Obama's Housing Policy Reform May Spare Fannie and Freddie

Anyone who hoped that taxpayers might be shielded from future losses will be sorely disappointed

The government just can't seem to let go of Fannie and Freddie. Huge accounting scandals didn't deaden their impact. Gigantic taxpayer losses, at $170 billion and counting, haven't taught Washington its lesson either. According to a new report, the Obama administration is considering keeping the firms around, though their mission might change a little. Unfortunately, the possible role that the article's sources describe doesn't sound like very substantial housing finance policy reform.

Here's Zachary A. Goldfarb of the Washington Post with the scoop from his White House sources:

President Obama has directed a small team of advisers to develop a proposal that would keep the government playing a major role in the nation's mortgage market, extending a federal loan subsidy for most home buyers, according to people familiar with the matter.

The decision follows the advice of his senior economic and housing advisers, who favor maintaining the government's role as an insurer of mortgages for most borrowers. The approach could even preserve Fannie Mae and Freddie Mac, the mortgage finance giants owned by the government, although under different names and with significant new constraints, said people knowledgeable about the discussions.

If you connect the dots here, then the Obama administration's proposal begins to take shape. We are told that the government would insure most mortgages. Of the Treasury's three policy alternatives offered back in February, only one could apply. That was the "catastrophic guarantee" option, where government agencies would sell a guarantee on most mortgages to investors. Those investors would face some first loss percentage and pay a premium for the catastrophic guarantee that the government provides. If Fannie and Freddie are kept around, then presumably they would be involved in creating these guarantees.

There's a strange narrative being pushed by lobbyists in Washington that somehow if the government guarantees mortgages, we'll end up with a safer housing market than we experienced during the bubble. This view assumes a lot and forgets even more.

First, we can be pretty certain that Fannie and Freddie had no intention of going under due to their housing bubble strategy. Presumably, they had risk analysts who wrongly believed that they had enough capital on hand to cover losses that could result when the music stopped. Obviously, they miscalculated wildly. Now remember, Fannie and Freddie were for-profit firms that cared a lot about what investors thought. If they couldn't get the numbers right to provide safe guarantees, then are we really to believe that they would do any better if led by bureaucrats instead of investors?

Next, remember all of those mortgage losses faced by Fannie and Freddie? Last year I explained that about three-quarters of those losses were the result of guarantees gone bad. In other words, the most dangerous thing that Fannie and Freddie did was guarantee mortgages -- precisely what the government wants to do. Under the scenario described the government (read: taxpayers) would still be left with the bulk of catastrophic losses if another bubble were to arise.

But what about investors? Wouldn't they be more careful since they would take the first loss? Maybe, but banks and investors had plenty of mortgage exposure during the housing bubble -- and took massive losses. That is, after all, what caused the financial crisis: mortgage securities became toxic and the market seized. Bank and investor losses would be even smaller under this framework if limited to some finite first-loss piece. Would that really stop them from attempting to profit from an overheating housing market? Perhaps I'm just too cynical, but I don't see it.

Of course, we shouldn't be surprised about how this narrative is evolving. Of the three Obama administration alternatives, the one it is reportedly leaning towards would provide the biggest role for government going forward -- and the most cover for the real estate industry and Wall Street. Their lobbying is so powerful that it has managed to create an alternative reality in which few people now question the assertion that without a government guarantee, there could be no 30-year, fixed-rate mortgage. Indeed, Goldfarb's article implies that this assertion is an obvious, unquestionable fact:

But if this approach became law, it probably would keep in place the kind of popular home loans that have been around for decades -- 30-year fixed-rate mortgages with relatively low interest rates.

I suppose the jumbo market -- mortgages too large to have obtained a government guarantee -- should just be overlooked? After all, qualified borrowers were able to obtain 30-year, fixed rate, relatively low interest rate mortgages without a government guarantee. Any claim that the 30-year, fixed rate mortgage cannot survive without government support is unfounded.

But it really isn't quite fair to single out the Obama administration here. Many Republicans also appear to be embracing a continued strong government role in the mortgage market. In fact, two California Republicans have already introduced bills that would keep the government's aggressive role in housing finance mostly intact.

As I've said before, we know how this is going to end. Taxpayers never stood a chance when facing opponents as formidable as the real estate industry and Wall Street.

Update: The Treasury has provided a response to the WaPo piece, suggesting that it still intends to wind down Fannie and Freddie and protect taxpayers. On the first point, this may be a technical dispute. The WaPo piece appears to indicate that Fannie and Freddie may have new names and somewhat new purposes, but still exist in a reanimated form. On the second point, it comes down to whether or not you believe the government can safely protect taxpayers while providing catastrophic guarantees for most mortgages. I'm skeptical. Here's an additional excerpt from the Treasury's statement:

The Washington Post article also makes a factual error in suggesting that the Administration has settled on a single proposal for the long term structure of the housing finance market. In fact, at the request of the President, the housing finance reform team at the White House, the Treasury Department, and the Department of Housing and Urban Development continues to weigh and analyze each of the options laid out in the Administration's report to Congress.

So this may still be a work in process. But the WaPo appeared (to me anyway) to indicate that the White House was leaning heavily in the direction of the catastrophic guarantee option. Time will tell.

Image Credit: REUTERS/Jason Reed