Fannie Mae, Freddie Mac Don't Work

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Fannie and Freddie face an uncertain futureAt yesterday's Conference on the Future of Housing Finance in Washington, each panelist was asked what they would change and what would they preserve regarding the government's ongoing role in the housing sector? Their prepared responses offered the expected spectrum, from lip service to real substance. But all agreed that the current models for Fannie Mae and Freddie Mac are not doing the job.

Each panelist represents a substantial stakeholder in the final policy proposal that's due to be presented to Congress in January 2011.

They were invited by the current administration, so you can bet that the fundamental underpinnings of such start here.

The conference revolved around the (continued) level of government involvement in housing and finance, specifically as it pertains to Fannie Mae and Freddie Mac (the GSEs).

The argument for either more or less government involvement was lost on me, since the government -- via Fannie Mae and Freddie Mac -- are currently responsible for implicitly guaranteeing somewhere north of 90 percent of all mortgages today.

So it's a matter of gradually less and/or different levels of government involvement, done thoughtfully and over time. In other words, the GSEs aren't going anywhere, as they still represent stability to a fragile economy.
While what they turn out to look like is open to much more debate and speculation, they must either be part of the government or privately controlled. Either can be successful but one path must be chosen. The current hybrid model causes too many misaligned objectives.

But before we move forward, we must look back. While history may not repeat itself, it sure does rhyme ... or something like that:


The "Implicit Guarantee" by Fannie Mae and Freddie Mac
According to Lou Ranieri, the godfather of mortgage finance, this commitment to what equates to free insurance was the critical flaw to the entire system. Wall Street exploited it magnificently, knowing that investors the world over would almost infinitely buy any security guaranteed by the U.S. government. This flaw could be corrected by explicitly outlining the very detailed terms of any such guarantee by the GSEs, going forward.

This explicit guarantee should apply to the actual security or mortgage rather than the entity, with minimal risk to the taxpayer -- and for a fee. This fee would be used to subsidize against any potential losses and not for profit. Mark Morial of the Urban League added that any such government guarantees should be studied for impact to underwriting and ultimately the flow of credit, further noting that those who provide such guarantees will have great control and influence.


The Profit Motive
Ranieri astutely offered that the flashpoint where the GSEs stopped acting like themselves was in 2002, when the non-agency, residential-backed-securities market started to engineer a subprime class of loan. These loans were more profitable to investors and caused the GSEs to lose market share. Well, that's not good if you're a publicly traded company. That's when the GSEs began participating in exactly what they were created to prevent: unchecked growth, motivated by profit rather than prudence. This fallacy of morals primed the ultimate in systemic failure.

The FHA served the subprime marketplace very well for a long time, using tried-and-true methods. We need to get back to these fundamentals and the FHA should lead the way again. (Related, but for another article at another time, is the ban on "yield spread premiums.")


"Productization"
S.A. Ibrahim, CEO of Radian Group, noted that mortgages were created for the creditworthy who could not really afford the house they were buying. As the former CEO of GreenPoint Mortgage, he should know. As a former mortgage broker who originated loans for GreenPoint, I know that they stepped well outside of their own loose underwriting guidelines for a slight bump in price (or profit) on the front side of the life of the loan, while passing the elevated risk down the back side. Ibrahim also insightfully pointed out that piggyback loans, a combination of first and second mortgages, allowed many borrowers to get around downpayment requirements -- another common practice of GreenPoint. Investors blindly bought the mortgages in first position, as if the consumer actually had some skin in the game -- again, passing unchecked risk into the market.

The engineering of mortgage products became more and more exotic to fuel the demand of investors and consumers alike, and GreenPoint was an architect that served as a conduit to such products under the guise of innovation. While future innovations in this sector are vital, they cannot be to the detriment of a system that properly assigns risk. Rewards for any such innovations should stretch the life of the mortgage to better align objectives.


Without a solid understanding of the mistakes that were made, we're doomed to repeat them. I've identified three such mistakes that these panelists-turned-policy-influencers thought enough of to bring to this administration as fundamentally essential for change. In subsequent articles, I'll dive into some future-looking recommendations from the panel, such as: availability and cost of credit; assisting the under-served borrower; firming up the multifamily and rental market; as well as the potential for an expanded role of the private sector in the housing finance arena.


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