As mortgage giants Fannie Mae and Freddie Mac near a deal that could lower barriers and restrictions on borrowers with weak credit, it’s hard not to wonder if Americans have learned anything from the 2008 financial crisis.When the nation’s housing market crashed, these companies owed the U.S. government $187 billion.Clearly, it had become far too easy for borrowers with bad credit to get approvals for mortgages and for families to borrow more than they could afford. Virtually everyone agreed that officials needed to fix this problem so that it never happened again. In a column for the National Post on July 12, 2008, David Frum, a former speechwriter for George W. Bush, cleverly summed up the sentiment at the time when he wrote:
“The shapers of the U. S. mortgage finance system hoped to achieve the security of government ownership, the integrity of local banking and the ingenuity of Wall Street. Instead, they got the ingenuity of government, the security of local banking and the integrity of Wall Street.”
Given such sentiment, few would have imagined that during the next six years Fannie Mae and Freddie Mac would continue to provide the vast preponderance of the new single family mortgages being issued in this country. Rather than wind down their role, while operating under conservatorship, their market share has increased and there have been few real changes to the housing finance system. In fact, the concept of “qualified mortgages” in the Dodd Frank bill, which was supposed to ensure that banks retain some of the risks for the mortgages they wrote, has now been watered down to the point where the only mortgages for which banks need to retain a risk position on their balance sheet are those where borrowers are paying more than 43% of their income. And once again, Fannie Mae and Freddie Mac are guaranteeing mortgages with as little as a 3.5% down payment.
We would like to propose, as have some others, that the Federal Housing Finance Agency, which oversees Freddie and Fannie, take a significant step and begin to get these companies out of the business of refinancing home mortgages. By doing so, the agency will reduce, over time, the $5.3 trillion they currently guarantee, focus on the home ownership and job creation sides of their activities and offer the private sector an attractive new market. According to the Department of Housing and Urban Development, over 50% of the single family mortgages these agencies purchased the last 15 years were to refinance existing mortgages.
What is the appropriate role for Fannie Mae and Freddie Mac? Some people say the mortgage market would behave better privatized than propped up by Fannie Mae and Freddie Mac. Others cite the fact that since these agencies control such a large share of the present mortgage market, it would be disastrous to phase them out.
A number of people have put forth thoughtful proposals for reforming the housing finance system, including the Bipartisan Housing Commission and its Mortgage Finance Reform Working Group. These proposals try to deal with fundamental flaws in our system such as the fact that the private sector continues to push virtually all of the risk onto U.S. taxpayers. However, because we are not in crisis and because Fannie Mae and Freddie Mac have repaid their loans and are operating profitably, serious efforts at reform are not gaining much traction.
Without taking sides in this debate, continuing to allow these agencies to make new loans to facilitate purchase of a person’s prime residence seems an idea that should be acceptable to both sides. As long as these agencies continue to exist, a good case can be made that helping people purchase homes serves a useful public purpose and helps create jobs. In this role, these agencies can also ensure that there is adequate capital and liquidity in the mortgage market.
In contrast, there is little public purpose in refinancing most home mortgages. Why should Fannie Mae, Freddie Mac and the U. S. taxpayer subsidize homeowners who want to lower the mortgage rate on their home from 5% to 4%? And why should they subsidize homeowners who want to pull money out of their house by taking on a bigger mortgage? It is noteworthy that, in a single quarter in 2006, borrowers pulled out $84 billion dollars of net equity in cash-out refinancings, some portion of which became part of the $187 billion bailout. By guaranteeing the mortgages in a refinancing, Fannie Mae and Freddie Mac are both subsidizing the homeowners and taking on greater risk.
Even with this relatively simple proposal, there are a number of issues that will require further discussion. For example, should Fannie Mae and Freddie Mac continue to finance second homes or refinance mortgages to enable borrowers to make significant home improvements? Should they guarantee loans that might help a homeowner avoid foreclosure?
While refinancing may have limited public purpose, it seems like an ideal product for the private market. Banks can still process these loans and then securitize them to institutional investors. We believe institutional investors would love a security backed by mortgages made to homeowners with stellar track records of on time payments, especially if this pool of mortgages offered a slightly higher rate than a Fannie Mae or Freddie Mac pool. If the rate or terms were too onerous, the homeowner could stay with the existing mortgage.
Will this proposal to phase Fannie Mae and Freddie Mac out of the business of refinancing home mortgages fully protect U.S. taxpayers? No. But it might significantly reduce the potential losses. By narrowing the scope of Fannie and Freddie’s activities, it will ensure that we are no longer responsible for borrowers who overleveraged through cash out refinancing. Ideally, as the private sector gets more involved in the mortgage refinancing market, it will set the stage for greater involvement in other areas of the housing finance market.
Few people believe that the current mortgage finance system is sustainable over the long run. And fewer still believe that the government has taken the steps necessary to protect the U.S. taxpayer from another bailout. While the next disaster may not be the same as the last one, we believe that action needs to be taken. As Mark Twain warns us, “History doesn’t repeat itself, but it does rhyme.”
John Vogel is an adjunct professor at the Tuck School of Business at Dartmouth College, where he teaches courses in real estate and entrepreneurship in the social sector. Bill Poorvu is an adjunct professor in entrepreneurship emeritus at Harvard Business School.