(Bloomberg Opinion) -- Trump administration officials announced last week that if Congress doesn’t come up with a plan to overhaul Fannie Mae and Freddie Mac in the next couple years, they will. Their plan is to simply privatize the two giant mortgage banks. A better one would be to liquidate them.
Fannie Mae and Freddie Mac have been under the control of the government ever since they were nationalized during the Great Recession a decade ago. The federal government took responsibility for Fannie and Freddie’s debts, and in exchange gets to keep all their profits. On the surface, the deal has worked out for the U.S. Treasury: The government paid out roughly $191 billion in bailout money and has earned about $280 billion in profits. That gain, however, masks the enormous liability that taxpayers are carrying — and the way in which Fannie and Freddie make the mortgage markets more risky.
Quicktake: Fannie Mae and Freddie Mac
Fannie and Freddie are middlemen. They buy loans made by banks and retail mortgage lenders, then repackage them into mortgage-backed securities that they sell to investors. These securities come with a guarantee that payments will be made on time even if the original borrowers are late or default on the mortgage.
Currently about $4.7 trillion of mortgage-backed securities are guaranteed by Fannie and Freddie. The theory is that this guarantee makes it cheaper for Americans to buy homes because it makes investors willing to purchase mortgage-backed securities and thus fund the issuance of new mortgages. In practice, however, Fannie and Freddie loans tend to be slightly more expensive than so-called “jumbo loans.”
When Fannie and Freddie securitize a loan, they charge a fee of just under 0.5%, on average. But Fannie and Freddie are not allowed to securitize large mortgage loans (the ceiling, somewhere between $484,000 and $727,000, varies depending on the average home value in the county the loan was issued). Because lenders of jumbo loans do not pay this fee, they pass some of the savings on to their customers.
While a small percentage of jumbo loans are sold to Wall Street, most are held by the lender. And precisely because they are holding on to the loans, lenders typically have higher standards. In 2018, the average credit score for someone with a jumbo loan was 18 points higher than for a homebuyer with a mortgage backed by Fannie or Freddie.
So, to review: Fannie and Freddie don’t actually lower costs, but they do lower standards.
Now, there may be a legitimate public interest in making mortgages easier to get for those who’ve had bad credit. There is already a federal agency, however, to serve that interest: the Federal Housing Administration. The FHA accepts borrowers with lower credit scores and smaller down payments than do Fannie or Freddie, but has more stringent debt-to-income requirements to ensure buyers don’t get in over their heads.
Just after the financial crisis, many conservative commentators blamed Fannie and Freddie for the housing bubble. That’s wrong. The housing crisis was primarily fueled by risky subprime and so-called alt-A loans that were made by private lenders and securitized by Wall Street.
Fannie and Freddie did, however, set the stage for the crisis by popularizing a business model of lending and then passing the risk off to someone else. By keeping the securitization market alive today, they are discouraging banks from developing expertise in evaluating individual borrowers and deciding which credit risk they are willing to hold. They are also weakening the ties between mortgage lenders and the communities they serve.
Economists, myself included, used to see those types of tangible links between businesses and their communities as antiquated. The financial crisis and subsequent slow recovery have changed my view. While the securitization and globalization of mortgage finance is inevitable, it needn’t be subsidized with taxpayer dollars or implicit federal guarantees. The primary responsibility for home mortgage lending belongs with private banks. Local institutions still matter.
(Corrects eighth paragraph to remove reference to FHA only making loans to first-time buyers or those who haven’t owned a home in at least three years.)
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Karl W. Smith is a former assistant professor of economics at the University of North Carolina's school of government and founder of the blog Modeled Behavior.
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