The Mission for Freddie and Fannie
Keep them as government agencies, but narrow their focus
In 2008, the government took the mortgage giants Freddie Mac and Fannie Mae away from their shareholders and placed them under conservatorship. This was long overdue. Freddie and Fannie were problematic for many reasons.
They helped to subsidize the demand for housing. But with the other hand of government (primarily local government) restricting supply, the net result was little increase in home ownership and instead an increase in house prices.
Their profits were privatized but their losses were socialized. They enjoyed an explicit line of credit and an implicit guarantee that went beyond that. This allowed them to soak up huge amounts of capital while paying very low interest rates.
They lost focus on home ownership. They subsidized mortgages for refinancing, for non-owner-occupied housing, and for multifamily properties.
They lost focus on mortgages altogether. With their advantage in borrowing costs, they could speculate in the credit markets more broadly, acting like hedge funds. I remember when someone at Freddie talked very excitedly about arbitrage opportunities in the Eurodollar market.
During the Trump administration, Fannie and Freddie’s overseers tried to return the mortgage giants to the private sector. The intention was to reduce the government’s profile in the mortgage market. But I do not think that the plan did enough to mitigate the risks that they would once again become too important to fail and abuse that privilege.
If I were in charge of the agency that oversees Freddie and Fannie, I would keep them as government enterprises, but with a narrow mission. The only mortgages that they could purchase would be 30-year, fixed-rate first mortgages for purchasing owner-occupied homes. All other mortgages would be left to the private sector.
There is no public interest in encouraging purchases of second homes or investment properties. There is no need for a government enterprise to subsidize 15-year mortgages, adjustable-rate mortgages, second mortgages, home equity loans, or mortgage refinances.
Why have a government enterprise for 30-year fixed-rate mortgages? Because those mortgages are very risky for lenders. If interest rates go up, lenders take a loss. If rates go down, borrowers refinance. As the Savings and Loan Crisis of the 1970s-1980s showed, a concentration of risk in 30-year fixed-rate loans is fragile.
Nowhere in the world, or in U.S. history, have there been financial institutions able to offer the 30-year fixed-rate loan without having the backing of a government guarantee—either deposit insurance in the case of S&Ls or the Too Big to Fail guarantee provided to Freddie and Fannie. The private sector, if left to itself, would not supply those mortgages. But our housing market has become dependent on them.
Freddie and Fannie have proven capable of offloading much of the risk of 30-year mortgages. Issuing callable debt1 backed by their government guarantee, they are able to make these loans without incurring the risk that they could suffer catastrophic losses from interest-rate swings. The buyers of callable debt bear the interest-rate risk and help set the price of 30-year fixed-rate mortgages.
The United States cannot transition to a completely private mortgage market without disrupting the ability of home buyers to get 30-year fixed-rate loans. But there is no need for Fannie and Freddie to get involved in any other type of mortgage lending. Restricting Fannie and Freddie to a narrow mission is the best practical approach to handle their status.
Callable debt pays a fixed interest rate for, say, 10 years. But if market interest rates fall, the borrower can pay off the debt early, the way that a mortgage borrower can pay off a mortgage and refinance.
but why as a matter of public policy should we want 30 year fixed rate mortgages? they are virtually non existent in other countries.
Arnold proposes that Freddie and Fannie be confined to a narrow purpose - subsidizing 30-year fixed-rate mortgages for first-time home buyers. That would be an improvement over the status quo, but it's still unclear to me what the market failure is, unless one shows that home ownership is a public good and, therefore, that first-time home buyers should be subsidized. (In full disclosure, I benefited from mortgage subsidies for a good fraction of my adult life.) Fixed-rate mortgages have interest rate and default risk, the former due to options implicit in mortgage contracts, i.e. zero or low prepayment costs, the latter due to the usual risks of default in consumer lending - job losses, moral hazard, and others. The market could cover these risks by building their costs into interest rates. Mortgages then would be more expensive and less attractive to potential borrowers, leaving some people out of the market for home ownership. But that is not a market failure, it's merely pricing in the full cost of lending. Again, unless we can demonstrate that home ownership is a public good, the government ought not to subsidize it. This comment is agnostic on the matter and merely draws a distinction between possible public benefits and market risks.
If subsidizing homeownership is desirable, then the question is whether the Fannie / Freddie approach is the best way to do so. An alternative that might be simpler and more efficient could be to spend an equivalent amount of public treasure on subsidizing down payments.