Promoting Homeownership in the United States: The Rise and Fall of Fannie Mae and Freddie Mac
By Kelsie Brandlee
Americans take great pride in homeownership. For many Americans, homeownership is synonymous with success, independence, and the achievement of the American Dream. Because of the importance that the United States places on homeownership, it is no surprise that the government goes to great extremes to promote it. Before the housing bubble burst in 2008, lending to American homebuyers was considered to be one of the safest lending practices that a bank could engage in. Historically, less than 2% of homeowners have lost their homes due to foreclosure. It has often been said regarding mortgages that what is good for the lender is also good for the borrower. However, as this Briefing Paper will discuss, the advent of the securitization of mortgages changed that premise and culminated in huge amounts of foreclosures and plummeting property values.
This Briefing Paper will explore one of the primary ways the government has promoted homeownership: through Fannie Mae and Freddie Mac. It will discuss the creation of these entities, how they support the housing market, the role that they played in the 2008 financial crisis, and the Obama administration's proposals for their reform. It will also address the policy debate regarding whether Fannie and Freddie are the appropriate vehicles to promote homeownership.
I. The History of Fannie Mae and Freddie Mac
Congress chartered Fannie Mae during the Great Depression in 1938 to help keep the mortgage market liquid; that is, to keep lenders actively providing mortgages. At that time, Fannie Mae ensured a supply of mortgage funds by purchasing mortgages from the Veterans Administration (VA) and Federal Housing Administration (FHA). This exchange enabled the VA and FHA to trade their existing loans for cash so that they could offer more home loans to potential homebuyers. In 1968, Congress split Fannie Mae into two companies: Ginnie Mae, which continued to buy government-issued loans and remained a government entity, and a new Fannie Mae that was part government entity, part private entity. This transition resulted in Fannie Mae's status as a government-sponsored entity (GSE).
The government privatized Fannie Mae in order to reduce the budget deficit, which had been exacerbated due to the Vietnam War. By reorganizing Fannie as a publicly traded corporation, the government was able to remove Fannie's debts from its balance sheet while allowing Fannie to continue promoting the government's mission of homeownership. Congress allowed the new Fannie Mae to buy conventional mortgages, as opposed to only mortgages the government issued. Fannie was also able to issue mortgage-backed securities, which will be discussed in Section II.B. Fannie maintained a unique relationship with the government due to its previous position as a wholly public institution. For example, it had a line of credit with the U.S. Treasury and the President was authorized to appoint five members of Fannie's board of directors. These features blurred the line between a government entity and a private corporation.
In 1970, shortly after Congress reorganized Fannie Mae, it chartered Freddie Mac to buy up mortgages under the Federal Home Loan Bank Board, allowing these institutions to make more mortgages. In 1989, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act, which dissolved the Federal Home Loan Bank Board and put in place a shareholder-elected board of directors for Freddie Mac, making it a publicly traded company. This gave Freddie Mac GSE status. Throughout this Paper, GSEs will refer exclusively to Fannie Mae and Freddie Mac.
In 1991, Congress began developing a regulatory scheme to oversee the GSEs. It created the Office of Federal Housing Enterprise Oversight (OFHEO), which was a subsection of the Department of Housing and Urban Development (HUD) and was succeeded by the Federal Housing Finance Agency (FHFA) in 2008. When Congress created the OFHEO, it also amended the GSEs' charters to include an affordable housing "mission." In 1999, for example, the GSEs reached an agreement with HUD that by 2001, half of the mortgages they guaranteed would be made to low-income borrowers. As discussed below, this affordable housing mandate contributed to the GSEs’ demise.
II. Fannie Mae and Freddie Mac Are Government-Sponsored Entities (GSEs) Created to Stabilize the Mortgage Market and Increase Homeownership Opportunities
By virtue of their GSE designation, Fannie and Freddie have a unique status that has proven to be very beneficial for their success as a corporation. This Section will discuss what a GSE is and how the GSEs operate to make the dream of homeownership more accessible for many Americans, particularly those with low to moderate incomes.
