The following post addresses some of the unique characteristics of Fannie Mae and Freddie Mac that made them different from other private corporations prior to their 2008 conservatorship. What are the pros and cons of privatizing Fannie Mae and Freddie Mac with no government support of any kind?
Government-Sponsored Entities (GSE’s) Fannie Mae and Freddie Mac were unique from other private corporations because of their confusing relationship with the US government. In its last incarnation – prior to conservatorship – Fannie and Freddie were stockholder-owned corporations organized and existing under the Federal National Mortgage Association Charter Act. Established in 1938 pursuant to the National Housing Act and originally operated as a U.S. government entity, their charters were amended in 1954 (via Title III of the National Housing Act) and they became mixed-ownership corporations. The preferred stock was owned by the federal government and the non-voting common stock held by private investors. In 1968, Fannie’s charter was further amended and the entity was divided into the present Fannie Mae and Ginnie Mae. Ginnie Mae remained a government entity, but all of the preferred stock of Fannie Mae that had been held by the U.S. government was retired, and Fannie Mae became privately owned. Curiously, however, the fact that this was now a privately-owned company that was NOT explicitly backed by the full faith and credit of the United States government was somehow lost on investors. Instead, Wall Street invested confidently under the guise that these organizations (and their FNMA-approved “conforming” loans) were impliedly guaranteed by the federal government. Although a full government endorsement was clearly not attached, Fannie and Freddie did little to clarify this distinction because the specter of government assurance did wonders for their business (especially via their preferential interest rates and minimal regulation).
In its infancy, the then-existing government guarantee was a wonderful thing. The preferentially lower rates obtained on FNMA conforming loans greatly benefited a booming, post-war American populous by allowing for incredible expansions in home ownership rates across the country. As a result, the concept of a 30-year mortgage became the standard on the street. What many Americans don’t realize, however, is that a 30-year mortgage is unheard of in most other countries because those countries don’t have similar “market makers” like Fannie and Freddie. The government guarantee led to an overall reduction in mortgage interest rates and increased secondary market investor confidence – therefore facilitating a market for these otherwise less-saleable loans. During their conservatorship, calls for the complete privatization of Fannie and Freddie, while meritorious in many respects, were also dubious in that they would completely change the concept of home-ownership in the United States. Once considered a near birthright in American culture and the crown jewel of the American dream, home ownership would revert back to pre-depression disparities by allowing large, mega-landlords to control a massively increased tenant population. Home ownership without GSE’s would mean much larger down payments, increased loan qualification requirements and sky-high mortgage rates. Accordingly, home prices would be likely to fall across the US – especially in already hard-hit “suburban sprawl” cities – reverberating further financial problems in all sectors of the economy. In short, despite the evils of the Fannie and Freddie model which, in part, ultimately led to the housing crisis of 2008, we may come to find that they are necessary evils; because without them, we just might send our housing market (and with it our entire economy) back to 1900.
While the creation of the 30-year mortgage term has obviously benefitted the American economy in numerous ways, the creative or “designer” mortgage loan programs should not necessarily be vilified on their face; despite their dubious role in the housing bubble of the mid-2000s. Take, for example, the “option arm” style mortgage. In this type of adjustable-rate loan, the interest rate is tied to a major mortgage index such as the LIBOR, and the mortgagee has the choice to pay one of four different amounts each month. These payment choices range from traditional principal & interest payments to riskier interest only or extremely risky “minimum/negative amortization” payments. While the negative amortization that results from the use of an “option arm” style mortgage seems like a terrible idea in light of the 2008 financial crisis, there are situations where a borrower might find such a tool useful. For instance, if the borrower is leveraging themselves for a large purchase, but gets paid on substantial, infrequent commissions, it may be a better situation for them to not be OBLIGATED to make the full principal and interest payment each month, provided they would incur no pre-payment penalty during the “option” term.
Another borrower who might benefit from this type of loan would be the real estate investor/speculator. For example, assume the borrower is purchasing an investment property that they plan to rent out after completing some initial renovations. If the borrower knows the renovation process may take a few months and he therefore can’t fill the rental property with a tenant, the borrower may want the “option” to pay the lesser mortgage amount during the time where he has yet to derive any rental income. Ultimately, any borrower who takes an option arm mortgage must realize a larger increase in the value of the asset that they’re mortgaging than the amount of negative amortization they may accrue if making the minimum “option” payment. Therefore, this mortgage product is going to be most advantageous in a booming housing market, because there is a greater likelihood that the value of the mortgaged asset will increase enough to withstand (and ideally exceed) the increase in principal balance via the option payment’s negative amortization.