There was plenty of controversy this week in Washington with the government shutdown and the looming deadline for raising the debt ceiling. However, there was another controversial situation at play that has been pushed further off into the future. Fannie Mae and Freddie Mac are government sponsored enterprises that guarantee and securitize mortgages for U.S. homeowners. These entities perform an important function in the U.S. economy by guaranteeing the payment of principal and interest and securitizing or “packaging” mortgages for sale to institutional investors. Americans will recall that Fannie Mae and Freddie Mac both got into financial distress during the financial crisis due to excessive leverage and lax underwriting standards. As a result, the U.S. government had to step in and take Fannie Mae and Freddie Mac into conservatorship in September of 2008.
Fannie Mae and Freddie Mac have now been stabilized and have actually been returning robust profits. Specifically, since 2011 they have paid back $131 billion in dividends to the U.S. Treasury of the $187 billion bailout they received. Fannie Mae and Freddie Mac have long been viewed as an uneasy mixture between a private enterprise and a public entity. Recently there have been legislative attempts to eliminate Fannie Mae and Freddie Mac as we know them. The current administration believes that private capital should play a larger role in the mortgage market.
Investors in mortgage-backed securities issued by Fannie Mae and Freddie Mac rely on the implied government credit guarantee. If that is removed, the cost of mortgages is estimated to rise by one to two percentage points. As such, investors will demand a higher return to own mortgage-backed bonds with a greater risk that interest and principal will not be repaid. In a housing market that is still recovering from the financial crisis, an increase in mortgage rates due to this change would hamper the pace of economic growth.
What will actually happen is still very much up in the air. One thing that is virtually certain is the payoff of Freddie and Fannie debt obligations. To back off the current guarantee would throw financial markets and especially the mortgage-backed securities market into turmoil.
- The evolution of mortgage financing and the eventual fate of Fannie Mae and Freddie Mac is a political controversy that does not have a simple private market solution