We’ve Nationalized the Home Mortgage Market. Now What?
The home loan market was nationalized in a slapdash fashion and is now riven by conflicts of interest and competing goals. To solve it, a consensus is forming to head down the path of the least resistance but greatest risk.
At the height of the 2008 financial crisis, the country heatedly debated whether to nationalize the failing banking system. Both the George W. Bush and Barack Obama administrations rejected that path as excessive government intrusion into the marketplace.
Yet since then, with little planning and paltry public discussion, the government has almost completely taken over the American home mortgage market. Banks and other for-profit financial services companies lend money to homeowners, but without the guarantees and other support the government provides, the housing market would barely be functioning now.
The Government Takes Over the Mortgage Market
Percentage of all new mortgages backed by the U.S. government
Note: Data for 2012 is through September. Source: Inside Mortgage Finance
Fannie Mae and Freddie Mac, the taxpayer-controlled housing giants, guaranteed 69 percent of new mortgages in the first nine months of the year, up from about 27 percent share in 2006, according to Inside Mortgage Finance. Meanwhile, the Federal Housing Authority and the Department of Veteran's Affairs currently back another 21 percent of mortgages, up from just 2.8 percent in 2006. Altogether, 9 of every 10 new mortgages are backed by the U.S. taxpayer, up from three in 10 in 2006, when the government share hit a decade-low, according to the publication.
"It is creeping nationalization," says Jim Millstein, an investment banker who worked in the Obama administration's Treasury Department as the Chief Restructuring Officer.
The problem isn't just that the market is nationalized. It was nationalized in a slapdash fashion so that now it is riven by conflicts of interest and competing goals.
The possible solutions are well known and have been for years. But during its first term, the Obama White House made a tactical decision — politically astute but tinged with calculation, some say — not to push for change. Now with the election over, a bipartisan centrist consensus is forming to head down a path that offers the least resistance but could be the most dangerous: returning to what existed before the housing market imploded.
After taxpayers pumped $187.5 billion into them starting in 2008, Fannie and Freddie exist today in a limbo state, under government "conservatorship." They aren't fully private, profit-seeking entities, but neither are they explicit arms of government policy. They act both as profit-seeking businesses and as public agencies.
Freddie and Fannie's main business is insuring mortgages, and they back $5 trillion or about half of the American mortgage market. They buy mortgage loans and bundle them to create mortgage-backed securities, earning fees. If a borrower stops making mortgage payments, Fannie and Freddie step in to continue the flow of payments to the mortgage-backed securities investors. The two companies also invest in mortgage-backed securities.
But Freddie and Fannie are also chartered by Congress to implement public policy goals, such as keeping home ownership available for Americans.
The goals of making a profit and enacting public policy create a deep-seated conflict of interest. Under conservatorship, the conflicts and problems have become amplified.
In recent years, Freddie Mac made it harder for homeowners to refinance their high-rate mortgages for fear it would cut into the company's profits and hinder its ability to repay taxpayers.
Under conservatorship, Congress has been tempted to milk the companies. Loathe to raise taxes and eager to cut them, Congress has used Fannie and Freddie as a private kitty, raiding them for cash. In 2011, Congress siphoned off 10 years' worth of part of Fannie and Freddie's guarantee fees to fund a mere two months of a cut in the payroll tax. Recently, the House passed an immigration bill that is funded by their guarantee fees.
"It's a sign of weakness for this country if we can't make hard decisions without using the GSEs" — Washington-speak for Freddie and Fannie — "as piggy banks," says Dave Stevens, the head of the Mortgage Bankers Association and former official in the Obama administration.
The companies are regulated by the Federal Housing Finance Agency, which clears all their major business decisions. That has added to the muddle: The FHFA's acting director Edward DeMarco controversially has interpreted its main goal as preserving the assets of Fannie and Freddie and de-emphasized its mission to "support housing finance and affordable housing, and support a stable and liquid mortgage market," as it puts it on its website. Earlier this year, the FHFA decided against forgiving principal on delinquent mortgages, arguing that the benefits were too small and the risks unknown. The decision drew a rebuke from Treasury Secretary Timothy Geithner.
The longer Fannie and Freddie stay in purgatory, the more likely they are to suffer from key departures of executives, who are frustrated that they cannot make their businesses' key decisions. The worry is that important areas of their businesses erode, such as their risk management, raising the possibility of sudden, large losses for taxpayers.
Few Democrats, Republicans, housing advocates and economists want to preserve the current situation. Yet while there are dozens of congressional bills, think-tank plans and an Obama administration white paper with proposals to resolve the mortgage giants, there has been little change.
