In September 2008, on the precipice of the economic crisis finally catching up with Wall Street, Treasury Secretary Henry Paulsen, Federal Housing Finance Agency Director James Lockhart and Federal Reserve Chairman Ben Bernanke converged on Fannie Mae’s and Freddie Mac’s boardrooms — and they were not in a good mood. The world credit markets were in free fall, and Fannie Mae and Freddie Mac, together holding more than half of all the mortgage debt outstanding in the US market, were reeling from unprecedented losses from plunging real-estate values, rapidly escalating delinquencies in their single-family portfolios, and a sudden lack of interest in their debt securities around the world.
The G-men told the two boards that they could either make it hard or make it easy, but before the meetings were over, both would turn over the reins of their companies to Director Lockhart.
And just like that, institutions born during the last great mortgage crisis of the 1930s to ensure that lenders and consumers always had access to capital for mortgages were out of business. The privately owned, high-flying companies that once were Wall Street darlings and charmed investors from Peking, Illinois to Beijing, China were finished, turning over majority ownership to the US Government in return for more than $80 billion in funding to keep the two companies solvent.
How did this happen, and why does it matter? What, if anything, will be built to replace the two companies whose investments fueled the biggest homeownership growth in history? And why should advocates and activists who fight for working families and their communities care?
The Federal National Mortgage Association was chartered in 1938 to issue US government debt and to use it to buy mortgages insured by the FHA, which four years earlier had launched the first long-term, fixed-rate, self-amortizing mortgages through its insurance authority. Before this, homebuyers had only two basic choices in financing their homes: pay cash or get a short term, interest only loan that had to be rolled over through a refinancing, usually every five years. FHA insurance placed the government’s guarantee behind 20 year, fixed-rate, self-amortizing mortgages, establishing for the first time the financing model of choice for housing consumers for the next 75 years.
But without some effective secondary market, lenders would quickly reach the limit of their ability to hold such long-term paper. The new agency’s job was to buy up these mortgages from the lenders, and resell them where possible to private investors, to provide new capital and use the federal government’s own balance sheet to absorb the risks if necessary.
This new model worked, and worked well. Especially after World War II, when the US economy boomed and millions of demobilized servicemen returned to resume their lives and start families, mortgage lending through FHA and later VA mortgages boomed, too.
In 1954 Congress adopted a mixed ownership model for the company. The US Treasury retained nonvoting preferred stock in the company and lenders selling loans to Fannie Mae were required to buy nonvoting common.
In 1968 Fannie Mae was fully privatized with the sale of the Treasury’s preferred stock and its transition to private shareholder ownership with a national charter, was complete. The newly-formed Department of Housing and Urban Development (HUD) retained a new entity, the Government National Mortgage Association (Ginnie Mae) to provide liquidity for government guaranteed home loans, primarily those backed by FHA and VA and provide liquidity for special government-sponsored mortgage programs. Fannie Mae in its new, private form developed into the dominant secondary market actor for the conventional market, although it could and did purchase government guaranteed loans in some amounts.
In 1970, the secondary market was expanded with the addition of the Federal Home Loan Mortgage Corporation (Freddie Mac). Freddie Mac was capitalized through the sale of $100 million in stock to the 12 Federal Home Loan Banks. Freddie Mac was designed, and operated for more than a decade, as the secondary market arm for the Home Loan Bank system, and was housed within the Federal Home Loan Bank Board, which was the Federal Home Loan Bank system’s overseer. When the Board was reorganized after the collapse of the S&L industry in 1989, Freddie was privatized, too, with the same charter as Fannie Mae.
Give and Take
The companies’ peculiar status as government sponsored enterprises (GSEs) stems from their unique congressional charters. Other institutions, like national banks, also have national charters that trade certain benefits for specified obligations and have long been used to encourage private participation in meeting public ends.
The Fannie and Freddie charters provide a clutch of valuable terms: exemption from state and local income taxes; exemption from registering their debt and equity securities with the SEC (although both agreed voluntarily to register their equities with the SEC in 2002); special treatment of their securities held by regulated banks; access to the Fed window; and a Treasury line of credit for $2.25 billion in case of a liquidity crisis. An additional benefit that arose from their charters was the ability to borrow money only slightly more expensively than the US Treasury, based on the “implicit guarantee” provided through their charter relationship to the US Government.
