Will Fannie & Freddie's Slow Death Create a Housing Stimulus?

If Friday's Treasury report on housing finance is any indication, Fannie Mae and Freddie Mac's fate has been decided. Over some period of time, probably within the next decade, they will suffer a slow, sure death. This outcome has those who favor strong government intervention in the mortgage market worrying about what less federal involvement means for the housing. Will the 30-year, fixed rate mortgage cease to exist? Will required down payments hit 30%? Will fixed mortgage interest rates rise by 1% or more? Time will tell, but the process could also result in an interesting unintended consequence: a temporary housing stimulus.

This is best understood through analogy. Imagine that the government said it was starting a new tax on auto sales. It would be a 10% tax, phased in over the course of five years. So you would be forced to pay an additional 2% each year on the total sales price in taxes. For example, starting in 2012, a $20,000 car would cost you $400 more. In 2013, if you bought a car for the same price, it would cost you $800 more. And so on, until in 2016, the car would cost $2,000 more. And that tax would stay at that rate going forward.

What would you expect to happen? Americans would rush to buy cars over the next five years. Now imagine that the U.S. does the same thing with mortgages. Only instead of a tax, they reduce a subsidy that allows for cheap mortgages. That's almost exactly what's going to happen as Fannie and Freddie's influence is reduced.

Let's say that the government decides the maximum mortgage size accepted by Fannie and Freddie will be cut to $500,000 immediately, and decline by $50,000 for the following ten years. And let's also assume that the private market charges more for its mortgage financing, because it is more concerned with mortgage losses. Consequently, people looking to get mortgages with sizes that are being phased out will rush to finance them while they can still obtain lower mortgage interest rates due to the government guarantees.

In fact, the government might do more than just lower the mortgage size limits for its backing. It might also gradually increase the cost of its guarantees until it phases them out entirely. This would make even those mortgages that qualify for Fannie and Freddie's support to become gradually more expensive. Again this should encourage demand in the shorter-term.

So if Congress does pass a measure to remove a significant portion of the government's influence from mortgage financing and slowly eliminates Fannie and Freddie, there could be consequences for interim home buying demand. We could see consumers who are considering to buy a home sometime over the next several years to exhibit a little bit more urgency to do so sooner than later. There would likely also be greater demand for mortgage refinancing. If sales and refinancing do occur at elevated levels, then mortgage interest rates should stay relatively low. Moreover, those elevated sales could help home prices from falling as much as they otherwise would or could push prices higher in some areas.

This could actually be an unintended benefit for housing finance reform. At a time when Americans need a little extra encouragement taking the plunge to buy a home, the threat of a mortgage market without Fannie and Freddie might help to do the trick. Of course, any process to wean the mortgage market off government support will be gradual, so there's a question here of whether or not people will feel the urgency to act, or whether the process will be slow enough that no one really notices until they one day find themselves with higher mortgage rates and new mortgage financing options.

If the U.S. housing market does experience such a stimulative effect through such legislation, this wouldn't be a permanent phenomenon. It would essentially be pulling forward future demand. Whatever home sales occur more quickly might have happened in the months or years to come instead. So once the private market has to take on mortgage financing without full government guarantees for most mortgages, the housing market might have additional difficulty functioning without as much government.