Time to Rethink Fannie and Freddie

As the White House pushed for a Wall Street overhaul this year, Republicans hammered Democrats for ignoring two of the biggest problems in American finance: Fannie Mae (FNM) and Freddie Mac (FRE). The government-backed mortgage giants have cost taxpayers $145 billion and counting. Now, with work on the 2,300-page financial-regulation bill all but complete, the Obama Administration will soon turn to revamping the pair of institutions that own more than half the nation's $11 trillion in residential mortgages. The political struggle could be long and bitter.

Some Republicans in Congress contend that killing Fannie and Freddie is the only wise course. President Obama is expected to advocate something closer to the rough consensus for moderate reform emerging among Washington lobbyists representing banking, real estate, and consumer groups.

Fannie and Freddie operated as shareholder-owned corporations that financed home loans with the tacit support of the federal government. When the housing market collapsed, so did Fannie and Freddie. They were formally seized by the Treasury Dept. in September 2008.

Setting aside their occasional animosity, industry and consumer advocates say they share certain core goals on mortgage finance. Banks and builders by and large agree with representatives of home buyers that it's in all of their interests to have the government continue to promote residential lending by encouraging what Fannie and Freddie have done for decades: buy mortgages and bundle them into securities for sale to investors. When it functions properly, the mortgage-backed securities market generates fresh cash that can be channeled back into additional affordable loans. The challenge is figuring out how to do this without the lax practices and open-ended federal commitment that left taxpayers on the hook for catastrophic losses in 2008.

"There will be a government role in the market whether we like it or not," predicts Phillip Swagel, Assistant Secretary for economic policy at the Treasury under President George W. Bush.

At the heart of the emerging consensus across industry and consumer lines is the preservation of the 30-year, fixed-rate mortgage. "People regard it as a right as Americans to get a 30-year, fixed-rate loan," says Susan Woodward, former chief economist at the Housing and Urban Development Dept. and a founder of Sand Hill Econometrics, a research firm in Palo Alto, Calif.

To inject more caution into the system, Washington lobbyists working on housing-finance reform say mortgage lenders who bundle loans into bonds should contribute to an insurance fund that would be available in case of calamity. The fund could be modeled on the Federal Deposit Insurance Corp., which protects consumers from bank failures with a fund financed by lending institutions.

Another step that would limit taxpayer exposure could be mandating that only the safest loans—such as those that include a down payment by the borrower and carry private mortgage insurance—would be bundled into government-guaranteed bonds marketed to investors. It will be important to strike a balance that doesn't stifle innovation, argues Edward J. DeMarco, acting director of the Federal Housing Finance Agency, which oversees Fannie and Freddie. "We've got over 50 million homeowners with mortgages, and they represent all kinds of different financial conditions," DeMarco adds. "We need to be a little bit careful about shoehorning the entire country into one particular mortgage type."

The government's role in the new system ought to be a lot clearer than it was in the past, according to industry and consumer advocates. Federal officials traditionally insisted they had no legal obligation to stand behind Fannie and Freddie, even though investors assumed they would. When the market imploded, Treasury stepped in, despite past disclaimers.

Executives with the Mortgage Bankers Assn. and the National Association of Realtors say mortgage-backed securities that meet government standards should receive an explicit guarantee. Without it, they say, investors will balk at buying mortgage bonds, especially in times of economic distress. "To have long-term investment in a 30-year fixed mortgage, you have to have some confidence that there is government backing," says Paul Leonard, a lobbyist for the Financial Services Roundtable, whose members include JPMorgan Chase (JPM), Wells Fargo (WFC), Bank of America (BAC), and BlackRock (BLK).

These industry-inspired proposals are less radical than some ideas emanating from Congress. During debate over the financial-services overhaul, Republicans offered dozens of amendments to abolish Fannie and Freddie, only to be rebuffed by Democrats. Led by Senator John McCain of Arizona and Representative Jeb Hensarling of Texas, Republicans say Fannie's and Freddie's competing missions—to serve shareholders and promote homeownership among low-income households—drove the financial institutions to ruin. The Republicans want the government to abandon any role in housing finance.

The Obama Administration and Democrats, including House Financial Services Chairman Barney Frank of Massachusetts, insist that the government continue to promote homeownership. "We should not compromise any of our core policy goals in the decisions we make in structuring our housing finance system," Housing and Urban Development Secretary Shaun Donovan told Frank's committee in April.

One thing is for sure: The White House will not lack for advice on the future of Fannie, Freddie, and the housing market. "Everybody's telling them, 'Don't do anything stupid,' " says Barry Zigas, director of housing policy for the Consumer Federation of America. "It's easy to forget that this system worked awfully well for 75 years." That is, until it didn't.

The bottom line: Industry and consumer advocates agree on moderate reform of Fannie Mae and Freddie Mac.

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