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Are We Moving Too Quickly With Fannie and Freddie Reform?

Written By:
March 08, 2011 at 5:49 PM

To say Fannie Mae and Freddie Mac have been grossly miss-managed may be an understatement. Conservative estimates put the bail out of the Government-Sponsored Enterprises (GSE) at a cost of at least $380 billion. The released of the Treasury's Department white paper covering reform of the two mortgage finance behemoths has ratchet up the volume regarding their final deposition. The debate centers on privatization of the home mortgage system or retaining some semblance of government control. Change is coming; how fast it takes place demands careful consideration.

The Treasury Department's Proposal

The reform report released by the Obama Administration did not commit to a definite path of reform, which the Administration intends to work out with Congress by the end of the year. Below are some key aspects of the report that the administration recommends as a starting point for moving forward with reform:

  • Reduce the GSEs portfolio at the rate of ten percent annually
  • Increase the fees charged for guaranteeing mortgage securitizations
  • Gradually increase mortgage down payment requirements to 10%
  • Reduce the mortgage loan limit that GSEs can buy to a maximum of $625,000
  • Increase Federal Housing Administration (FHA) mortgage insurance fees

The administration outlined three choices for the long-term reform of Fannie and Freddie. First, evolve into a completely private home mortgage system. Second, move to a mostly private mortgage market, but the government will offer limited mortgage guarantees and intervene during housing crises. Third, Uncle Sam will continue to provide home mortgage guarantees through FHA, VA and the Department of Agriculture.

The Argument for Privatization

Dwight M. Jaffee, banking, finance and real estate at the University of California, Berkeley, argues privatization spares taxpayers from having to bailout the mortgage system in the future. In addition, home buyer will benefit from an expanded array of products and terms, such as mortgage types, maturity and prepayment options. Homeowners who bring more to the table -- higher down payments, foregoing prepayment choices, higher credit scores - will receive lower mortgage interest rates. Conversely, home buyers less well off - low credit scores prepayment options, and lower down payments will pay higher mortgage interest rates.

Professor Jaffee also points to the many European countries, such as Denmark provide low interest fixed-rate mortgages with longer maturity dates, without the need for government involvement in the mortgage market. Some argue that privatization would lead to bigger banks squeezing smaller lenders completely out of the home mortgage business. One reply to this criticism involves creating lending cooperatives, which allow smaller players to combine their funds and compete with larger mortgage lenders.

Why Public Involvement Is Necessary

Middle-class home buyers represent just on group that benefits from government-backed lending as a vital cog in the home mortgage system. A diverse range of other factions operating within the housing industry depends on a vibrant home mortgage industry that promotes home ownership to the greatest number of people. This advocacy creates a dynamic market for their products and services. Home builders, realtors, mortgage brokers, construction workers, community banks, home improvement contractors, furniture makers, and appliance makers make their living off this industry.

Do not forget the role, some say criminal, private investment banking firms like Goldman Sachs, JP Morgan, and Merrill Lynch. Private bankers knowingly made risky loans and bundled those sub prime mortgages into securities. The credit rating agencies -- Standards & Poors, Moody's, and Fitch -- rated the subpar Collateralized Default Obligations (CDO) as AAA when in fact they were “junk.”

You know the story. These securities became worthless. Many individual investors, Fannie, and Freddie now hold the risky investments. Moreover, let us not forget the insult added to injury - the same investment bankers that the saw an “opportunity” to gain profits by selling worthless CDOs also made billions by betting that the bottom would drop out of the CDO market.

The question begs: Can we trust the private industry to run home mortgage finance system, including secondary markets, when questions about the lack of ethics on the part of private mortgage industry players thrive? Investment bankers repeatedly stated before Congress, they acted ethically even when putting their financial interest ahead of their clients and the economy.

Fix the Economy

Fannie and Freddie make more Americans eligible for home mortgages loans, thereby stimulating home ownership. Currently, Fannie, Freddie, or the FHA account for most of the new mortgage activity. Usually, private mortgage lenders provide, at minimum, 20 percent of mortgages without government guarantees. Historically, housing has function as a core element in fueling economic recoveries starting with the Great Depression.

However, we live in different times. No longer do we have a solid base of manufacturing, home building, and other well-paying jobs that enable consumers to become homeowners or maintain ownership of their homes. Corelogic states that an estimated 11.1 million or 23.1 percent of residential homeowners had underwater mortgages as of December 31, 2010. Meantime, banks have made off with billions to strengthen their balance sheets, purchase failing banks, and pay out questionable bonuses.





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