In return for these benefits, the companies have limitations and obligations: business is restricted to the secondary market in residential mortgages; they cannot operate outside the United States; they are expected to operate in all markets, at all times; and they were given specific percent of business goals to lend to low- and moderate-income borrowers and underserved communities. In 1992 and again in 2008 Congress adopted oversight provisions and terms that govern their capital and safety and soundness, assigning “mission” oversight to HUD and safety and soundness oversight to a new agency, OFHEO. In 2008 these functions were consolidated into the new FHFA.
Despite their special status, until the September 2008 takeover neither company had ever received any direct federal funding after their privatization. But under 2008 revisions to their charters, both could be placed in conservatorship by their regulator to protect their safety and soundness. It was this authority that was invoked at the September meetings with both companies’ boards.
The development of this system served a number of basic and vital functions in the mortgage market. One is liquidity. Fannie and Freddie insured a reliable source of financing for mortgages that did not depend on a lender’s access to deposits. A closely linked function is stability, achieved both through ready liquidity and a growing standardization of mortgage terms. Third is access, for communities and borrowers across the country and in all times. Fannie’s and Freddie’s ability to attract investments across the yield curve and manage the extensive duration risks of holding long term assets enabled them to make 30 year, fixed rate mortgages available to any buyer.
What’s My Line?
Fannie and Freddie carried out a number of distinct but related businesses. Financed through the issuance of debt, the companies’ portfolio businesses originally were used to purchase whole loans directly from lenders. But over time as securitization became more and more important, the portfolios also purchased mortgage-backed securities, both their own and those issued by others, like Wall Street banks.
The far larger business of guarantee fees accelerated with the growth of the market for mortgage-backed securities in the 1990s. In return for providing a guarantee of the timely payment of principal and interest to the investors who buy Fannie Mae and Freddie Mac mortgage bonds, the companies charge lenders a fee, which is passed on to borrowers. These assets are not held on the companies’ balance sheets, although they must hold reserves against loan losses, and these fees continue throughout the life of the loan and are collected through the borrower’s monthly payment.
While both companies also developed other fee generating business, notably in technology as they developed automated underwriting systems, their principal businesses are the portfolio and the guarantee businesses.
Both the portfolio and guarantee businesses are dominated by single-family loans for homeownership. But starting in the 1980s, the companies began to expand into financing for multifamily rental housing. With the adoption of the Low Income Housing Tax Credit (LIHTC) in 1986, they also became equity investors in affordable rental housing, eventually coming to dominate this market with more than a 30 percent share of all tax credit investment equity by the middle of this decade. Their withdrawal from this market following their financial distress has been a major cause of developers’ challenges to raise equity in today’s market.
The companies also invested in community development activities, although on a much smaller scale. This took the form of loans and lines of credit to community development financial institutions (CDFIs), debt and equity investments in development linked to the creation of residential housing, and through financing state and local government community development activities through bridging affordable housing and community development grants from the federal government.
In 2008, Congress directed that a portion of GSEs’ earnings be diverted into an Affordable Housing Trust Fund that would be used to finance affordable housing for extremely- and very low-income residents. The companies’ current financial crisis has forestalled any contributions through this new mechanism.
Organizing for the Future
The functions Fannie and Freddie provided – liquidity, stability, and access – remain important for the housing economy. Indeed, the two companies today are providing more than 70 percent of all the financing for housing even while under conservatorship. But their collapse into the federal government’s arms is causing a wholesale reevaluation of how best to provide those functions in the future. Plans for a new secondary market model are complicated by the realization that ALL very large financial institutions, not just Fannie and Freddie, turned out to be covered by an implicit federal guarantee by being “too big to fail.” The Treasury Department, through TARP, and the Federal Reserve have stepped in to shore up a host of the largest banks during this crisis with several trillion dollars of support. Ironically, the terms of the Treasury and the Fed support for large banks have been more aggressive than for the GSEs, including a temporary full guarantee of the banks’ senior debt, which has not been extended to the GSEs’ debt. The market perception that Fannie and Freddie enjoyed a special status in this regard, different than other very large lenders, is shattered. And that means that the value previously attached to that status might have been diminished significantly.
