Are we ready to phase out Fannie Mae and Freddie Mac? This is not an idle question for anyone who needs a mortgage, worries about interest rates or wonders where real estate values are headed.
The Obama Administration now says that it's time to begin “the orderly and deliberate wind down of Fannie Mae and Freddie Mac.” As a result the secondary market — the electronic platform where mortgages are bought and sold — will be placed in the hands of the private sector once the transition is completed.
Huh? Wait a minute. Why should we deliberately make Fannie Mae and Freddie Mac less competitive? And what happens to mortgage rates and the availability of real estate financing if we do?
The Secondary Market
The secondary market is the important and largely hidden engine which makes cheap mortgages universally available across the US. It's been dominated for decades by Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs) that were taken over by the federal government in 2008.
Fannie Mae and Freddie Mac are the world's largest buyers of local mortgages. They package the loans into mortgage-backed securities, sell them to investors such as pension funds, insurance companies and foreign governments and then guarantee the returns. Interests in mortgage-backed securities can be bought and sold worldwide and with electronic speed.
“A major attraction of Fannie Mae and Freddie Mac was that each organization had a unique ability to borrow up to $2.5 billion directly from the U.S. Treasury,” said Jim Saccacio, Chairman and CEO at RealtyTrac. “There was a presumption — which proved to be true — that the federal government would make good on all guarantees if the two companies got into trouble, that they were too big to fail. The result was that the GSEs were able to borrow at cheaper rates than private-sector lenders, savings which could be passed through to homeowners in the form of lower mortgage costs.”
Who Wins With Privatization?
In a world without Fannie Mae and Freddie Mac there will still be a secondary market, but it would be different.
A secondary market can function if it simply has parties willing to create, buy, sell and guarantee mortgage-backed securities. To do this you need a steady supply of loans, servicers to administer the mortgages on a day-to-day basis and packagers to buy and sell mortgage-backed securities to investors. Freddie Mac and Fannie Mae are packagers and loan guarantors but do not originate or service mortgages.
A handful of major banks now dominate the financial system — except for the secondary market. If the Obama plan goes through that exception will end. To understand why we need to look at some numbers, vertical integration and the economies of scale.
Consolidation & Competition
In 1983 there were 14,884 banking institutions in the U.S. Today, according to the FDIC there are just 7,643 insured banks and S&Ls with assets of $13.4 trillion.
Not only has financial competition shrunk, it has also become more concentrated. As of Sept. 30, the four largest banks had assets of $5.4 trillion, roughly 40 percent of all lender holdings. The big four include JPMorgan Chase Bank ($1.6 trillion), Bank of America ($1.5 trillion), Citibank ($1.2 trillion) and Wells Fargo Bank ($1.1 billion).
In terms of mortgages, MortgageDaily reports that home loan closings from the three biggest lenders totaled about $1.53 trillion in 2010.
Three banks — Wells Fargo, Bank of America and Chase — originated 56 percent of last year's mortgages, says MortgageDaily. The fourth largest originator was GMAC and the fifth was Citibank.
The biggest lenders originate a lot of loans but who does the servicing?
“The servicing portfolios of the eight largest national bank mortgage servicers account for approximately 63 percent of all mortgages outstanding in the United States — nearly $33.3 million loans totaling almost $5.8 trillion in principal balances as of June 30, 2010,” said John Walsh, acting Comptroller of the Currency, a major bank regulator.
Walsh says the eight banks are Bank of America, Citibank, JPMorgan Chase, HSBC, MetLife, PNC, Wells Fargo, and U.S. Bank.
Is further consolidation in the financial marketplace good for the country?
Bigger banks could have more efficiencies of scale and thus the possibility of lower operational costs per transaction. However, not everyone is comforted by the idea increased agglomeration.
“This would have ruinous effects by eliminating community banks from the mortgage market,” said Jim MacPhee, chairman of the Independent Community Bankers of America, “depriving small town and rural customers of the ability to get the mortgage financing they need, especially in these underserved markets. It will also make the too-big-to-fail institutions even bigger, and will create a dangerous concentration of mortgage assets in just two or three mega institutions.”
Guarantees & Regulation
Once Fannie Mae and Freddie Mac are gone, a federal mortgage authority is supposed to provide strong oversight under the Obama plan and set standards for conforming loan products and mortgage-backed securities. The revenue from packaging and selling mortgage-backed securities would go from Fannie Mae and Freddie Mac to private lenders, but the government would ultimately guarantee such investments.
Essentially, this is the same regulatory and guarantee system we had in 2008, a system which did not prevent the origination of toxic loans or the need for taxpayer bailouts. No less important, there's now an effort to substantially reduce regulatory budgets and therefore trained oversight staff.
Whether the new regulatory system will be any better than what we had before is unclear. There is, for example, a tough new regulation which could result in lower borrowing costs
“Starting April 1, under a new compensation rule from the Federal Reserve, borrowers who get their mortgages through brokers will most likely pay less for their services and must be offered the lowest possible interest rate and fees for which they qualify,” reports The New York Times.
The catch, according to the paper, is that not every lender is covered by the new regulations.
“Most banks and other direct lenders, including the few mortgage companies that function like banks, are exempt.” (See: New Fed Rule for Mortgage Brokers, Feb. 17, 2010)
Translation: The huge banks that dominate the mortgage system are not covered by the new rule, a rule designed to lower borrower costs. It's like requiring buildings to be fireproof, except for structures made of wood.
The risk to taxpayers can be considerable with any financial guarantee plan. For instance, the government has already provided more than $130 billion “so both Fannie Mae and Freddie Mac could honor their debt and guarantees.”
The Obama plan, which in one form or another is likely to pass on Capitol Hill, will create a new secondary system and in time phase out Fannie Mae and Freddie Mac. It will not end the need for mortgage regulation, conforming loan standards or taxpayer guarantees. Billions of dollars in fees that once went to the GSEs for packaging and selling mortgages will soon go elsewhere, but the same essential functions, guarantees and taxpayer risks will remain in place.
Peter G. Miller is syndicated in more than 100 newspapers and operates the consumer real estate site, OurBroker.com.