First Wall Street, then Your Street

Replace Fannie Mae and Freddie Mac Responsibly

Congress should reform Wall Street before reorganizing the two mortgage securitization giants that underpin our housing market, argues David Min.

Sen. John Mccain (R-AZ) will propose an amendment to the critical Wall Street reform bill that would radically reshape Fannie Mae and Freddie Mac. The amendment, however, is reckless and poses a significant risk to our housing markets. (AP/Charles Dharapak)
Sen. John Mccain (R-AZ) will propose an amendment to the critical Wall Street reform bill that would radically reshape Fannie Mae and Freddie Mac. The amendment, however, is reckless and poses a significant risk to our housing markets. (AP/Charles Dharapak)

On the Senate floor tomorrow, Sens. John McCain (R-AZ), supported by Richard Shelby (R-AL) and Judd Gregg (R-NH), will propose an amendment to the critical Wall Street reform bill that would radically reshape Fannie Mae and Freddie Mac, severing all federal involvement with these two mortgage securitization giants within 24 months. The amendment is reckless, poorly thought out, and poses significant risk to our housing markets, which have only recently begun to stabilize. Indeed, the McCain amendment threatens to derail our broader economic recovery.

Major reforms of the housing finance system are clearly necessary. We can’t go back to the system of the past, and the status quo of Fannie and Freddie under federal conservatorship is untenable. But such changes must be thoughtful and deliberate.

In the near term, we must ensure that the government’s temporary but essential support of the mortgage markets through its conservatorship of Fannie and Freddie is prudently managed so as not to jeopardize the fragile U.S. economic recovery. Over the long term, as we design a revised housing finance system to replace the structures we currently have in place, we must be careful to do so in a way that protects the consistent availability of sustainable mortgage credit with minimal economic disruptions.

American homeowners who have seen so much of their wealth evaporate, and many of whom now find themselves tied to a home with an underwater mortgage, can ill afford more housing market gyrations. The McCain amendment would fail these hardworking families in all of these areas because it:

  • Poses significant risk to the economic recovery: About 95 percent of mortgage originations are currently being backed by the federal government, with the vast majority of this coming through Fannie and Freddie. The McCain amendment would cause significant uncertainty among investors in mortgage-backed securities issued by Fannie and Freddie, threatening the primary source of mortgage credit we have at this time—without offering any alternative sources of liquidity.
  • Fails to ensure that sufficient mortgage credit will be available in the future: Private sector securitization of housing mortgages alongside securitization done by Fannie and Freddie account for approximately $9 trillion of the $14 trillion total outstanding mortgages in the United States today. With the future of private securitization highly uncertain, policymakers seeking to reform the housing finance system must ensure that our future housing finance markets provide sufficient liquidity to meet the mortgage needs of Americans. The McCain amendment would eliminate existing sources of mortgage liquidity without addressing the more difficult question of how to replace them.
  • Neglects to replace the public purposes served by Fannie and Freddie: These two institutions clearly serve a number of important public purposes, such as making 30-year, fixed-rate mortgages broadly available for American homebuyers and providing countercyclical liquidity to prevent housing downturns from reaching epidemic levels. These are hard issues to address, but they must be considered when designing our future housing finance system. The McCain amendment would casually tear down the central pillars of a U.S. mortgage system that until recently served to provide consistent access to sustainable homeownership for millions and millions of middle-class Americans.

Let’s consider in detail what the results of each of these outcomes would mean for our economy and American homeowners.

The McCain amendment poses significant risk to the economic recovery

In the wake of the U.S. housing and financial crises, private sector mortgage lending, financed either by bank deposits or through the private securitization of mortgages, has essentially stopped. This reflects the impairment of bank balance sheets and the total implosion of private sector mortgage securitization.

As a result, some 95 percent of all mortgage lending is currently through the backing of the federal government, with the vast majority financed by the institutional investors who buy the mortgage-backed securities issued by Fannie and Freddie If you are considering buying a home right now and you are not doing so with a loan insured by the Federal Housing Administration then you are almost certainly being offered a mortgage financed by Fannie or Freddie.

As a result, the unfortunate reality is that the government is currently the “only game in town” when it comes to mortgage liquidity, and this will remain the case until the private sector can begin to pick up some of the slack. That could take a while—a fact understood by experts across the ideological spectrum, even American Enterprise Institute Senior Fellow Peter Wallison, an outspoken critic of Fannie and Freddie. Despite some tentative signs that the private securitization market may eventually re-emerge (including the first postcrisis private securitization issuance last month), it is clear that investors remain extremely wary of these and other complex financial instruments that do not carry a government guarantee—no matter how highly they are rated by the credit rating agencies.

Similarly, depository institutions are not doing much lending. The reasons? They are facing high levels of unrealized losses, such as on commercial real estate loans that are expected to see large writedowns. And they are taking a cautious approach to lending in this still uncertain economic environment.