A. Fannie Mae and Freddie Mac Were Created To Inject Liquidity Into the Mortgage Market to Enable Mortgage Lenders to Provide More Loans
The GSEs are like a government enterprise because they were created by Congress and have a Congressional mandate to help make home ownership a reality for low to middle-class Americans who may not otherwise be able to afford a home. However, they are like a private enterprise because they have shareholders and the structure of a traditional corporation. Fannie and Freddie have dual missions that emphasize this public-private dichotomy: a public mission to support the mortgage market and a private mission to maximize shareholder profits.
The GSEs make homeownership more accessible by injecting liquidity into the mortgage market. They do this by purchasing "conforming mortgages" (mortgages that meet their underwriting standards) from banks, thrifts, and mortgage companies. By purchasing mortgages from banks and other lenders, those lenders are able to use that cash to provide additional loans. Further, once a GSE purchases the mortgage, the lender no longer has to worry about the default risk associated with the mortgage; namely, that the borrower will not be able to pay back the loan. After the GSEs purchase mortgages, they bundle them into securities that they either hold onto and collect the borrowers' loan payments or sell to investors with a guarantee that the borrowers will make their payments. If a borrower defaults, the GSEs pay the investors because the guarantee.
The GSEs make it easier for lenders to make thirty-year, fixed-rate mortgages, which would otherwise be risky loans for lenders to make if Fannie and Freddie were not there to purchase them. These loans are risky because they involve both credit risk and interest-rate risk. Credit risk, which increases as the length of the repayment period increases, is the risk that the borrower will not be able to pay back the entire loan. Thirty years is a long period of time over which the borrower has to pay back the loan. Because of that length of time, many unforeseeable events could arise that could result in the borrower defaulting on the loan. These loans also involve interest-rate risk because the interest rate is fixed over thirty years. If market interest rates rise over the repayment period, the loan becomes less valuable because the interest rate on a thirty-year, fixed-rate mortgage will remain constant. When Fannie and Freddie buy mortgages from lenders, they absorb the credit and interest-rate risk, making it easier for lenders to provide more long-term loans.
B. The GSEs Issued the First Mortgage-Backed Securities
The GSEs either hold onto the mortgages that they buy from lenders or securitize and guarantee them. Freddie Mac issued the first mortgage-backed securities in 1971 and Fannie securitized its first mortgages in 1981. When the GSEs securitize mortgages, they essentially pool all of the mortgages they have bought and repackage them into securities called mortgage-backed securities (MBSs). For an investor who has purchased a MBS, the security represents a claim on the principal and interest payments that the borrowers will make on the mortgages in the pool. The GSEs guarantee the payment of principal and interest to the investors. By doing so, they are taking on the risk that the borrower may default, making these securities very popular among investors.
Selling mortgage-backed securities is also profitable for the GSEs for two reasons. First, they profit because of the fees they charged to guarantee the MBSs that they issue. These fees are called guarantee fees or "g-fees" and consist of the amount the GSEs receive per month for guaranteeing the default risk on a MBS. This fee covers the GSEs' projected losses due to borrower defaults and administrative costs. Because the GSEs had such a large market share over MBS sales, they were able to charge fees that covered more than potential losses; they also provided profits. Second, these sales allow the GSEs to get rid of some of the risk inherent in holding onto the mortgages, other than the default risk, which they guarantee. Investors assume the interest-rate risk—i.e., that the market price of the MBSs will decline if interest rates rise.
For a while the GSEs were the only institutions that issued MBSs. However, by 2005, commercial and investment banks and thrifts were securitizing more home loans than the GSEs and selling them to private investors. The GSEs were losing their market share to Wall Street, resulting in reduced profits and unhappy shareholders. In an effort to regain the market share that they enjoyed in the 1990s and better compete with these entities, Fannie and Freddie expanded the type and quality of loans they purchased to include subprime and Alt-A loans. Alt-A loans are less risky than subprime, but carry more risk than prime loans, usually because of a lack of documentation of the borrower's credit or income. A subprime mortgage is a mortgage given to a borrower who is not eligible for a conventional mortgage because he or she has a low credit rating, typically, below 620. These mortgages tend to have higher interest rates because of the inherent risk in providing a loan to an individual with such a low credit score.
