgent matter, considering the risks and distortions of their continued survival as government-owned and controlled enterprises.

The institutions’ dominant status, giving them broad influence on lending and credit availability, is one consideration. Fannie Mae and Freddie Mac own or guarantee a monumental $5000bn, or 60% of all mortgages, in the country’s secondary mortgage market, which is the world’s second biggest securities market, next only to US treasuries, US Treasury officials say.

That dominant position hinders competition and "the growth of a healthy non-government-guaranteed part of the mortgage finance market, the private label security market,” according to Michael Stegman, secretary for housing finance policy at the US Treasury. He says that this could represent about 15% of the market.

Added to that, the systemic risks of such a position were proven not so long ago, when the government, to prevent the whole US housing finance system seizing up and with it the global economy, rescued Fannie and Freddie at the height of the 2008 financial crisis, after losses from subprime mortgage investments brought the two firms to the brink of collapse.

Just how substantial a commitment that intervention was in broader global terms may never be calculated. But as far as nursing the two firms back to health goes, between September 2008 and 2011, it took $187.5bn in taxpayer money to keep them afloat. It was the biggest bail-out by the US government of the financial crisis. Without that injection, Fannie and Freddie would have disappeared.

Capital lock out

Ever since the privatisation of Fannie and Freddie some 40 years ago – they were launched in the 1930s to increase the supply of mortgage finance, to keep mortgage costs low – they have had an ambiguous status. During the US housing boom preceding the 2008 meltdown, they benefited enormously from being considered by investors as private companies with an implicit government guarantee, or too big to fail.

Now, under government 'conservatorship' – a step short of outright nationalisation reflecting the government’s 79.9% shareholding in the firms – they have continued their core business of buying loans from banks, and pooling and packing these into mortgage-backed securities (MBS) which could be sold to pension and mutual funds. The securities are then guaranteed by Fannie and Freddie so the buyers or investors face no risks. If the underlying loan of the MBS defaults, Fannie and Freddie pay for the loss.

Since the two firms started being profitable again in 2012, buttressed by extensive government support and a housing recovery, they have been obliged to pay all their profits, amounting to $213bn between January 2012 and the end of March 2014, to the US Treasury as dividend payments.

Under the terms of the bail-out agreement, the firms cannot use these profits to rebuild their capital. That puts them in a vulnerable position should there be any sudden shock in the financial system. It is also a requirement that made proposed legislation this year, that would leave the government’s bail-out agreement intact, wind down Fannie and Freddie, and gradually shift some of their massive mortgage risk to the private market, a flashpoint with the companies' shareholders.

Though both companies were delisted when the government rescued them, wealthy hedge fund and mutual fund speculators bought Fannie Mae and Freddie Mac common and preferred shares on the grey market and now they want to redeem them. The investor groups have sued the government; US courts are set to hear their cases later this year.

At the same time, coalitions backed by the funds aggressively lobbied US Congress and the sponsors of the proposed legislation, to derail it. Meanwhile, the US government and taxpayers will again pick up the bill for Fannie and Freddie if there is another housing market downturn, or even a hiccup.

David Stevens, the head of the Mortgage Bankers Association, which groups large and small banks and non-bank mortgage lenders, says: “The point we make is that those who say the status quo is a sustainable environment, or even call to put these institutions back to where they were before the crisis [re-privatise them], this is a bridge to nowhere. It is legally not possible to put them back where they were without legislation.”

According to a well-informed banker, who does not wish to be named: “Whichever way you slice it, Treasury cannot act unilaterally, either to wind down Fannie Mae and Freddie Mac or to re-privatise them [which is not an option the government wants]. There has to be an act of Congress."

Difficult to replace

Against this background, a bipartisan bill, sponsored by senators Tim Johnson, a Democrat from South Dakota, and Michael Crapo, a Republican from Idaho, to overhaul the US housing finance business and wind down Fannie Mae and Freddie Mac, passed in a committee vote on May 15, 2014, but failed to muster a large majority. It won 13 votes out of 22. The weak result makes it highly unlikely that the US Senate will allow the measure to come up for a full vote before attention moves away to this year’s mid-term congressional elections.

It is the fourth legislative attempt to overhaul Fannie and Freddie in two years that has ground to a halt. Lobbying by powerful hedge funds against the measure may be one reason why the bill stalled but, analysts say, it is not the only reason.

In spite of the high stakes of such a reform – the housing market accounts for nearly 20% of US gross domestic product – it has proved hard to forge an agreement on a business model to replace Fannie and Freddie that can be supported by key players in the housing industry. Those include the country’s large and small banks, the National Realtors Association, the National Home Builders Association, and consumer and civil rights groups defending affordable housing.

The administration of US president Barack Obama, and centrist Republicans and Democrats who backed the reform, also had to walk a fine line balancing the largely Republican goal of heading off future taxpayer bail-outs with the desire of liberal Democrats to preserve broad access to mortgage credit and, especially, the 30-year fixed-rate mortgage, which has been a hallmark of middle-class America for decades.

