ECONOMICS APRIL 4, 2013
Fannie Mae and Freddie Mac, the government-backed guarantors of residential mortgages, hold a particularly reviled place in our political culture. They stand accused of taking a $187.5 billion government bailout (correct) and inciting the housing bubble and financial crisis (largely incorrect). And now that they've been nursed back to profitability—Fannie Mae announced this week that 2012 was the most profitable in its history—the big fear in Washington is that the mortgage giants have become "too successful to fail." Members of Congress and Administration officials desperately want to wind down Fannie and Freddie and reduce the government's role in backstopping mortgages. But it’s hard when the federal coffers are filling up with dividend payments: Fannie Mae delivered $11.6 billion in 2012 alone.
But this gets the story backwards. Fannie Mae and Freddie Mac's lifeline is not extended by their profitability. It's extended by their their monopoly. Unlike the go-go housing bubble years, Fannie and Freddie and its federal counterparts are practically the only entities buying mortgages from lenders on the secondary market and packaging them into securities. Winding the companies down now would effectively freeze the market for mortgage credit. The reasons for this have nothing to do with Fannie and Freddie, and everything to do with the fact that private investors are disinclined to trust "non-agency" securities issuers, typically the nation’s biggest banks. Investors are currently embroiled in protracted litigation seeking payback for the last round of mortgage-backed securities (MBS). Only now, six years later, have banks hesitantly offered new bonds, with terms favorable to them. How that works out, more than anything else, will go a long way to determining the future of housing finance.
In the old days, lenders would sell you a mortgage and hold onto it, profiting from the interest on the loan. This almost never happens today. Lenders originate loans with the express purpose of distributing them. This offloads the default risk onto the secondary purchasers, and it also provides the lender working capital to originate new loans. During the housing bubble, private banks dominated the secondary market, buying up millions of mortgages and pooling them into MBS, selling over $1 trillion per year at the height.
Fannie Mae and Freddie Mac now serve this securitization function by themselves. Before the crisis, they securitized around 35 to 40 percent of all residential mortgages. Now that number has risen into the high 60s. Add in Ginnie Mae, a government entity which securitizes mortgages insured by the Federal Housing Administration, the Veterans Administration and the Farmers Home Administration, and roughly 90 percent of all home loans pass through a government backstop at some point in the chain. This is dangerous, especially if the economy ever dips back into recession, leading to a wave of mortgage defaults. As Fannie and Freddie guarantee the loans they securitize, this would put the taxpayer on the hook for hundreds of billions of dollars in losses—a replay of the 2008 crisis and bailout.
The market for new private-label securitizations vanished because, as you may have heard, the housing market imploded during the financial crisis. Investors in the allegedly safe assets took a beating. And in the aftermath, investors realized that they were simply dealt with in bad faith. Big bank issuers promised that the loans in their securities met prescribed underwriting standards. But during the housing bubble, those underwriting standards went up in smoke. Seeking ever more mortgages to fuel a securitization bubble, the banks took whatever toxic loans they could find, stuck them into mortgage bonds and sold them off, misrepresenting their quality to the purchasers. All the risk went to the investors, who took huge losses; the banks got bailouts and went on with life.
This backfired on the banks in two major ways. First, investors have waged a years-long campaign to get their money back, arguing that they relied on those promises (“representations and warranties,” per the parlance) that the loans in the securities would meet underwriting guidelines. Forcing the banks to repurchase those loans represents a potential exposure of hundreds of billions of dollars. After much effort, investors are actually making some headway in these cases. A federal lawsuit in New York could set a precedent, allowing investors to use statistical sampling of loans to determine whether the issuers truly broke their promises, significantly lowering the barrier to entry in these lawsuits. Even before this breakthrough, banks have had to pay back billions on the soured mortgages. (Incidentally, one of the biggest repurchase cases is being waged by… Fannie Mae and Freddie Mac, suing 17 banks over $200 billion in faulty MBS, in a case so nasty that the banks recently took the presiding judge to court.)
The other problem for the banks is that investors went on strike, refusing to purchase any new MBS until they got assurances that they wouldn’t get burned again with massive losses on fraudulent securities. This cut the private-label MBS market in half in the past few years. It also contributes to tight lending standards, which many have argued inhibits the recovery. Banks simply don’t want to carry the capital reserves needed to keep mortgages they sell on their balance sheets, especially at the current low interest rates. So the banks’ only recourse for selling off the loans is Fannie and Freddie, whose mortgage purchase standards are quite high, and who have been aggressive in seeking repurchases from banks. Repurchase risk has led to fewer and fewer loan originations, according to Federal Reserve Governor Elizabeth Duke.
Removing government supports for the mortgage market, and shrinking Fannie and Freddie, therefore depends on the private securitization industry creating new products with sound standards that investors might actually want to buy. Nobody wants that market to reach the levels it did during the housing bubble, but a more controlled, better-behaved market could create more liquidity and lead to more mortgage originations.
JP Morgan Chase has quietly issued the first non-agency MBS by a major bank since the financial crisis. The deal is small—about $616 million, per presale reports. But if it succeeds, they plan to follow with several billion more this year. However, the deal has already stoked controversy, as JP Morgan tries to eliminate its biggest risk from the last round of MBS: the representations and warranties. According to the Wall Street Journal, the securities would place an expiration date on when investors could demand the repurchase of faulty loans in the pool, even in the case of fraud. Essentially, JP Morgan refuses to fully stand behind the securities, and if the mortgage market collapses again, they would be indemnified from civil litigation, really the only impediment to the fortunes they made off securitization during the bubble. These weaker representations and warranties even led credit rating agencies to initially back away from blessing the securities with super-safe AAA ratings, though two agencies, Fitch and Kroll Bond Ratings, eventually relented.
Fannie and Freddie have not crowded out private capital, as Senator Bob Corker said this week. They’ve stepped in for it. The new enticements to coax that private capital back into the market look even less advantageous to investors. As a result, we have this strange limbo, with the status quo in place to prop up the housing market. At the moment, Fannie and Freddie’s profitability means a windfall for taxpayers, as the companies must pay the bulk of their profits to the Treasury. But that won’t hold forever. And this anxiety about a government-sponsored housing market could lead to big banks getting their wish—a market with privatized profits and socialized losses.