There are a number of different approaches being offered in policy discussions about how to restructure the secondary mortgage market. One would sell off Fannie’s and Freddie’s assets, possibly using a “Good Bank/Bad Bank” model, and leave the functions entirely up to private companies with no more of a relationship to the government than any other private financial firm. At the other extreme, the companies would be fully nationalized, folded into Ginnie Mae with a full faith and credit guarantee but no private investors. In the middle are a host of mixed models, including a special purpose company whose stock would be wholly owned by the government; a “utility” model where the charter would regulate allowed returns and prices for an entity owned by private shareholders; and an evolved hybrid of the current situation, with private companies relying on private shareholders’ capital, in which the government owns a significant share and retains much more significant oversight than in the past. This would resemble Fannie’s structure between 1954 and 1968. Covered bonds issued by private lenders also has been suggested as a possible alternative to the past secondary market model.
There are important outcomes that community and low-income housing advocates should care deeply about seeing emerge from this policy discussion.
Long-term, fixed rate financing. Outside of the U.S. and Denmark, long-term, fixed-rate mortgages without prepayment penalties are rare. GSEs are a significant, if not the principal, reason this option still exists here. Denmark uses a well-organized system of covered bonds through a limited number of specialized banks that functionally match many of the functions of the US MBS market. As monoline companies with their charter benefits, Fannie and Freddie were able to borrow advantageously across the yield curve and manage the many risks long-term mortgages contain. Their history with the product and their willingness and ability to finance it gave them a formidable market advantage and forced the primary market to offer it, when banks would much rather offer adjustable rate mortgages in which consumers bear those risks, and pay higher prices to do so.
Universal Access. The GSEs’ willingness to buy or securitize mortgages from any lender willing to conform to their underwriting guidelines meant that very large banks could not totally control the mortgage business. Small community lenders could sell to the GSEs directly. This served to keep mortgage prices lower across the industry, and gave these smaller banks the ability to operate independently, rather than being forced to become agents of much larger institutions with their economies of scale and access to capital markets.
Innovation. Through their ability to purchase effectively unlimited amounts of mortgages, the GSEs could bring innovations in mortgage products to scale quickly and efficiently. Many of these innovations, like lower down payments and alternative credit evaluations, came first from primary market lenders using their own portfolios. But once adopted by the GSEs, these quickly became industry standards and enabled consumers everywhere to benefit from them.
Efficiency. The scale that the GSEs were able to accomplish in their businesses meant that mortgages were increasingly commoditized and their costs inexorably reduced. This translated into significant consumer savings in the costs of a mortgage. Without their influence in the market, margins on mortgage products would have been higher and consumers would have paid for them, although the magnitude of these price differences is the subject of much energetic academic debate among economists.
The White House has signaled its intention to begin the debate about Fannie and Freddie with its FY 2011 budget, which it will release in February next year. An administration task force with representatives from FHFA, Treasury, HUD, the National Economic Council and the Council of Economic Advisors has been formed to begin framing alternatives. A trial balloon hinting at the Good Bank/Bad Bank offer already was floated earlier this summer; the White House quickly disowned it, and whether it is a durable policy alternative remains to be seen.
The stakes for community housing advocates in this debate are high. First, because a robust secondary market system that will finance long-term, fixed-rate home loans is an essential means of extending and sustaining homeownership opportunities. Second, a secondary market outlet for rental apartment development and preservation is a critical underpinning for a balanced national housing policy. Third, a stable national secondary mortgage market will help sustain homeownership lending through lenders of all sizes, helping to moderate the natural drift of the banking industry to larger and fewer national players with indifferent stakes in local communities. Fourth, whether through special levies on retained earnings as under the Trust Fund mandate or through regulation requiring the reinvestment of profits into affordable housing and community development investments, a national secondary market could produce valuable resources for these activities.
Not every voice in the coming debate will care about all of these points. Private market ideologues will argue that government should play no role at all in supporting housing finance. Some lenders will argue that a secondary market system should be focused only on serving their needs, on their terms. And financial interests that hope to cream off the best quality mortgage business for themselves while leaving the hard work of mortgage lending for affordable rental and ownership will argue for only a very limited federally sponsored role.
Meanwhile, the two companies now dominate the mortgage finance business again. And while under conservatorship they have been used by the administration to play leading roles in the design, execution and monitoring of its mortgage modification program to stem foreclosures. Shareholders have been wiped out by the government’s takeover and are out of the picture. And it’s not clear that advocates, the administration or Congress need be in any rush to settle their future anytime soon. It’s much more important to get it done right than to get it done quickly. Neighborhoods, homeowners, lenders, landlords, and renters all deserve a careful and deliberate debate about the future of the mortgage system. There is too much at stake to rush a decision.
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