The increasing popularity of MBSs helped contribute to the financial crisis and introduced new threats to the housing market. Once a lender sold a mortgage to a third party such as the GSEs, it severed the link between itself and the borrower. Securitization of mortgages contributed to a shift from originate-to-hold to originate-to-distribute lending practices. In a traditional originate-to-hold lending practice, the lender retains the loan on its balance sheet, so it has an incentive to loan exclusively to creditworthy borrowers because the lender will only profit if the borrowers repay their loans. This incentivized banks to check borrowers' credit histories and ensure that they would have enough income to pay back the loan.
However, this traditional lending practice gave way as originate-to-distribute lending became more popular in the early 2000s. Originate-to-distribute lending occurs when lenders sell their loans to third parties and therefore no longer hold those loans on their balance sheets. When an originating bank is able to separate itself from the default risk associated with the loan, its screening incentives diminish because it no longer risks losses if the borrower defaults. This practice incentivized lenders to make more low-quality and subprime mortgage loans.
In an environment where lenders could profit from the sheer volume of the loans made, regardless of their quality, it became profitable for lenders to make loans to subprime borrowers because the lenders did not have to worry about the default risk. However, the originate-to-distribute model did not eliminate the risks inherent in mortgage loans. Rather, it just transferred the risks to investors and other institutions. For a variety of reasons, many subprime borrowers were unable to repay their mortgages. Other borrowers made calculated decisions to default on their mortgages when home prices began to decline in 2006, as many of them owed more on their mortgages than their homes were worth.
III. The GSEs Played an Important Role in the 2008 Financial Crisis
While they are certainly not the only institutions deserving of blame for the financial crisis, Fannie and Freddie bear at least some responsibility for the 2008 global financial meltdown because their actions helped the subprime mortgage business prosper. The GSEs purchased large quantities of subprime mortgages and sold them as MBSs to investors around the world, thereby increasing the liquidity and appetite for more subprime lending. Increased subprime lending led to high default rates and increased home foreclosures. The GSEs’ role in the financial debacle can be explained by their goal of promoting affordable housing and their pursuit of profit
A. The Government Set Affordable Housing Goals for the GSEs Which Contributed to Increasingly Lax Underwriting Standards
In order to achieve government-set housing goals, the GSEs employed increasingly lax underwriting standards that contributed to their increased exposure to risky debt. However, by enforcing less-strict standards and investing in subprime securities, the GSEs made it easier for those with poor credit scores to obtain mortgages, thereby aiding them in reaching their affordable housing goals.
The GSEs' underwriting standards did not become more lax because of a lack of government regulation. Rather, the government pushed the GSEs to lower their standards in order to increase the availability of home mortgages for low-income Americans. The government first urged lenders to help low-income individuals get home loans when Congress passed the Community Reinvestment Act of 1977. This Act was passed in response to growing concerns that lenders were not providing loans to individuals from certain neighborhoods and encouraged lenders to lend to individuals with poor credit to assist them in purchasing a home, regardless of his or her creditworthiness. This government pressure continued to grow, particularly in the 1990s. For example, a 1992 federal law required that a "reasonable portion" of the GSEs' mortgage purchases support low-income individuals seeking to buy a home. Over time, that gentle urging was transformed into government-set quotas promulgated by HUD, requiring that a certain percentage of the mortgages that the GSEs purchase were made to the "underserved population." In 1996, the quota was set at 40%, and it continued to rise until 2008 when it reached 56%. Many commentators have argued that through these regulations, the government was promoting lower lending standards. The lower standards made it possible for nearly anyone to get a mortgage, even individuals with poor credit histories and little income. Therefore, the increased access to home ownership helped the GSEs reach their affordable housing goals—in 2004 nearly 63% of Americans were homeowners.
