After a massive effort to expand the number of Americans who own a home, the agencies are now directed to pursue profit and minimize losses
During the housing boom, Fannie Mae and Freddie Mac were all about boosting home ownership. Gretchen Morgenson and Joshua Rosner wrote an entire book, Reckless Endangerment, about how Fannie built a culture around increasing mortgage availability as a cover for loosening credit standards and pursuing short-term profits. Years later, as millions of Americans struggle to make mortgage payments and avoid foreclosure, the companies have done a 180. They will help troubled borrowers to keep their homes only if doing so is in their self-interest. This might seem particularly strange, considering that the government now owns the companies, but it shouldn't: they're now focused on protecting taxpayers.
Fannie and Freddie's new philosophy is based on its conservatorship. Now their mission is twofold: to continue to provide mortgage market liquidity and to minimize losses to taxpayers. At a recent hearing on Capitol Hill, Federal Housing Finance Authority Acting Director Edward DeMarco explained:
I do not believe I've been appropriated taxpayer funds for the purpose of providing this more general support for the housing market. We're supposed to undertake our loss mitigation activities with regard to the cost to the taxpayer.
This strategy can be seen pretty clearly by looking at the ways in which the FHFA is directing the firms on several key issues.
A number of economists argue that the best way to slow foreclosures and heal the housing market would be for those who own the mortgages to engage in principal modifications. The logic goes that if underwater mortgages were bailed out by reducing their balance to their home's market value, then defaults would slow and the market would stabilize. Of course, Fannie and Freddie stand behind a huge chunk of the mortgage market, so their compliance on principal reductions would be pivotal in making the policy work -- and setting a precedent for banks to follow. But the firms remain firmly against principal reductions.
Nick Timiraos explained the three components of their logic in a WSJ blog post earlier this month. Here's a summary:
- Around 87% of Freddie's underwater mortgages are current. Cutting the principal on the other 13% that are delinquent could create a moral hazard that induces defaults on the other 87% of mortgages that are current. This potential cost could far outweigh any benefit from fewer foreclosures.
- Other mortgage modification tactics that do not reduce principal are working fairly well. So the firms see no reason to create bigger losses for themselves by reducing principal instead.
- Third party mortgage insurance covers many underwater mortgages. So Fannie and Freddie will avoid losses on those foreclosures anyway, leaving the firms no financial incentive to reduce principal.
In short, these firms have analyzed the consequences of providing principal reductions and have concluded that doing so will create bigger losses for taxpayers.
As strange as it may sound, providing lucrative executive bonuses also helps taxpayers. I explained why in a post last week. In order to attract the sort of expertise that these companies need to function properly and minimize taxpayers' losses, executive pay has to be relatively high.
This may enrage some taxpayers. But billions of dollars more in losses that these firms could experience if unqualified executives run them while in conservatorship would cost taxpayers far more than millions in bonuses.
The outlier might appear to be the revitalization of the Treasury's mortgage refinancing program. Last month, we learned that Fannie and Freddie had finally agreed to take measures that would enable underwater borrowers to refinance their mortgages at current historically low interest rates. Why the change of heart?
There could be a few reasons. First, as home prices have begun to decline again this year, these firms may fear strategic defaults, which occur when underwater borrowers who are current on their mortgages stop paying even though they can continue to afford to pay. One way to pacify people in this situation is to cut their mortgage payments by providing a lower interest rate. That's what HARP II does.
But refinancing at very low rates involves significant interest rate risk. Shouldn't Fannie and Freddie worry about a time when interest rates rise and they're stuck with lots of mortgages that pay relatively little interest? They would be if they weren't hedged against interest rates rising. We know that they are: their big third quarter losses were caused in large part by derivatives purchased for precisely this purpose.
So again, the FHFA may be allowing Fannie and Freddie to participate in this new program because current conditions imply that doing so could minimize losses to taxpayers. Strategic defaults will be lower, and interest rate risk is already hedged.
At this point, the survival of Fannie and Freddie will be very difficult. Obviously, their future will face significant political resistance, as taxpayers won't soon forget bailing them out for more than $150 billion. But their financial fate might be even more hopeless. They are required to pay 10% dividend payments on their giant bailout tabs. Their profits may never be large enough to sustain an ongoing annual cost of that size even before they begin to pay back the bailout principal. But that remains their goal, as doing so is their only hope for survival.