During its second term, the Obama administration has vowed to overhaul how Americans buy their homes — and the central problem is what to do about Fannie and Freddie. Wind them down? Return them to private company status? What role should the government play in the mortgage market, and how big?
Political Machinations Lead to Paralysis
Conservatorship wasn't supposed to last four years. Hank Paulson, Bush's Treasury secretary, took the emergency measure in September 2008, right before Lehman Brothers collapsed. Internally, the administration considered it a short-term solution. In the midst of a much-worse crisis hitting the entire financial system, however, it did not plan an exit.
The Obama administration spent the bulk of 2009 stabilizing the financial system in the aftermath of the panic. Then it confronted the housing crisis, though it has received consistent and bipartisan criticism for its ineffective programs.
The pace of discussions about resolving Fannie and Freddie picked up in 2010. Even though the private sector mortgage market had just failed disastrously in 2008, the most influential voices in the Obama administration's first term advocated returning to a limited government role.
At a meeting in December 2009 with progressives who were pushing for a more active administration role in the housing crisis, Larry Summers, then the director of the National Economic Council, challenged them. "He would ask why housing is different from anything else — than widgets," recalls Andrew Jakabovics, a housing specialist who worked at HUD after having been at the Center for American Progress, a Democratic think tank in Washington that played an active role in advising the administration on housing policy.
It was a classic Summers interrogatory, and the attendees were left unclear whether he was provoking them to think more deeply about the market or reflecting his sincere belief. Internally, when Summers hosted meetings on the issue, he would split the group into the "hawks," who were pushing for a more laissez-faire approach, and the "doves," who favored strong government intervention, according to a person who was involved in the meetings. Summers did not respond to questions about his role in these discussions.
In February 2011, the administration issued a white paper outlining options to remake the American housing finance market, with three options to fix Fannie and Freddie.
Option 1: Largely privatize the market, unwind Fannie and Freddie and remove the government almost completely from the housing finance market.
Option 2: Provide some form of government guarantee for mortgages only in times of crisis.
Option 3: Restore Fannie and Freddie much as they were before the crisis, though with significant protections for taxpayers and with measures to attract private capital into the market.
Many criticize the Obama administration for not choosing one of these options. "Treasury punted," says David Min, a law professor at University of California — Irvine. Phillip Swagel, a former official in George W. Bush's Treasury Department, called the lack of progress on the issue "a failure of the Obama administration."
Privately, the administration came to favor some version of Option 3. But after the Republicans took Congress in the 2010 midterm elections, the administration made a political calculation not to push any specific solution, according to several people familiar with the administration's deliberations.
The Republican Party, the thinking went, is split on Fannie and Freddie. One faction, the tea party and others with a free-market philosophy, want the government out of the mortgage market. Another is made up of small community bankers, realtors and local developers, who would like to see Fannie and Freddie restored to something resembling the way it was before in order to keep the mortgage market flowing and to allow smaller banks to compete with the giant firms.
The big banks make up a third faction. They would like to see the government's role limited to a guarantee. That would allow them to continue to dominate the mortgage origination business without contending with the market power of government-sponsored entities. Before conservatorship, Fannie and Freddie had enormous influence over what kinds of loans banks would offer, which had the effect of restricting bank activity.
Backing a specific plan would have united the opposition against it, the administration felt. "We had deep research on the subject and long, lengthy, fully baked recommendations," says a person involved in the efforts. "The view was any position we took was going to bring out attacks from conservatives and the anti-Obama-ites. It would have polarized the debate."
Democrats also blame Republicans for making intransigence their overarching tactic during the first Obama administration. "The political reality was there was no way to bridge that difference. Could Treasury and the administration have reached out more? Sure, but I'm not sure they would have gotten anywhere. And it would have given them [Republicans] something to be against," says Min.
For their part, Republicans say that the Obama administration didn't reach out to them to discuss options or hear their ideas.
And of course, Democrats have factions as well, though they are less pronounced. The progressive wing wants to push the government to make sure there is sufficient backing to make housing affordable for more families.
Meanwhile, Fannie and Freddie had become politically toxic. Peter Swire, a law professor at Ohio State who was a special assistant for economic policy under Summers in the Obama administration, recalled driving through rural North Carolina during Christmas in 2009. Local talk radio was dominated by diatribes against Fannie and Freddie as symbols of what was wrong with the bailouts. "How the heck do you do any policy work when the topic is so radioactive?" he says.