Others contend that these goals gave the GSEs an excuse to deviate from prudent underwriting standards so that it could take advantage of a more profitable but high-risk segment of the housing market. Between 2005 and 2007, 57% of the mortgages acquired by Fannie Mae were characterized as subprime (because borrowers had FICO scores of less than 620). Over this same period, 61% of the mortgages acquired by Freddie Mac were characterized in this same way. As of June 2008, Fannie was liable for $619 billion worth of subprime and Alt-A loans, while Freddie was liable for $392 billion. As of August 2008, the GSEs held or guaranteed a combined total of over $1 trillion in unpaid principal balance exposures on subprime loans.
A federal agency looked on as the GSEs implemented lower underwriting standards. The Office of Federal Housing Enterprise Oversight (OFHEO) was charged with overseeing the GSEs and was aware of the GSEs’ risky practices. However, it determined that their purchases of risky mortgages and MBSs did not warrant concern. As a matter of fact, OFHEO routinely noted the increased exposure of the GSEs to subprime default risk, but it never did anything to address it. Rather, its examinations of the GSEs regularly concluded that they both had sufficient capital and prudent credit-risk management. One reason that OFHEO was unable to effectively regulate the GSEs was because GSE executives negotiated with Congress so that the agency was subject to the appropriations process. This meant that the OFHEO's budget was subject to the will of politicians who the GSEs were able to manipulate with their lobbying tactics. According to one Freddie Mac lobbyist, OFHEO could either "appease Fannie and Freddie or get reamed in the budget." Therefore, it is not surprising that OFHEO was a weak regulator.
B. Profit Maximization
Because the GSEs were structured like corporations, they had shareholders with a stake in their profitability. One reason that the GSEs reduced their underwriting standards and fought increased capital requirements is because, at least in the short term, it helped them maximize their profits. While lowering their underwriting standards helped the GSEs achieve their affordable housing goals, it also helped them earn record-setting profits. The GSEs were hesitant to enter the realm of subprime lending at first, but their investments in this area eventually took off, resulting in their exposure to huge amounts of risky subprime and other nontraditional loans. The more subprime loans that the GSEs bought, the more profits they made. This is because the GSEs charged fees when they resold these mortgages as MBSs to investors. The more mortgages the GSEs had to sell between their dual missions of making homeownership more accessible and affordable and making money for shareholders. The GSEs defended their interest in maximizing profits and, to a certain extent, argued that their dual missions could co-exist because the revenue, profits, and growth that the GSEs achieved through their subprime investments helped them attract more capital from global investors to the U.S. housing market. This enabled them to inject more liquidity into the market. However, many analysts have argued that the GSEs only real concern was maximizing profits and they used the goal of homeownership as a guise to protect themselves politically and portray themselves as an essential public entity.
The GSEs’ profits were worth protecting—the salaries of their top officials were staggering. Between 1992 and 2008, the GSEs' combined book of business grew significantly. In 2000, Fannie reported earnings of $4.448 billion, up from $3.912 billion in 1992. These profits continued to grow and by 2003, Fannie's net income was $7.9 billion. The salaries of GSE employees grew as well. For example, Robert Levin, Fannie Mae's former Chief Business Officer, earned $45 million between 2000 and 2008.
The risks that the GSEs took on in order to maximize profits are exemplified by looking at the relationship between the GSEs and Countrywide Financial. Countrywide originally only made loans that met the GSEs' underwriting standards, and then sold those conforming mortgages primarily to Fannie Mae. By 2003, Countrywide depended heavily on Fannie, which bought 72% of its mortgages. However, this relationship was threatened when Wall Street firms started buying MBSs. Countrywide no longer had to conform to the GSE standards and could instead make mortgages to individuals who posed a higher default risk, knowing that Wall Street firms would buy them even if the GSEs would not. Some executives at Fannie Mae saw the potential for more profitability by "meet[ing] the market where it is" and purchasing Countrywide's subprime loans. According to one Fannie executive, if Fannie would have maintained its standards, it would have protected the quality of its books, but it would have also reduced its market share and earnings, which may have weakened its ability to serve its mission of promoting homeownership.