The affordability of housing finance proved the biggest obstacle in negotiations between the bill’s sponsors and liberal Democrats leading up to the committee vote. The Democrats and their supporters objected that the bill did not do enough to force mortgage lenders to serve low and moderate-income borrowers and communities with lower credit ratings, for instance, a city such as Detroit, recently bankrupted, or rural areas.

“There has to be a clear duty to serve all markets at all times,” says Nikita Bailey, vice-president of the Centre for Responsible Lending.

Reversal of fortunes

Further complicating debates, after two years, the US housing recovery is stalling. Mortgage originations, new home sales and mortgage applications, especially by first-time home buyers, fell steeply in the first quarter of this year. That raised questions, according to Mr Stevens of the Mortgage Bankers Association, over whether the pendulum may not have swung back too far, from the reckless mortgage underwriting of the past decade, when housing was promoted too much, to an environment where mortgage underwriting may now be too strict and mortgage credit too tight.

“Things can go too far. You can get to the point where access to housing becomes a political issue on the other side. There are tipping points that can go either way,” he says.

Noting the changed environment, both Jacob Lew, the US Treasury secretary, and Janet Yellen, the Federal Reserve chairwoman, highlighted in May how doldrums in the housing market are a factor holding back the US economy’s recovery.

Then, just two days before the Senate vote on the bipartisan bill, on May 13, in a striking U-turn on US housing policy, Melvin Watt, the newly appointed director of the Federal Housing Finance Agency (FHFA), which oversees Fannie Mae and Freddie Mac, said at an event at the Brookings Institute, that the focus of the government-controlled mortgage behemoths must no longer be to retreat from the housing market but to keep making more credit available to home buyers. The retreat option had been the plan of his predecessor, Edward DeMarco, for four years.

Illustrating the change, Mr Watt said he would drop one of Mr DeMarco’s proposals to lower the loan limits on mortgages insured by Fannie and Freddie. Making the two firms guarantee only lower balance loans would have been a simple way to diminish their presence in the market.

In addition, under the previous FHFA director’s plan, attempts were made to attract private investors back into the mortgage finance market and reduce Fannie and Freddie’s footprint, by increasing the fees for government-backed bonds. In contrast, Mr Watt said: “I don’t think it is FHFA’s role to contract the footprint of Fannie and Freddie.” Shrinking the companies’ share of the market without clear evidence that private investors wish to come back in “would be irresponsible”, he added.

Analysts say that the remarks of Mr Watt represent a reversal in Fannie and Freddie’s position, from institutions that are in a process of being wound down to institutions that need to be equipped to be at the centre of the US housing system for years. Simultaneously, regulators at several government agencies, including the FHFA, are expected over the next few weeks to complete new rules for the underwriting and eligibility of mortgages that are pooled and packed into MBSs, jettisoning earlier proposals requiring bigger down payments on mortgages for certain MBSs.

Fine balance

The change follows the enactment of several new mortgage lending rules, as part of the Dodd-Frank Act, designed to prevent dubious mortgage products and extinguish any incentives banks may have to make loans that are unlikely to be repaid. One of the most significant of these stronger rules established that either borrowers would have to make a 20% down payment on the value of their home or banks would have to set aside 5% of the loan’s risk if it was sliced and packaged and sold as an MBS to investors.

But now these and other underwriting standards – sharply raised by lenders during the financial meltdown – are due to be relaxed, to make it easier for first-time and other entry-level home buyers to obtain a mortgage. Industry experts, including bankers and economists, worried about the change in direction at Fannie Mae and Freddie Mac, and regulators’ moves to ease lending standards, fear that the changes might open the door on another housing bubble and bust.

Mr Watt also said that under his directorship at FHFA, there will also be a relaxation in some of the conditions under which banks are obliged to buy back mortgages that they sold to Fannie and Freddie, if they turn sour.

Existing buy-back policies have had a chilling effect on major banks and are a principal reason why mortgage lending is still fairly tight years after the 2008 panic. Ron Haynie at the Independent Community Bankers Association says: “That has had a profound impact on how aggressive lenders are going to be.”

Legal settlements between Fannie Mae and Freddie Mac have so far been reached with eight banks, including Wells Fargo, the largest US mortgage lender and fourth biggest US bank by assets. The biggest settlement was with Bank of America, the second largest US bank by assets, which has paid, or set aside, $36.2bn in the past five years to buy back mortgages, mainly sold to Fannie and Freddie, which the bank originated before the crisis but that turned bad after.

The legal settlements, amounting to one-off windfalls, give a misleading picture of Fannie’s and Freddie’s profitability. In their first quarter 2014 earnings, a whopping $9.5bn of the two firms’ income, out of a total of $10.2bn that they will pass to the US Treasury as dividends, is the product of a settlement between a US bank and the FHFA, after Fannie and Freddie’s regulator won lawsuits.

Mr Watt noted that Fannie and Freddie’s recent profits should not determine policy. But, he still wants to maintain the two firms prominence.

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