Who Steps Up in Mortgages After Fannie, Freddie?

Treasury Secretary Timothy Geithner and Housing and Urban Development Secretary Shaun Donovan on Feb. 11 offered three options for shrinking Fannie Mae (FNMA) and Freddie Mac (FMCC), the bailed-out housing finance companies that own or guarantee more than half the nation's mortgage debt. By gradually reducing the dominant positions of Fannie and Freddie, the officials hope to coax private financial firms and bond traders to take on more of the U.S. mortgage market's risk and revive the secondary market for home loans. One government misstep, and a shortage of home loan money could send loan costs soaring and home prices tumbling. "We want to be careful that the process happens in a way that doesn't interfere with or impede the process of repair in the housing market," Geithner said.

The first option laid out by the Administration would limit government backing to loans for narrowly targeted groups of borrowers such as lower-income families, veterans, and rural residents. This option is likely to push up interest rates and make the traditional 30-year fixed-rate mortgage hard to obtain, the report said. The second option would build on the first by adding an emergency government backstop that would ramp up in times of financial crisis. The third imagines the biggest government role through a reinsurance program for a broad class of mortgage-backed bonds in which the U.S. would come to the rescue if a primary insurer failed.

While Geithner and Donovan haven't said which they prefer, all three options depend on luring private lenders and, more important, the bond market, into the breach. One positive sign: Redwood Trust (RWT), a Mill Valley (Calif.) real estate investment trust, plans to test the waters. Redwood told regulators on Feb. 15 that it will offer $290 million of bonds backed by mortgages that average about $1 million a piece, considered jumbo loans because they exceed the government's guarantee ceiling, now $729,750. Redwood floated a similar bond last April—the first mortgage-debt offering without government backing in two years. The idea that the bond market isn't ready to step in is "a red herring," says Redwood Chief Executive Officer Martin S. Hughes.

Skeptics abound. The earlier Redwood offering, which bundled nearly $240 million in high-quality jumbo home loans, was "a triple-gold-plated deal just done for showing that the mechanics are still there" for securitization, says Michael S. Barr, a University of Michigan law professor who until December was an Assistant Treasury Secretary.

While the Administration debates what to do with Fannie and Freddie, it's proposing a series of small steps to entice investors back, including reducing to $625,500 the size of loans the government will guarantee and raising the insurance premiums that Fannie and Freddie charge. The idea is to drive up borrowing costs on mortgages backed by Fannie and Freddie to give banks more room to compete. Such moves are likely to draw between $30 billion and $50 billion of new lender money, says Anthony "Tuck" Reed, a senior vice-president at Wells Fargo (WFC).

It's a start. Getting trillions of dollars into the game is another matter. That will require persuading burned investors to buy mortgage bonds again. Investors will demand iron-clad collateral, which means higher down payments. Even then, investors could resist. "No matter what the collateral—it could be gold bullion—investors won't buy it unless it has a government guarantee," says Guy Cecala, publisher of Inside Mortgage Finance, a trade publication in Bethesda, Md.

Viral V. Acharya, a finance professor at New York University's Stern School of Business, is more optimistic. "At some price, the private sector will come in," Acharya says. "The financial sector never leaves anything on the table."

The bottom line: As Fannie and Freddie shrink, the Administration needs to coax Wall Street to accept more mortgage risk.

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