Goodbye, Fannie and Freddie

The U.S. government is shutting down the largest mortgage agencies — Fannie Mae and Freddie Mac.

The U.S. government is liquidating Fannie Mae and Freddie Mac. The mortgage agencies, financed by the government, were named as being among those most guilty for the financial crisis, and saving them has cost the U.S. budget $150 billion. The reforms of the American mortgage market call for a gradual departure from government guarantees and a return to private capital markets. Experts warn that for the average American this will mean an increase in mortgage interest rates.

The U.S. administration has presented a plan for the reorganization of the American mortgage market, which currently has a volume of around $11 trillion. “We’re going to do fundamental reform, but we’re going to do it in a way that is carefully phased in over time. So we’re reinforcing, supporting this process of repair in the housing market,” announced U.S. Secretary of the Treasury Timothy Geithner on Friday, Feb. 11.

The key idea of the reform is to reduce the role of the government in the residential property lending market and decrease the work of mortgage agencies that receive funding from the government. Most of the talk focuses on the two giants of the American mortgage market, Fannie Mae, founded in 1938, and Freddie Mac, founded in 1970. Before the crisis in 2008, these agencies operated like private companies with funding from the government. The agencies guaranteed and bought up mortgages from other banks, reissuing them as backed securities, and the banks were able to receive new funds for loans. All of this collapsed when housing prices crashed, followed by the mortgage backed bonds market. The stock prices for Fannie Mae and Freddie Mac swiftly reduced in value. Many blamed the agencies for inflating the real estate bubble. According to JP Morgan Chase CEO Jamie Dimon, Fannie Mae and Freddie Mac became “the biggest disasters of all time” and a leading cause of the U.S. financial crisis.

In order to save the agencies, the government nationalized them. Fannie Mae and Freddie Mac “are so big and so interwoven into the financial markets and our financial system, we had no choice. A failure by either one of these companies would cause great havoc in the economic system,” former Secretary of the Treasury Henry Paulson explained in 2008.

The cost of government support has already reached $150 billion, and the losses from the agencies over the past three years have exceeded $200 billion. Moreover, from 2009 to 2010, the Federal Reserve System (FRS) bought the debt obligations and guaranteed the agencies’ bonds to the sum of $1.25 trillion. To date, the portion of Fannie Mae and Freddie Mac holdings are more than 90 percent of the mortgage securities market. “After the beginning of the crisis the private sector practically self-destructed, since they could not compete with Fannie Mae and Freddie Mac to attract funds on the market. In 2008 the government agencies issued $1.3 trillion of mortgage debts, in 2009 $1.93 trillion, in 2010 $1.71 trillion, the private sector in these three years issued a total of $0.1 trillion in mortgage debt,” said the director of the analytics department of GK Alpari, Egor Susin. The explanation given for this is that holders of mortgage debts that are passed to government agencies receive a government guarantee, but the private sector does not.

According to the Obama administration’s plan, after the reforms, the market should return to private capital. The discussions have led to three strategies for the reorganization of the market and the future of the housing finance market, which differ in the degree of government involvement. The most rigid variant calls for a totally privatized system: The government would only support a small category of low-income citizens and veterans. The second variant suggests a substantial limitation of support, which could be increased in a crisis. In the third method, which is close to the current system, the role of the government is preserved: This variant would lead to more regulations; the government will continue to support some paths of credit with the help of “reinsurance” borrowing. But each of these strategies calls for a departure from the system of government guarantees.

“The holders of debts, particularly sovereign wealth funds, should gradually shrink their portfolios of Fannie Mae and Freddie Mac debt, since it is a fact that they will become more risky after the abolition of government backing,” explains Susin. The Bank of Russia was among these holders: In the beginning of 2008 around $100 billion from the Stabilization Fund was invested in these bond agencies. Gradually (since the beginning of the summer of 2008) the Central Russian Bank reduced its investments in debts in Fannie Mae and Freddie Mac. In January 2009, the regulator announced that it will no longer put money into these debts. “Everything was sold, money was earned, nothing was lost,” announced the head of the Central Bank Sergei Ignatiev, without specifying exactly how much was earned. Debts in Fannie Mae and Freddie Mac were purchased and sold not only by the Central Bank, but in contrast to the regulator not everyone was able to do this in time. According to data from the website of the American Treasury Department concerning the holders of debt securities from the mortgage agencies, in January 2009 entities in Russia sold $876 million worth of debt, in February, $100 million, in August and in September 2010, $3 million.

The reforms will not only affect financial institutions and investors but also the average American. The Obama administration announced that home buyers should make an initial down payment of no less than 10 percent. If the government continues on its path of privatization for Fannie Mae and Freddie Mac, then mortgage interest rates could rise significantly and housing prices could fall, analysts from the international ratings agency Moody’s believe.

Real estate brokers and developers have told lawmakers that the housing market dominated by Fannie Mae and Freddie Mac remains too fragile to survive a precipitous overhaul, writes Bloomberg. However, the legislators themselves are not excited about the reform plans. “What the administration offered today isn’t a plan to move us forward, but rather a collection of options to consider. What’s needed is a real plan, and we intend to sit down with administration officials to find common ground.” said the chairman of the House Financial Services Committee, Spencer Bachus, R-AL.