Critics of the relationship between Fannie and Countrywide have argued that the two institutions had a quid pro quo mentality, as their toxic loans were percolating into the U.S. economy to the detriment of many Americans. This relationship consisted of Countrywide originating below-market mortgages for Fannie employees. In turn, Fannie would securitize and sell Countrywide's subprime mortgages so that Countrywide would not have to keep them on its books and, therefore, would not be liable if the borrower defaulted. In 2010, it was revealed that Countrywide had made 153 discounted loans to thirty-seven Fannie Mae employees while their subprime-based business relationship was growing. These mortgages came from Countrywide's "Very Important Person" (VIP) section, which was created to provide preferential mortgages to favored customers. These loans were likely made in Countrywide's attempt to expand its business with Fannie. In 1998, Countrywide sold $43.4 billion in loans to the GSEs. By 2004, this amount grew to $70.6 billion.
IV. The Government Bailout of the GSEs
When large numbers of subprime borrowers ultimately defaulted, the GSEs required a taxpayer-funded bailout because of the volume of defaulted subprime mortgages that they held on their books and that they had guaranteed and sold to investors. In 2007, both GSEs reported losses in income. These losses continued, and on September 7, 2008, the U.S. government put them under conservatorship where they remain today. The size of the bailout has been truly staggering. While the government provided huge bailouts to the banking and auto industries during the 2008 economic crisis, no institution received a bailout as large as the GSEs. As of February, 2011, Fannie and Freddie had received $153 billion from the U.S. government, a number that is still growing. The FHFA predicts that by 2013, the GSEs will have received over $210 billion.
As explained below, the GSEs fell in part because of the large number of private-label securities they held, backed by mortgages that became worthless when the borrowers defaulted. Second, they did not have sufficient capital to cover their losses. Third, the GSEs' "implicit" government guarantee contributed to their growth and their ability to dominate the market. Finally, the GSEs were rarely criticized and were able to avoid almost all Congressional attempts to regulate them because of their politically popular mission to increase access to homeownership and because they could attack anyone who criticized them as "anti-homeowner." Attempts to regulate the GSEs could have helped them avoid the huge losses they suffered in 2008.
A. In the 2000s, the GSEs Began Purchasing MBSs Created by Other Institutions
The GSEs' venture into the “private-label” MBSs—i.e., securities typically issued by Wall Street investment banks—resulted in their over-exposure to nonperforming real estate mortgages that ultimately lead to their bailout. In the early 2000s, the GSEs began purchasing private-label MBSs in addition to their own continued issuance of MBSs. Traditionally, private investors invested more heavily in private-label MBSs. However, the GSEs gradually became significant purchasers of these securities, grabbing 40% by 2004. Consequently, when the securities plummeted in value, the GSEs suffered significant losses.
B. Low Capital Requirement
Another reason the GSEs required a government bailout in 2008 was because they had insufficient capital to cover their losses, which grew as the value of the MBSs they held plummeted and as borrowers began to default on their mortgages at increasingly high rates. Generally speaking, banks are required to hold capital to cover at least 8% of their risk-weighted assets (many banks' capital exceeds the 8% minimum). However, the GSEs were allowed to operate with much lower capital requirements. In 2008, Fannie’s assets-to-capital (leverage) ratio was twenty to one or 5% of capital to assets; Freddie’s was seventy to one or just over1% of capital to assets. This was in part due to the GSEs’ lobbying efforts. Understandably, commentators have referred to the GSEs as being allowed to operate on "the thinnest wafer of capital" and as only having to put aside "a sliver of capital."
