Personal Finance: One step forward, one back for Fannie and Freddie reform

Personal Finance: One step forward, one back for Fannie and Freddie reform

May 21st, 2014 by Dave Flessner in Business Diary

Chris Hopkins

Chris Hopkins

Photo by Patrick Smith /Times Free Press.

Good news: the Senate Banking Committee voted last week to approve a compromise plan to reform the dysfunctional mortgage market. Bad news: the bill won't see the light of day in this Congress.

The financial collapse of 2008 had many causes, but none more prominent than the role of the two mortgage behemoths, FNMA (colloquially known as "Fannie Mae") and FHLMC ("Freddie Mac). Thanks to a perfect storm of mismanagement, fraud, cronyism, policy overreach and moral hazard, Fannie and Freddie nearly imploded and required $188 billion of taxpayer rescue money.

Despite the desperate need for reform, the system remains essentially unchanged since the financial crisis, with nearly three quarters of all American single-family home loans dependent upon Uncle Sam. The Banking Committee vote last week was a good first step.

The Senate proposal aims to liberate the mortgage market from the infructuous tentacles of government and reduce the likelihood of another taxpayer-funded bailout. Co-sponsored by Sen. Tim Johnson, D-SD and Sen. Mike Crapo, R-Idaho, the measure builds upon earlier legislation offered by Sens. Bob Corker, R-Tenn. and Mark Warner, D-Va., that gradually phases out the two 400-pound government gorillas and makes room for the private capital market to reassert its appropriate and necessary role.

Although the government would still play a part in guaranteeing loans, the Senate bill mandates that private investors absorb at least the first 10 percent of losses in the event of default. Subsequent losses would be largely covered by a newly created federal mortgage insurance pool funded by fees collected from borrowers. The new insurance fund would serve to minimize the potential future liability of taxpayers. This structure resembles the prevailing model in Canada, where the vast majority of mortgages are held by banks and partially backed by a government indemnification plan. Incidentally, Canadian home ownership rates exceed those in the U.S.

Unfortunately, despite strong bipartisan support in committee, the Senate majority leader is unlikely to allow a floor vote over the objection of some members of his caucus opposed to ending the government's outsized role.

Political opponents cite two basic objections. First, they note that mortgage credit will become harder to obtain for borrowers who are not qualified. Readers with a decent recollection of the subprime crisis and ensuing near-death experience of the financial markets might understandably respond with an "Amen."

More curiously, the second objection is that reforming the system entails too much change to absorb at one time. Substantial reform, even to a system as badly broken as mortgage finance, must be done more incrementally they say. Sorry about that tornado, pal, but we can't replace the windows and the roof in the same year. Here's some duct tape.

Meanwhile, fierce opposition to sensible reform also comes from a group of investors, including a number of hedge funds that gambled on the deeply discounted stocks of Fannie and Freddie. Their positions become worthless if the two mortgage giants are euthanized, but gain value if the taxpayers' interest is subordinated. Billions in profits or losses hang in the balance, and one may assume that these speculators are making their voices heard in Washington.

Free market advocates rightly prefer the alternative version of reform passed by the House Financial Services Committee, which envisions less government support and a purer role for market forces. But the Johnson-Crapo bill strikes a decent balance that phases out the government oligopoly yet is politically feasible. It's not perfect, but it's a start and it can pass. If only it could get a vote.

Christopher A. Hopkins, CFA, is a vice president at Barnett & Co. Investment Advisors.