Now that tax reform has passed, housing finance reform is stepping into the spotlight. This reform will have a potentially larger impact on the real estate industry. Representatives from across the housing and finance industry, as well as the federal government, believe the current Fannie Mae and Freddie Mac conservatorship arrangement is not sustainable. And they are probably right. Maintaining the status quo keeps taxpayers in a very similar situation to that of the bailouts from the last financial crisis. And, the government run nature of these entities resemble the state sponsored entities in other countries more than a free market system. However, there are some positive benefits of the current system that are at least worth understanding before scrapping everything.
To understand the benefits and drawbacks, it’s helpful to understand what the housing finance process is and how it works. Let’s say you buy a home and use your local bank for the mortgage. Your bank doesn’t keep the loan on its books, it sells the loan and the stream of payments to Fannie or Freddie who then package it with other loans. They then turn around and sell the whole portfolio as a mortgage backed security to investors. Through this process, the Government Sponsored Entities (GSEs) of Fannie Mae and Freddie Mac provide an implicit guarantee to the mortgage market by buying and packaging these loans from banks across the country into investment securities.
This process is intended to allow your local bank to use the proceeds from selling your loan to lend to another qualified buyer. This increases the liquidity in the loan market and reduces interest rates due to the implicit backing by the federal government. The whole system was originally designed after the Great Depression. At that time, there were only short-term loans available to borrowers and when the loan came due, there was not enough liquidity in the mortgage market to lend to homeowners. Many people lost their homes even though they were able to afford new loan payments. This spawned the mortgage finance industry and the drive to promote home ownership that resulted in our current system.
Differing opinions and options are being presented by a variety of senators, government agencies, and banking organizations. Generally the proposals fall along the lines of either eliminate the GSEs entirely or create a new form of regulated company that maintains some of the current government backing. Here are a few options that have surfaced so far:
- Create new regulated utility-like organizations with a rate of return and capital requirements set by regulators, then convert the GSEs into this new entity type;
- Create an explicit, paid for government guarantee to back mortgages through a mortgage insurance fund that new companies could participate in;
- Eliminate or privatize Fannie and Freddie and allow the private market to provide all liquidity and mortgage guarantees.
There are positives and negatives to the current system and these proposals. The positives to maintaining some elements of the current system include:
- Increases mortgage options, like the 30-year term with fixed rates;
- Lowers interest rates (due to the government guarantee);
- Promotes lending in smaller communities and rural areas through small local banks;
- Allows small banks access to secondary mortgage resale markets to provide additional liquidity;
- Increases the number of people who can afford and qualify for mortgages, therefore increasing home ownership rates.
Some of negatives to maintaining the current system include:
- Keeps taxpayers on the hook for bailouts and losses;
- Subsidizes the residential housing market at the expense of taxpayers;
- Induces home-owners to take on more debt than they otherwise could afford;
- Limits competition and is anti-free market;
- Promotes home ownership at a time when interest in owning a home is declining.
There are just as many opinions on the validity of each benefit or drawback but these issues are representative of the issues that are being weighed with the housing finance reform proposals. As we move through 2018, a decade now since the financial crisis drove Fannie and Freddie to seek government bailouts, keep an eye out for housing finance reform to become a hot topic. The result will have a major impact on the real estate market and your investments.