Their failures are manifest, and politicians of every stripe seem to revile them. Fannie Mae and Freddie Mac have turned out to be the biggest catastrophes of the 2008 financial meltdown. The government has already spent more than $130 billion in taxpayer money to keep them alive, and the tally is still rising.
If they were in any way expendable, the two mortgage agencies would be gone by now. But the credit crunch of the last three years has left middle-class home buyers more dependent than ever on Fannie and Freddie. The two agencies' main role is to purchase mortgages from banks and roll them into marketable securities, which benefits home buyers by keeping rates relatively low and giving banks a stronger incentive to lend. One byproduct is the 30-year fixed-rate mortgage, which most banks wouldn't offer without the government's backing, because the odds of losing money would be higher. Fannie and Freddie effectively reduce the risk of lending, making more people eligible for loans and therefore, homeownership.
That's the idea, anyway, but something obviously went wrong. During the housing boom, many lenders—including Fannie and Freddie—lowered their lending standards to accommodate millions of people who wanted in on the hot market, but ordinarily wouldn't have qualified for a loan. The result of those bad loans was an epic housing bust that's now in its fifth year, with home prices down more than 30 percent from the peak in 2006—and still falling. That led directly to the financial crisis that erupted in 2008, when Fannie and Freddie became insolvent and were taken over by the government.
The irony now is that Fannie and Freddie are keeping the housing market alive. Nearly all mortgages issued today are backed by Fannie, Freddie, or the Federal Housing Administration, a sharp increase from normal times when private lenders handled at least 20 percent of mortgages without any government backing. Without the government, in other words, hardly anybody would be able to buy a home today. The private mortgage market should revive as the overall economy heals. But as badly as policymakers may want to wind down Fannie and Freddie, it's obvious that doing so abruptly would crater the housing market all over again and trigger another recession.
So the first efforts at housing-finance reform call for a gradual wind-down of the two mortgage giants. The Obama administration's plan is to slowly reduce Fannie and Freddie's loan portfolios, with three options for how to replace them ultimately. One would be a housing-finance system that's mostly private, with the government backing only mortgages for some low-income and first-time buyers, and veterans. Another option is a private system with a mechanism for government intervention during emergencies or financial crises, to keep the housing market functioning. Under the third option, the government would still be involved, but it would have a more limited role than it does now and would charge private lenders more to backstop loans. Under all of those scenarios, Fannie and Freddie would go away, replaced, if necessary, by new or different agencies not stigmatized by loathsome bailouts.
But the Obama plan is a wish list, and even though some Republicans in Congress would gladly kill the two agencies tomorrow, it's not likely to happen. "We believe getting rid of Fannie and Freddie is much harder than it looks," advises analyst Jaret Sieberg of brokerage firm MF Global, in a research note to clients. "The status quo is the most likely outcome." For one thing, a reduced government role would almost certainly raise mortgage rates and other costs, since banks would have to add a cushion to cover the extra risk they'd be taking, without the government backstop. Down-payment requirements would probably go up. That might produce a healthier system less prone to shocks, but higher costs and monthly payments for buyers would also crimp demand for both new and used homes. Even some middle-class families with good credit might get priced out of a home, leaving politicians to explain how they killed the American Dream.
For all the daggers aimed at Fannie and Freddie, it turns out, there are many groups who like the housing-finance system just the way it is—and are fighting hard to keep much from changing. Some of them:
Home builders. They're reeling, and begging for a break. New-home construction has obviously tanked over the last few years, since plunging sales have created high inventories of unsold homes. The demise of Fannie and Freddie would effectively reduce government subsidies for mortgages, lowering demand for new homes even more.
Realtors. They too are looking for relief, so they can start doing deals again. Higher costs for home buyers would harm Realtors the same as home builders, by lowering demand for homes. It might also intensify pressure for Realtors to cut commissions, transferring a bit of the pain away from buyers and sellers. But Realtors have always guarded their commissions aggressively and will continue to.
Small and community banks. They could get priced out of the mortgage market if the government's not there to level the playing field, with megabanks undercutting them to grab market share. Small banks and credit unions have another powerful argument: Concentrating too much control of the housing market among a small number of huge banks makes the too-big-to-fail problem worse, not better.
Consumer groups. The Consumer Federation of America, for instance, has warned that a reduced government role in housing could cut off mortgages to many families and shift control to "Wall Street banks and investors whose previous missteps have already caused massive foreclosures and losses for consumers." They kind of have a point.
All told, the groups that support Fannie and Freddie—or at least reluctantly tolerate them—have significant clout in Washington. And populism is on their side, since they can plausibly claim that middle-class home buyers would be harmed if the government backed away. Of course, taxpayers bear a substantial cost for the current system too, since they're keeping Fannie and Freddie alive.
[See why low inflation seems high.]
The Obama administration has said that a loose timeline for reforming Fannie and Freddie is five to seven years, which might be slow enough to allow the housing market to get back on its feet before much begins to change. But there are a lot of reasons it could take even longer, or never happen at all. Despite a lot of jawboning in Washington, it's unlikely there will be many major changes—to anything—before the 2012 presidential elections. After that, most economists still believe that unemployment will remain uncomfortably high, not returning to "normal" levels until 2015 or later. Many of the economy's lost jobs are in construction and other fields related to the wrecked housing market. That makes it hard to see how it will be politically feasible to do anything that will raise borrowing costs and depress home sales, even marginally.
But home buyers could be in for some changes nonetheless. There are a few things that Washington can do to strengthen the mortgage market, without a major makeover of Fannie and Freddie, like raising the down-payment requirement for government-backed loans and boosting the fee banks must pay for the federal backstop. That could push rates up a bit and make lending standards tougher, just as the housing market starts to recover. Either way, the glory days of government-backed lending are probably over. Still, you might have Fannie and Freddie to kick around for a good while longer.