And so, after the administration issued its white paper in 2011, little happened in Congress or the White House.
Back to the Future
In the meantime, the FHFA is making a series of small decisions that ultimately could shape the future of Fannie and Freddie.
In working to increase the profitability of Fannie and Freddie, the FHFA is restricting mortgage credit and sometimes interfering with homeowner rights, critics say. Recently, the FHFA announced that it was considering a plan to raise its guarantee fee in five states which have high foreclosure costs. One reason for that: These are states where judges oversee foreclosures, which housing advocates argue can provide transparency and due process for homeowners. Without judicial foreclosures, it is unlikely that the banks' "robo-signing" abuses would have come to light back in 2010. In effect, these critics charge, the FHFA is punishing homeowners for living in states that provide crucial judicial oversight of the banks.
In another move, the FHFA has forced banks to put back on their own books the risk on mortgages that Fannie and Freddie have guaranteed. Fannie and Freddie have done this in cases where they later discovered that the firm that originally made the loan violated the terms of its contract. These aggressive "putbacks" have made banks wary of making new mortgage loans, say analysts.
These policies have the effect of working at cross-purposes to other arms of the government, such as the Federal Reserve, which is pushing down rates to increase lending. "The Fed is trying to open up the spigot to bring water to fight the fire. The FHFA is squeezing on the hose, holding credit standards that are tighter than any time in the last 20 years," says Christopher Mayer, a housing economist from Columbia University.
Today, Washington observers think that conventional wisdom is coalescing around something resembling Option 3, a return to the hybrid of a private and public finance market. The view is that private capital is needed in the market. But without a government role, the housing market would wither. Many believe that the 30-year mortgage, a pillar of the American Dream of homeownership, might cease to exist, since banks might be reluctant to offer a loan to be paid back over such a long period without some kind of government insurance.
This time around, private investors would be on the hook for the initial losses and Fannie and Freddie would not in theory charge too little for their insurance, as they did in the lead-up to the crisis.
Given that, Swagel, the former Bush appointee, contends that there is plenty of overlap between the mainstream Democratic and Republican views. A conservative, he agrees that the government should play some role in housing. "That's what the government is there for. Just do it explicitly and do it well," he says.
Swagel argues, contra more hard-right Republicans, that a fully private housing finance market is an illusion. Housing is so important for the economy that the government will inevitably bail it out in a serious crisis. Therefore, even if the government was somehow removed from the market explicitly, the backing would be there implicitly. Conservatives have an interest in pushing for the government to charge the right price for its insurance and to minimize its role.
Such views suggest there is a compromise available for the reaching. "This is one of these areas where a consensus should happen," Swagel says.
But some people, especially outside the Beltway and Wall Street, think twice about reverting to a large private-market role, given that profit-seeking led to the subprime debacle. While hardly anyone is pushing it, there is an Option 4: Expanding the government's role in the mortgage market, perhaps by having the government back home loans more directly. It could be done by a government corporation, akin to the Federal Deposit Insurance Corporation, which has a measure of independence from congressional or executive branch interference, but wouldn't seek profit. In that way it would avoid the conflicts inherent in the Fannie and Freddie public/private hybrid model.
"Profit-seeking is what gets banks and financial institutions into trouble. The government can get into trouble too, but it seems it gets into less trouble," says Susan Woodward, the former chief economist of the U.S. Department of Housing and Urban Development under Presidents Reagan and George H.W. Bush. Moreover, "It's very hard for government to do something that hurts consumers."
David Scharfstein, a professor at Harvard who served in the Obama Treasury, worked on the white paper pushing Option 2, limited guarantees for mortgages only when a crisis strikes. He worries about Option 3, which he calls a "re-do of Fannie and Freddie."
But the forces backing it are powerful. "It's striking — and very unusual — for the housing industry, Wall Street, and consumer groups to all be advocating essentially the same policy," he says.
That doesn't happen much and when it does, he says, look out. His fear is that private for-profit entities would want to grow and expand their market share. They would lobby to reduce the amount of capital they have to reserve for an emergency, and to lower the fees charged for mortgage insurance so they could compete on price. If another crisis hits, lower capital reserves and lower fees would make them far more vulnerable to going bankrupt, leaving the taxpayer to bail them out. "It should be a private market or the government. But the government backstopping private entities," Scharfstein says, "is the worst possible combination."
The taxpayer-owned mortgage giant made investments that profited if borrowers stayed stuck in high-interest loans while making it harder for them to get out of those loans.