The Implications of a World Without Fannie and Freddie

$321 billion -- the total estimated cost of keeping Fannie Mae and Freddie Mac on life support since both government-sponsored enterprises (GSEs) went into conservatorship in 2008. Given the high price tag, it's not surprising that the Obama administration has proposed plans for phasing out the programs over the next seven years. While the White House and Congress spar over a variety of partisan issues, they find common ground on the idea of getting the government out of the mortgage business. Recommending the end of Fannie and Freddie may sound like a sensible step to reduce the deficit and Federal exposure to the risks of mortgage backed securities, however, it also poses significant implications for the economy and a currently-struggling real estate industry. The biggest factor is additional uncertainty and insecurity in a market that has been unable to regain a stable footing.

In February, 2011, the U.S. Treasury Department recommended three options to phase-out the GSEs. The first option is predicated on mortgages guaranteed completely by the private sector. The second option is similar, but calls for some government involvement as a “backstop mechanism” which would be funded by premiums charged to a selected segment of higher-priced mortgages, the level of which needs to be determined. The final option relies on the private sector as primary guarantor, however, the government upon approving selected insurers and instituting strict underwriting oversight, would provide capital, if needed, funded by premiums charged to a select mortgage segment.

Under any scenario, FHA insurance would remain untouched; the government would only be divesting itself of the GSEs. Government insurance for mortgages secured for low-to-middle income borrowers by the FHA, the U.S. Department of Agriculture, and the Veteran’s Administration would remain in place under all three options.

The top tiers of the mortgage market could still encounter major headwinds with the phase-out of GSE backing. Adding private sector insurance with its associated higher premiums (undoubtedly passed on to borrowers) to the mix of sluggish home sales, depressed prices and rising mortgage rates could further postpone a full recovery in the real estate market.

Important to note as well is that the government’s proposals regarding the demise of Fannie and Freddie do little to address the inventory of toxic securities taxpayers have been burdened with since taking over their conservatorship. While the hope is that in time, these securities can be sold off, the options presented take a “go-forward” approach to prevent future catastrophes with no real strategies to deal with existing losses. The U.S. taxpayer holds an 80% stake in both GSEs, estimated to have a combined debt of $5 trillion which currently represents about 50% of U.S. first liens. While shuttering these two giants may achieve the long-term goal of extricating the government from the expensive business of mortgage insurance, it will fundamentally change the way loans are bought and sold in this country.