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Thursday, August 21, 2008

Consensus Forming on the Future of Fannie/Freddie?

Recently, here is what Alan Greenspan said about what we should do moving forward about Fannie Mae and Freddie Mac.

His quarrel is with the approach the Bush administration sold to Congress. "They should have wiped out the shareholders, nationalized the institutions with legislation that they are to be reconstituted -- with necessary taxpayer support to make them financially viable -- as five or 10 individual privately held units," which the government would eventually auction off to private investors, he said.


Today, here is what a commentary from the Financial Times said.

The lumbering GSEs are too big to fail several times over. If Mr Paulson needs to save them, he may need to act very quickly. But he should not be thinking about simply keeping them as they are but on tighter regulatory leashes. The GSEs are set up to socialise losses and privatise profits. This is clearly ridiculous. In the short term it would be better to nationalise them to align risk and reward. In the long run, the government should get rid of Fannie and Freddie.

There is no need for the government to engage in the secondary mortgage market, not least because doing so provides perverse incentives for the state to prop up US house prices. The GSEs should be cut into small-enough-to-fail pieces before a real privatisation. Winding down the GSEs as we know them need not be immediate or rapid, but it should begin now, when it is easier to gather the will for reform.


These two analyses echo exactly what I called for more than a month ago.

The solution involves two steps. The first is finally, once and for all, privatizing these two and totally separating them from the government. While both are publicly traded companies, they are also Government Sponsored Entities. They have access to government credit lines and their own debt is thus implicitly guaranteed by the government. That's done because their vitality is crucial to the market. Therein lies the rub. Here again, the government has created a situation where companies can't fail. That simply must stop. The first step towards that is cutting the cord entirely and no longer making these two GSE's, but rather fully privatized companies like any other private company. Fannie Mae and Freddie Mac can no longer enjoy any privilege from the federal government that an entity like Microsoft enjoys.

The second solution is to break them up. In fact, the Sherman Anti Trust Act was created exactly to prevent the situation we now have in mortgage securitization. In other words, the government created exactly what it usually would break up using Sherman. If Fannie and Freddie were six to eight companies most of the current problems would be avoided. By increasing competition, we would also increase the underwriting choice. Now, if you are denied by Fannie you go to Freddie. If you are denied by both, you have no conforming loan to do. Furthermore, if there were six to eight of them we would no longer face a situation where each is so vital that they can't fail.


Solutions for the Fannie/Freddie crisis take on an even more urgent need because of the nature of the current mortgage market. In the last five years, the market had plenty of choice. Besides Fannie and Freddie, most banks also carried their own portfolio of loans called Alt A. Second, there was healthy market for sub prime loans. FHA was also a viable loan option. This created choice. Right now, there are only three choices, a loan underwritten by Fannie Mae, Freddie Mac, or FHA.

Most people don't realize that when they apply for a loan at a bank, the actual bank is almost always NOT actually making the underwriting decision. That decision is usually made by either Fannie or Freddie. That's because said bank is likely going to sell said loan to one of the two, and then they will securitize them. Since they will securitize the loans, they also will make the decision. This is the system we are stuck with and any change must keep it in mind.

That said, the mortgage market is effectively operating as a monopoly and socialistic one at that. FHA is not a viable option as more than 10% of the mortgage market. That means that Fannie and Freddie split the rest amongst themselves. Since they are both Government Sponsored Entities, they are extensions of the government. This dynamic is a recipe for disaster and every day we continue to operate in such a dynamic is a day we are closer to having it all blow up.

The problem is that most folks don't understand how this fallacious dynamic affects them. There is no momentum for change because most folks don't know just how vital change is. Yet, this dynamic is affecting folks right now and I have written about it. Right now, both Fannie and Freddie are both systematically forcing the market to be a market that demands a minimum of a 20% down payment. How do they do this? They are the market and both are making that number the standard. What would happen if there were five to ten of these companies? One would naturally take advantage of the vacuum if everyone else demanded a minimum of 20% down. Next, they are both effectively engaged in red lining. They have created something known as "adverse markets" which in many cases effectively redlines certain properties and property types. One of the first effects is that multi unit properties are significantly more difficult to finance. Imagine if you happen to own a multi unit and are attempting to sell. The two have effectively made that job next to impossible. Of course, if we had five or ten, one of them would again step into the vacuum created by such a maneuver. Both of these two have made it more difficult for folks with multiple properties to buy more. They no longer count rental income for any property that doesn't have at least 30% equity. They are both even considering no longer doing loans for anyone that owns more than four properties total. These last two things make it painful and difficult for anyone to be a real estate investor. Worse than that, those that are already leveraged are left with little or no option. Of course, they do this because they are the market.

In fact, the time to act is now, but that needs grass roots momentum. In order for grass roots momentum to take hold, the public must not only understand the vicious dynamic currently at play in mortgages, but furthermore how that dynamic affects them.

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