C. The Implicit Government Guarantee of the GSEs
Many investors assumed that the government would bail out the GSEs in the case of an emergency. This is because of Fannie and Freddie's GSE status, i.e., because they were quasi-government enterprises charged with the pivotal role of promoting homeownership. This implicit guarantee helped the GSEs become large and powerful for two reasons. First, they were able to pay less to borrow money than any other financial institution, which gave them a competitive advantage and helped them achieve their large market share. Second, investors felt safe investing with the GSEs because they believed that even in a financial crisis they would get their money back (if not from the GSEs themselves, then from the government). This also contributed to their growth. When financial crisis did strike in 2008, this is exactly what happened: the U.S. government bailed out the GSEs and the investors got their money back.
This government guarantee is implicit. There is no statute privatizing the GSEs or explicitly guaranteeing that the government will back Fannie and Freddie if they fail. Further, GSE executives and government officials often denied that the government would provide a safety net for them in the case of a crisis. However, this assumption of an implicit government guarantee has been well recognized and was crucial to the success of the GSEs. According to a Federal Reserve Report from 2005, the value of the privileges the GSEs received due to this implicit guarantee was worth between $122 and $182 billion.
D. The GSEs Were Rarely Criticized Because of Their Politically Popular Mission to Help Increase Home Ownership
The lack of criticism of the GSEs contributed to their demise as well. The GSEs' political clout helped them avoid regulation and increased capital requirements, both of which could have helped prevent their downfall. Further, some analysts and members of Congress may have recognized that the GSEs were engaged in destructive practices, but didn't speak out about them due to the political pressure to support the GSEs.
Fannie Mae and Freddie Mac were very strong companies politically for two primary reasons: First, they were able to "wrap themselves in the American flag" because of their mission to help underserved populations achieve homeownership. Second, they were able to lobby Congress successfully, warding off any Congressional attempts to increase government regulation of the GSEs or raise their capital requirements. Because of their mission, it was easy for the GSEs to convey the importance of their success to Congress. However, it was not just this mandate that made the GSEs so powerful. They also spent staggering amounts of money on campaign contributions, lobbying efforts, and charitable donations in order to garner support. They were also well connected with Washington insiders who helped them quash potential regulations and silence dissenters.
From 2000 to 2008, the GSEs made $14.6 million in donations to several Congressional campaigns. In total, from 1998 to 2008, Fannie and Freddie spent $79.5 million and $94.9 million, respectively, on their efforts to lobby Congress. Further, the GSEs could attack any dissenters by labeling them "anti-homeowner." The GSEs were also very good at maintaining a positive public image. For example, Fannie Mae's foundation provided significant contributions to groups like the Congressional Black Caucus and the Congressional Hispanic Caucus.
Even when individuals did speak out against the GSEs' risky practices, their warnings were never heeded. In 2005, Federal Reserve Chairman Alan Greenspan said that "if [Fannie and Freddie] continue to grow, continue to have the low capital they have, [then] they potentially create ever growing potential systemic risks down the road." President Bush also publicly expressed his concern over the increased risk that the GSEs posed in 2004. However, in response to his warning, twenty-seven House Democrats sent the President a letter condemning his statements and defending the GSEs, stating that "an exclusive focus on safety and soundness is likely to come, in practice, at the expense of affordable housing." GSE executives also supported the focus on affordable housing over "safety and soundness," as it helped them increase their profits and achieve the housing goals that the government set for them. The fact that nobody wanted to criticize the GSEs for their risky practices and that Congress did not push regulations or increased capital requirements upon them ultimately contributed to their fall.
V. Proposals for the Reform of the GSEs
As of 2011, Fannie Mae and Freddie Mac contribute to 90% of all home loans, so it is difficult to imagine cutting them out of the mortgage market completely. Nevertheless, it seems likely that the GSE structure will change in the near future. The approach Congress takes could have huge ramifications on the U.S. financial system, the mortgage market, and on individual homebuyers. In February, 2011, the Obama administration laid out three proposals for reforming the GSEs, recognizing that Congress will ultimately determine their fate and work out the details of whichever plan they choose. Each of these proposals would reduce the government's involvement in the mortgage market and potential taxpayer liability, resulting in a system that is more reliant on the private sector. Any changes will likely be phased in over a period of at least five years.
