Lawmakers have three options for getting Fannie Mae and Freddie Mac out of conservatorship: nationalize the companies, retain their public-private status with increased oversight, or sell them off to private investors.
That’s according to James Lockhart, who was appointed by former President George Bush in 2006 to head the regulatory agency that oversees Fannie and Freddie.
Lockhart continues as head of the Federal Housing Finance Agency — the successor to the Office of Federal Housing Enterprise Oversight, or OFHEO — which was given considerably more power to oversee Fannie and Freddie in July 2008.
That’s when Bush signed the Housing and Economic Recovery Act of 2008, the legislation that paved the way for the government to provide billions in assistance to Fannie and Freddie and place the companies in conservatorship.
With Fannie and Freddie purchasing or guaranteeing about three in four mortgages originated in the last three months of 2008, few are questioning that the government will continue to prop the companies up.
In fact, the foreclosure prevention plan rolled out this week by the Obama administration included a commitment for the government to buy up to $200 billion of each company’s preferred stock — double the previous commitment of $100 billion.
That commitment provides an effective guarantee that Fannie and Freddie have a positive net worth. Although Freddie has needed only about $13.8 billion in support, it will need another $30 billion to $35 billion to cover fourth-quarter losses, Lockhart said. Fannie recently announced it will need the government to invest $11 billion to $16 billion in the company to cover fourth-quarter losses.
The Obama administration’s announcement that it’s ready to provide up to $200 billion in capital to each company removes "any possible doubt from the minds of investors that the U.S. government stands behind Fannie Mae and Freddie Mac," Lockhart said in a speech Thursday at a meeting of government accountants.
While Fannie and Freddie haven’t come close to exhausting the government’s original $100 billion backstop for each company, Obama and Treasury Secretary Tim Geithner are counting on the companies to play an even bigger role in stemming the tide of foreclosures.
The Obama administration’s $275 billion plan to help up to 9 million families restructure or refinance their mortgages assumes that Fannie and Freddie will stand behind 4 million to 5 million loan refinancings at up to 105 percent loan-to-value ratios. Fannie and Freddie will each be allowed to increase their retained mortgage portfolios — loans the companies hold for investment — to $900 billion, an increase of about 6 percent from the existing limit of $850 billion (see story).
That means Fannie and Freddie could soon hold $1.8 trillion in mortgages as investments — not to mention the guarantees the companies have on nearly $4 trillion in mortgage-backed securities.
All told, Fannie, Freddie and the nation’s 12 Federal Home Loan Banks — collectively known as the government-sponsored enterprises, or GSEs — have a combined debt of $6.7 trillion, Lockhart said.
When the market for "private-label" mortgage-backed securities seized up in the summer of 2007, Fannie and Freddie’s market share grew from a low of 35 percent during the housing boom to 73 percent in 2008.
As private mortgage insurers struggle with growing losses that limit the number of loans they can insure, FHA and VA loan-guarantee programs have also seen their market share grow, from less than 3 percent in 2006 to more than 35 percent in the fourth quarter of 2008.
Lockhart called such rapid growth a "very worrisome issue to any insurance program, but especially a government one," because it may indicate that risk is being underpriced.
Loose underwriting standards and the underpricing of risk during the housing boom left the lending industry and insurers exposed to huge losses when rising home prices reversed course.
"Virtually everyone involved in home mortgage lending — builders, borrowers, lenders, mortgage insurers, credit rating agencies, the Enterprises, and other secondary market investors — failed to appreciate the likelihood of a severe house-price correction," Lockhart said.
At the tail end of the boom, as house prices shot up and rising interest rates reduced housing affordability, low-documentation Alt-A, interest-only loans and adjustable-rate mortgages proliferated, and subprime lenders commanded a 20 percent market share.
While Fannie Mae, Freddie Mac and FHA had once set the standards for prudent mortgage underwriting, the companies responded to their declining market share by lowering their own underwriting standards and buying hundreds of billions of private-label mortgage-backed securities.
The pricing models of Fannie Mae and Freddie Mac assumed that home prices would continue to go up, Lockhart said, leaving the companies exposed to huge losses when home prices started coming down, and delinquencies and foreclosures started to rise.
The loans Fannie and Freddie own or guarantee are performing better than those originated and bundled into securities by private-label lenders, but in the end, the government was forced to intervene.
Fannie and Freddie own or guarantee almost 31 million mortgages, or about 56 percent of all single-family mortgages, Lockhart said. But those loans represent 19 percent of serious delinquencies. Private-label mortgage-backed securities represent 16 percent of the mortgages but more than 62 percent of the serious delinquencies, Lockhart said.
The Housing and Economic Recovery Act of 2008 gives Lockhart’s FHFA greater authority over Fannie and Freddie’s capital requirements and the size of their portfolios.
The Bush administration has blamed Democrats for failing to pass "GSE reform" legislation before the housing boom got out of hand. At the time, Democrats said Fannie and Freddie served as a counter to private-label and subprime lenders, who would gain greater market share only if Congress went too far in restricting the GSEs.
Lockhart said the changes came too late, and that he told Bush a few days before he left office that had a GSE reform bill been passed "several years earlier, we could have prevented many of the problems that led us down the path we are now traveling."
The role played by Fannie, Freddie and the Community Reinvestment Act — legislation intended to encourage lending in underserved areas — in the housing boom and bust has been hotly debated (see story).
But the question remains: Now that Fannie and Freddie are in conservatorship, what should be their ultimate fate?
"The Obama administration has indicated that Fannie and Freddie will continue having a key role in the nation’s economy as we go forward," Lockhart said. "At this point our primary focus has to be getting through the present crisis. However, I do think it is useful to look beyond it."
Lockhart said he is opposed to nationalization because of his belief that government insurance programs are "particularly high risk."
Government insurance programs typically need legislative approval to adjust their charges to stay in step with changes in the market that properly account for risk, Lockhart said. That makes them more susceptible to adverse selection — they attract clients more likely to make claims — and encourages "moral hazard," or greater risk-taking by those who are insured, Lockhart said.
Another option is for the government to spin off Fannie and Freddie to private investors, creating private-sector firms that provide liquidity to mortgage markets either with or without "catastrophic insurance" from the government.
But in Lockhart’s view, the most obvious alternative would be to keep Fannie and Freddie as public-private companies, with increased oversight that builds on the changes instituted through the Housing and Economic Recovery Act.
Fannie and Freddie might continue operating with the $200 billion in net-worth protection the Treasury is currently providing, or the government could create a reinsurance program for catastrophic losses. Lawmakers might also mandate a sharp reduction of Fannie and Freddie’s retained portfolios, which Lockhart said poses the largest market risks and credit risks.
If a public-private model is retained, a public utility model might also be feasible, or a cooperative ownership model similar to that of the Federal Home Loan Banks.
At a hearing in December, Thomas H. Stanton, a fellow of the Center for the Study of American Government at Johns Hopkins University, said Fannie and Freddie could serve as "agents of reform" for the mortgage market if they were placed in government receivership for a time.
At the same hearing, Columbia Business School professor Charles Calomiris recommended privatization, with the government selling off Fannie and Freddie’s assets or carving the companies up into a number of competing businesses with no government guarantees of their debts or liabilities (see story).
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