Fannie and Freddie to the Rescue?
Hoping to speed delivery of its $150 billion pick-me-up for the U.S. economy, the Bush Administration reluctantly agreed to temporarily increase the size of the mortgages Fannie Mae (FNM) and Freddie Mac (FRE) can purchase, from $417,000 to nearly double that. Proponents of the shift hope that Fannie and Freddie—which together own or guarantee about half of the $10 trillion in total home loans in the U.S.—can unfreeze the market for those "jumbo" loans and kick-start the housing market. But for a variety of reasons, Fannie and Freddie may not be in position to cure the subprime mortgage mess.
Economists and analysts agree that boosting the mortgage limit will help inject the jumbo loan market, which is under significant strain, with much-needed financing. The additional business Fannie and Freddie will generate with that financing should eventually help bring down prices and increase the availability of such loans. However, the two companies still haven't fully rebounded from the big accounting scandals that first came to light in 2003. With substantially thinner profit margins and tighter regulatory constraints, they have limited financial freedom to bail out others' bad investments.
"The real issue is that home prices are overvalued, and it gets uglier by the day. This might help on the margin, but it's not going to stop home prices from falling," says mortgage analyst Paul Miller of Friedman, Billings, Ramsey (FBR). "It's not going to solve the problem, but it's a way for [Democrats] to get something through that they've wanted for a very long time."
"A Bipartisan Steamroller"
The measure is part of a broad package of tax incentives that policymakers have frantically cobbled together over the last week as global fears of a U.S. recession drove international markets into bear territory. Washington seemed unable to calm jittery investors until the Federal Reserve intervened Jan. 22 with an unexpected 0.75-percentage-point emergency cut in its target rate for overnight loans between banks. After months of rose-colored reassurances, policymakers are finally acknowledging that the housing crisis could pull the U.S. economy into recession.
"It is timely, it is targeted, and it is temporary. And it was done in record time," House Speaker Nancy Pelosi (D-Calif.) said in announcing the deal on Jan. 24 with Treasury Secretary Henry Paulson.
In the frenzy, the Administration surrendered its opposition to lifting the limits on Fannie and Freddie. Bush officials had been pushing for a broader bill that would tighten the Office of Federal Housing Enterprise Oversight's (OFHEO) regulation of the two companies. Worried the companies are too highly leveraged and aggressively managed, the Bush Administration, the Fed, and Republicans on Capitol Hill have been pushing for legislation to expand the power of the OFHEO to at least match that held by other financial regulators. Unlike the Fed, the Federal Deposit Insurance Corp. (FDIC), and other federal agencies, the OFHEO has limited authority to raise Fannie's and Freddie's capital requirements and lacks the power to place either into receivership and pay out bondholders if either company should fail, among other things.
"I got run down by a bipartisan steamroller," Paulson said in explaining the about-face. "I was somewhat skeptical that, without this, we wouldn't get the reform. So now I've got to be an optimist."
Not everybody on the Hill was happy with the package. Senator Max Baucus (D-Mont.), chairman of the powerful Senate Finance Committee, announced he'll hold hearings next week to put together his own stimulus plan. The bipartisan plan, which awaits approval by both houses of Congress and signing by President Bush, could also deliver tax-rebate checks to qualifying individuals as early as June.
Under the deal, individuals who pay income taxes would get an advance of up to $600 on next year's refund, and working couples would get up to $1,200. Those with children would receive $300 in additional tax credits for each dependent.
New Territory for Fannie and Freddie
The agreement gives Freddie and Fannie access for the first time ever to the jumbo loan market. (Jumbo loans are defined as loans above the $417,000 limit on so-called conforming loans.) Currently, jumbo loans are restricted to private lenders. That means borrowers in high-cost areas—such as Pelosi's home district in San Francisco, where the median price of a home is $825,400—have limited financing options. "Here in Massachusetts, $500,000 and $600,000 homes, which are above the limit now, are not luxury homes," House Financial Services Chairman Barney Frank (D-Mass.) recently told CNBC.
In their haste, policymakers left some important details unresolved. Democrats say the plan lifts the companies' loan caps to $729,750 in high-cost areas for one year, while Administration officials say the cap will be $625,000 through Dec. 31. Both sides agreed to permanently increase the cap on Federal Housing Administration (FHA) loans in expensive markets to $729,750.
Although Fannie and Freddie have dabbled with riskier loans in recent years, their bread and butter is backing conventional loans to borrowers with good credit and packaging those loans into securities for other investors. Their securitization business has largely kept that segment from seizing up along with the rest of the industry.
The Troubled Jumbo Loan Market
Lawmakers are hoping the companies can do the same for jumbo mortgages. Right now, no one wants to buy securities backed by the oversize loans. "It's almost impossible" to sell a jumbo mortgage, says Jim McKillop, president and CEO of Independent Bankers Bank of Florida, which helps smaller community banks in Florida, Georgia, and Alabama sell their loans to investors. Demand for securities backed by jumbo mortgages dropped dramatically beginning in the summer of 2007. The volume for new jumbo mortgage securities was cut in half, from $124.5 billion in the second quarter to $62.5 billion in the third, according to data from Inside Mortgage Finance.
Few banks are approving bigger loans and, when they do, the interest rates generally run 0.75 to 1 percentage point higher than for loans under $417,000. That has compounded the foreclosure problem in high-cost areas such as Los Angeles, where home sales have slowed to a crawl and the median price for a single-family home is $588,400, according to the National Association of Realtors. The banks still making jumbo loans can't sell them, and smaller institutions aren't equipped to manage the extra risk of holding them on their books.
Allowing Fannie and Freddie into the jumbo market should help off-load some of that risk for banks, free up credit for borrowers, and with any luck, slow foreclosure rates and stimulate sales in high-cost housing markets. Raising Fannie's and Freddie's loan limits should allow more borrowers in high-cost areas to refinance.
Not Without Its Own Risks
But not everyone is as optimistic as policymakers. Like the rest of the industry, the companies are struggling to manage their own balance sheets as foreclosures and delinquencies steadily rise. Jumbo loans carry more risk than conventional loans and are heavily concentrated in a handful of states. Loans from California alone accounted for nearly half of the market for jumbo securities during the first half of 2007. "Of course, many of the jumbo loans are in places where house prices are falling, so there are collateral risks in those areas," says Douglas Duncan, chief economist for the Mortgage Bankers Assn.
OFHEO also will have a say. Director James Lockhart opposes raising their loan caps without additional oversight. "We just don't think it would be good to divert resources and manpower of these two firms from doing what they do best, which is supporting the conforming loan market," Lockhart told BusinessWeek in a recent interview. "They've never bought jumbo loans. They don't have pricing models, they don't have risk management models. So it would be a new world."
Duncan estimates it will take Fannie and Freddie at least three to six months to assess the new risk and ramp up their systems to process jumbo mortgages. To offset that risk, Fannie and Freddie will have to charge higher fees for jumbo loans. So the interest rates won't be much better than today's pricing, according to Duncan and a separate analysis by OFHEO.
The companies are also hamstrung by a regulatory order that keeps a tight leash on their operations, requires extra capital, and limits their growth. "While Freddie Mac will continue to do what it can to assist borrowers and help restore liquidity to the market, this additional responsibility would create a significant challenge for Freddie Mac as we continue to operate under severe capital constraints," said Freddie Mac spokesperson Sharon McHale.