As a result, it is critical that policymakers carefully safeguard the mortgage liquidity we currently have. A significant reduction in available mortgage credit would greatly depress homebuyer demand, crippling our fragile housing markets and threatening the broader economic recovery. The Obama administration deserves credit for its deliberate, step-by-step management of our housing markets during the crisis, particularly in taking pains to keep the existing pipelines of mortgage credit flowing. Despite the significant turmoil surrounding Fannie and Freddie, investors have maintained their confidence in the securities issued by these enterprises, thus providing the financing necessary to meet the mortgage demands of Americans when no other sources would.

By setting an arbitrary timetable ending federal conservatorship, the McCain amendment undermines investor certainty in the creditworthiness of the securities issued by Fannie Mae and Freddie Mac, and threatens to jeopardize this important source of mortgage financing during these tenuous economic times. Simply stated, the McCain amendment is totally irresponsible because it would potentially shut down the primary source of mortgage lending without any contingency plan for how to replace any of that lost liquidity. 

The McCain amendment neglects the important question of where future mortgage credit will come from

In addition to the short-term collateral damage the McCain amendment would cause, it also takes an ill-advised and poorly thought-out approach to the very complex question of how to reform our mortgage markets going forward. The U.S. housing finance system historically strives to meet a number of key public purposes, among them:

  • Maintaining a constant and broad availability of mortgage credit
  • Ensuring that mortgage lending remains stable and not prone to excessive bubbles and busts
  • Providing affordable and sustainable mortgage products to Americans, including the affordable 30-year, fixed-rate loan we have all taken for granted as a mainstay of U.S. housing finance

Any reforms of the system should aim to meet these same, worthwhile goals.

The McCain amendment offers nothing to replace the functions Fannie and Freddie provide. This problem is most easily seen in the area of mortgage liquidity. Up until the crisis, U.S. residential housing finance operated through four lending channels:

  • Loans kept on the books of regulated banks and thrifts financed by deposits
  • Loans originated with government insurance from the Federal Housing Administration or the Veterans Administration and financed by the sale of mortgage-backed securities guaranteed by Ginnie Mae
  • Loans originated by third-party lenders for sale to Fannie and Freddie, which securitized them with an implicit government-backed guarantee
  • Loans originated by third-party lenders for sale to private financial institutions, typically subsidiaries of the big Wall Street firms, which in turn securitized these home loans into mortgage-backed securities with high credit ratings provided by the credit rating agencies

The last two channels—Fannie and Freddie securitization and private securitization—grew to dominate U.S. mortgage lending in recent decades, accounting for roughly $9 trillion of the $14 trillion total outstanding mortgages today. Private securitization is effectively dead today, and it is unclear whether and to what extent it will return as a major lending channel given the huge problems exposed during the financial crisis, including major conflicts of interest with the ratings agencies. Bank lending financed by deposits is also unlikely to come back in force for some time given the major balance-sheet problems of these lending institutions.

And therein lies a major problem with the McCain amendment. The question that policymakers face is how to replace this mortgage liquidity so that Americans, including those who have been hardest hit by the mortgage crisis, continue to have access to affordable mortgage credit such as we have known for many decades now. The McCain amendment would simply close off existing sources of mortgage liquidity without providing new sources of mortgage finance, recklessly threatening the availability of mortgages to a generation of Americans.

The McCain amendment neglects to replace the public purposes served by Fannie and Freddie

The McCain amendment also fails to consider whether there are other functions currently being served by Fannie and Freddie we might want to preserve before rushing to end their current activities. For instance, the broad availability of an affordably priced 30-year, fixed-rate mortgage is a core reason for the existence of Fannie and Freddie. So, too, is multifamily housing finance.

While it is certainly possible to design and structure new institutions and lending channels to serve these needs, it will be a difficult task. And there is likely to be a delicate and complex transition between the status quo and any new housing finance system. The McCain amendment would simply do away with the old structures in 24 months without contemplating how to replace the functions these institutions provide.

What’s more, the political grandstanding represented by the McCain amendment is completely unnecessary. The Obama administration is already addressing the question of how to reform the housing finance system in a thoughtful but decisive manner. Last month, the Treasury Department released a list of questions about the future of housing finance reform, asking the public to respond. This is the first step in a deliberate and informed process toward developing and transitioning into a new mortgage system, while responsibly ending the federal conservatorship of Fannie and Freddie.

Politicians on both sides of the aisle should recognize the enormous potential harm the McCain amendment poses to the housing markets and economy, both now and in the future, and reject it accordingly.

David Min is Associate Director of Financial Markets Policy at the Center for American Progress. To read more of our analysis and policy proposals in this arena, go to the Markets and Regulations page of our website.

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