The Obama administration has also proposed some short-term measures to help private firms compete with Fannie and Freddie in the mortgage market to help ease the transition into a system with less government involvement in the mortgage market. One such proposal would reduce the size of mortgages that Fannie and Freddie may purchase from $729,750 to $625,600. Another proposal would increase the emphasis on governmental support for affordable rental housing for low-income individuals in order to provide housing alternatives for those who can not afford a home. This rental proposal represents a shift in government policy away from homeownership, suggesting that not everyone should own a home.
A. The First Option Would Give the Government the Smallest Role in the Mortgage Market
One option would provide that the government's only role would be to provide assistance to low-income borrowers through government agencies such as the Federal Housing Administration (FHA), which backed 20% of mortgages last year. However, even this role would be reduced. The mortgage market would rely entirely on the private sector; lenders would originate mortgages and securitize them with no government backing. If Congress implements this option, it would result in the largest impact on mortgage prices. This is because with no government guarantee, mortgage prices would go up. However, it would also provide for the most significant reduction in taxpayer liability. Of all of the proposed options, this one is the least likely to result in a taxpayer-funded bailout.
The government has played a large role in the mortgage market since the 1930s, so this plan represents the most dramatic shift from the current GSE system and comes the closest to privatization. The implementation of this option is likely to have a considerable impact on mortgage prices and individuals seeking to purchase a home. For example, one report suggested that in a privatized system, the cost of financing a $204,900 mortgage would go up $159 per month. It is also likely that this option would make the thirty-year, fixed-rate mortgage unattainable for most borrowers. For those borrowers with enough credit to remain eligible for such a mortgage, it would likely be significantly more expensive than it is today. The option of a thirty-year, fixed-rate mortgage is essential for some homebuyers. It spreads mortgage payments out over a very long period while guaranteeing that the interest rate will not go up over time. Without the GSEs' support, the thirty-year, fixed-rate mortgage is unappealing for banks because of its inherent risk. This option has been polarizing among analysts. Housing advocates worry that this proposal will lead to a serious drop in homeownership. Nevertheless, some analysts were calling for privatization even before the financial crisis, arguing that the existing GSE structure put too much liability on taxpayers.
B. The Second Option Would Provide Limited Government Support During a Financial Crisis
The second option provides a middle ground between option one and three. It would provide a limited government backstop that would provide for increased government support for the mortgage market when there is less private capital available during a financial downturn. During normal times, the government would provide only limited support. While this option would maintain an explicit partial government guarantee, some commentators have suggested that it would be difficult create a government program that is small in good times and large in bad. Here, the risk to taxpayers is less than it is today, but not as low as in option one. The availability of a thirty-year fixed-rate mortgage will be greater in this scenario than in option one because the government backstop would be there to protect against another credit crunch.
C. The Third Option Provides For the Greatest Amount of Government Involvement
The third option leaves the government with the largest role and is most comparable to the current system. It would create privately owned companies that would buy mortgages from banks and sell them as securities, much like Fannie and Freddie do today. Under this option, however, the government would explicitly guarantee those securities as long as they meet certain underwriting standards. Here, mortgage rates would likely be the lowest. However, government involvement would be the highest, putting taxpayers at the most risk. Advocates of this option favor government involvement and argue that the mistakes made in the private sector leading up to the financial crisis far outweigh those made by the GSEs. Further, MBSs that were backed by the GSEs performed better than those that were not.
Today, the private market plays an even smaller role in the mortgage market than it did pre-2008 and the GSEs back almost the entire U.S. mortgage market. The future of Fannie and Freddie now lies primarily with a divided Congress under increasing pressure to wind down taxpayer commitments to them. While Fannie and Freddie have cost taxpayers a lot of money over the past two years, they also played an important role in the mortgage market since 1938. Reforming them will require lawmakers to find a balance between providing for stability in the market and promoting homeownership where appropriate, while reducing the potential for taxpayer loss.
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