(Dr. Ann B. Schnare is currently principal of AB Schnare and special consultant to Criterion Economics. Prior to that, Senior VP for Corporate Relations at Freddie Mac, and VP for Housing Economics and Financial Research. The opinions expressed here are her own.)
WASHINGTON (Reuters.com) — You may not know much about beleaguered mortgage giants Fannie Mae and Freddie Mac — but without them you might find it much tougher to buy a house, especially in a real estate market like this one.
Fannie Mae and Freddie Mac are not arms of the government, but “government sponsored” private companies set up to help segments of the mortgage market run smoothly. To date, they’ve performed that task extremely well: homebuyers looking for plain vanilla 30-year mortgages, the kind that Fannie and Freddie deal in, still have a relatively easy time finding loans. In the meantime, markets for larger or more exotic mortgages — such as those tailored to borrowers with poor credit histories — have all but dried up.
Still, as you’ve probably learned, Fannie and Freddie are in trouble. Both have reported significant losses in the past two quarters, and additional losses are anticipated at least through the end of the year. Their stock prices plummeted last week, losing almost 50 percent of their market value due to increasing concerns over a possible government takeover. In response, the Federal Reserve and the Treasury are granting the two GSEs access to additional credit in the event that it proves necessary.
So far, financial difficulties at Freddie and Fannie have not imperiled the important and constructive role that both companies play in the mortgage markets. That’s in large part because investors believe that the Federal government will be forced to stand behind the guarantees and debt that these companies issue. Failing to do otherwise would have dire consequences for the housing market and broader economy. The immediate effects would be felt on Wall Street. Fannie Mae and Freddie Mac securities and debt have become an integral part of capital markets, and a loss in confidence in their value would send shock waves throughout the world. The effects would also be felt on Main Street. Among other things, it would mean that Americans would pay significantly higher interest rates when they purchase or refinance their homes, and that fewer Americans would qualify for a mortgage at all. These factors would place additional downward pressure on already-declining housing prices and further undermine an anemic economy.
So far, it is unlikely the government will need to step in. However, this doesn’t mean that Fannie and Freddie will come out of this mess without some changes.
THE ROLE OF GSEs
How do Fannie and Freddie work? They provide liquidity to the mortgage markets by buying loans from lenders — such as mortgage firms like Countrywide and large banks such as Wells Fargo and Bank of America — and packaging them into securities, which they sell, with a guarantee, to large investors like hedge funds and pension funds. They also purchase mortgages for their own investment portfolios and fund their purchases through the issuance of corporate debt. By providing a secondary market outlet for mortgage loans, the GSEs replenish the funds that are available to lenders, thereby enabling them to make additional mortgages to other borrowers.
Because of their Congressional charters, investors have typically viewed both GSE securities and debt as carrying the implicit guarantee of the federal government. This implied guarantee has enabled the GSEs to raise money at rates that are only marginally above those of comparable US Treasuries, which has translated into lower mortgage rates for borrowers. It has also helped to make the 30-year fixed-rate mortgage the financing vehicle of choice for most Americans.
The critical role that the GSEs play in providing stability to the mortgage market has never been more evident than it is today. While other sectors of the mortgage market have come to a virtual standstill, the supply of “conforming” credit — i.e., mortgages that are eligible for purchase by Fannie Mae and Freddie Mac — continues to flow and interest rates are close to historic lows. Even with last week’s turmoil, the interest rates on a 30-year fixed-rate conforming loan averaged just over 6 percent. And while government-insured mortgages such as FHA are also on the rise, Fannie Mae and Freddie Mac now purchase almost 9 out of every 10 mortgages that are sold into the secondary market today.
Other sectors of the mortgage market have not fared as well. Since the subprime crisis exploded in August 2007, the securitization of subprime and so-called “low doc” loans has essentially come to an end. Combined monthly issuances of securities backed by such mortgages fell from about $87 billion in March 2007 to effectively zero today. The collapse of the secondary market for both subprime and low doc mortgages has inevitably led to dramatic declines in the origination of such loans. Origination volumes for both subprime and low doc loans fell by about 50 percent in the final quarter of last year, and preliminary evidence suggests that these trends are continuing.
More telling, perhaps, is what has happened in the jumbo market. Jumbo mortgages — that is, mortgages that are ineligible for GSE purchase due to their size — have experienced essentially the same fate as subprime and low doc loans. Between March 2007 and March 2008, the monthly volume of security issuances backed by jumbo mortgages to borrowers with strong credit fell from $20 billion to $1.3 billion. While some banks are continuing to originate jumbo loans and holding them as investments, their willingness and ability to expand their mortgage holdings over a protracted period of time is problematic. Jumbo originations to “prime”” borrowers dropped by about 47 percent in the fourth quarter of 2007, and preliminary estimates for 2008 suggest a continued downward trend.
Interest rates on jumbo mortgages have also risen dramatically. Over the last two decades, the difference between the interest rate on jumbo and a conventional conforming mortgage has ranged from about 0.25 to 0.50 percent. In other words, if the rate on a loan that could be purchased by Fannie or Freddie was 6 percent, a jumbo borrower would typically pay between 6.25 and 6.50 percent on an otherwise similar mortgage. However, since mid-August, the so-called “jumbo conforming spread” has risen to unprecedented levels. In March, for example, the typical jumbo mortgage had a rate that was about 1.40 percentage points higher than an otherwise similar conforming loan.
While jumbo mortgages may be restricted to a privileged few in many markets, this is not the case in high cost areas. In 2006, for example, jumbo mortgages represented 68 percent of all home purchase loans in San Francisco; 53 percent in Los Angeles; 33 percent in Bridgeport-Stamford-Norwalk; 29 percent in New York; and 27 percent in Washington DC. These statistics refer to the entire metropolitan area and not to exclusive enclaves such as Manhattan.
Concerns over the availability of mortgage credit in high cost areas led Congress to enact a temporary increase in the conforming loan limit as part of the 2008 Economic Recovery Act. Under the Act, the limit for single family mortgages was raised from $417,000 to as much as $729,750 in certain high cost markets, depending on their median house price. While the increase is scheduled to expire at the end of the year, provisions for raising the limit to a maximum of $625,000 on a permanent basis in high cost markets are included in pending housing bills.
What Lies Ahead?
Going forward, it is clear that some type of reform is necessary. Too much risk has been concentrated in two privately owned corporations heretofore subject to a relatively weak regulatory regime. Some have argued that the GSEs should be “privatized” by revoking their Federal charters. However, the last year has provided ample evidence that the private securitization model as currently constructed does not work. Risk in that market was so widely dispersed (and misunderstood) that virtually everyone involved was asleep at the wheel. In contrast, the GSE model has performed remarkably well. While not impervious to the excesses of the market, Fannie Mae and Freddie Mac have been a stabilizing force that has prevented a bad situation from getting even worse.
Pending housing bills call for the creation of a new federal regulator with significantly expanded powers over the GSEs. The regulatory challenge going forward will be to ensure that the GSEs’ private interests do not outweigh their public purpose or expose the taxpayers to unnecessary risk. Otherwise, there is a danger that shareholders will reap all of the gains, while the government assumes all of the risk. While this tension has always been inherent in the GSE model, recent market turmoil has served to highlight both the benefits and risks of the current system in a severely stressed housing market.