In September 2008, Fannie Mae and Freddie Mac were placed in a Federal Governmental conservatorship. The crisis-induced rise in mortgage defaults had eroded their capital, and made it impossible for them to continue operations without support from the US Treasury.
The conservatorship also eroded the agencies' political support. Their continuing existence is an embarrassment to the liberals in Congress responsible for the agencies heavy involvement in sub-prime mortgages, which was a major cause of their downfall. Conservatives opposed to government intrusions in the market as a matter of principle, who were never more than ambivalent toward the agencies, now relish the opportunity to get rid of them altogether.
Yet despite the loss of virtually all of their political support, we are now into the ninth year of conservatorship and the agencies are still with us. The reason is an entirely plausible concern that terminating them would depress the mortgage market and new housing construction. While the prevailing political sentiment is hostile to the agencies continued existence, it is also fearful of the consequences of their demise. The result has been a policy paralysis.
But the paralysis won't last forever, at some point it will give way to a plan to phase out the agencies by progressively narrowing the segment of the market that they can serve. William M. Isaac and Richard M. Kovacevich in a recent Wall Street Journal article proposed a 7-year phase out.
The phase-out approach assumes that within the specified time frame, the private system will evolve to fill the gap. In my view, that will not happen without a well-developed Federal plan to make it happen. Without such a plan, our existing system of private financial institutions will not create a viable private secondary mortgage market that would replace Fannie and Freddie.
The private market that was the vehicle used to fund sub-prime mortgages employed a house-of-cards structure that completely collapsed during the financial crisis. Unlike the mortgage securities issued in Denmark, which are full faith liabilities of the institutions issuing them, the US securities were no one's liability. Each security carried its own "credit enhancement" as a back-up to cover potential losses, and if losses exceeded the back-up, the security would default. Redundant credit enhancement on other securities, even if they had the same issuer, was not available to support the security with a deficiency.
That market collapsed, and good riddance. As a point of comparison, not a single mortgage security issued by Danish mortgage banks defaulted during the crisis - or any other time!
Existing private institutions in the US are not going to develop full-liability mortgage-backed securities, even if all legal roadblocks were removed. Commercial banks have never been interested, and even less so now following the heavy losses they have sustained from being held legally liable for misdeeds committed prior to the crisis. Home mortgages are now viewed as carrying high political risk.
The existing mortgage banks in the US are loan originators and don't have the capital to become security issuers. The one industry for which mortgage security issuance might have made sense because of its focus on home mortgages was the savings and loans, but that industry is long gone.
What is needed is a new industry of mortgage banks that fund themselves with mortgage-backed securities, similar to those in Denmark. They could be regulated by the Federal Housing Finance Agency, which currently regulates Fannie and Freddie. Depository institutions would be encouraged to charter mortgage bank affiliates, and existing mortgage banking companies would be encouraged to convert.
But it will take time for a new industry to evolve, and in the meantime, Fannie and Freddie should be moved out of conservatorship purgatory. Over the years the agencies have accumulated enormous intellectual capital that is embedded in well-honed secondary market systems and processes, some of which could be used by an emerging mortgage banking industry. The agencies also could be involved in helping new mortgage banks raise capital.
Phasing out the agencies would destroy much or all of their intellectual capital - for no good purpose other than achieving a political catharsis. The wiser plan is to establish the legal foundations for a new mortgage banking industry, and retain the agencies until the new structure makes them redundant.
For more information on mortgage or to shop for a mortgage in a fair, unbiased environment, vist my website The Mortgage Professor