Posted on Friday, February 4, 2011
What can be done with Frannie? We love her and we need her. But we have to get along without her, or at least learn to live without relying on her so much.
Frannie is an amalgam of Fannie Mae and Freddie Mac, the two government-sponsored enterprises that became government-run operations after the financial crisis left them insolvent.
The two mortgage giants were managed differently, but the distinctions did not turn out to be very important. So I’ll combine their names and call them Frannie.
The name rhymes with Grannie, which seems appropriate for the role she now plays. Whatever the sins of her younger years, now she represents loving stability, particularly to the younger members of the family. It is not at all clear that the American mortgage market could function without her.
But it needs to learn how to do so. It is not just a matter of ideology to say that the country needs a privately financed system of home finance. There are clearly roles for the government to play, as regulator and perhaps as backup financier for those deemed worthy of special treatment, such as veterans or disadvantaged workers who need a helping hand. There can and should be debates on how large that role should be, but just now it is clearly too large.
Why is it so large?
There are, I think, two possible explanations.
One is that Frannie is undercharging for the insurance she provides. Without such insurance, the default risk remains. We used to think that risk was minimal. It was not, and that is why we are in this mess.
The other explanation is that the private system is simply unable or unwilling to make such loans without a government guarantee. Or at least it is not willing to do so at any price that would seem reasonable.
Could that be true? Amazingly, a lot of people think it is. Certainly, there are reasons they could be right. Banks are not eager to take on the interest rate risk inherent in a traditional 30-year mortgage loan that has no prepayment penalty. If rates fall, the borrower is likely to refinance, and the lender will not get the rate that was bargained for. If rates rise, the lender is locked in even though its cost of funding is on the rise. Such mortgages might vanish, or become too costly, without some form of guarantee.
Before the crisis, the private label securitization system had found a way around that problem. Some investors were willing to take on the risk, while others were spared it through the wonders of financial engineering. But that whole system relied on cheap funding for the most secure tranches, which brought in most of the money and were rated triple-A.
There has been a lot of talk about — and some legislation and regulation aimed at — fixing the securitization model. Lenders should have “skin in the game” to assure they care about whether loans will be repaid. Investors should get better disclosure of the loans and their performance. There should be a limited number of tranches.
But there has been no revival of residential mortgage securitization. It is not yet clear whether, or at what price, mortgages without a guarantee from Uncle Sam can be packaged and sold in the postcrisis world.
Without securitization, banks will have to keep the mortgages on their books. There is a limited amount of that going on, for so-called jumbo loans that are larger than Frannie is allowed to guarantee. The national jumbo level now is $417,000, but is as high as $729,750 in some areas, and even more in Alaska and Hawaii. Jumbo loans cost more to the borrower, which may be a sign that Frannie is not charging enough for its guarantee.
The best proposal I have heard is a remarkably simple one put forth by John Hempton of Bronte Capital, a hedge fund based in Australia. He says Frannie should simply raise the fee for its guarantee — now about 20 basis points, or one-fifth of a percentage point — every six months by five basis points.
He would have the rate continue to go up until no one wanted to buy the insurance anymore and the private market was once again lending to the vast majority of borrowers. Frannie — a name he introduced me to — would still have a huge business in a slow runoff. But it would no longer be taking new risks that could cost taxpayers money.
The beauty of that idea is that it lets markets set rates, but does so slowly to give everyone time to adjust. It is possible that would lead to mortgage interest rates so high that the society would find them intolerable, and might prefer to have the government guarantee back. But we won’t know until we try.
There are two other ideas around that may have some traction. One, proposed by Peter J. Wallison, Alex J. Pollock and Edward J. Pinto of the American Enterprise Institute, would put Frannie out of business by simply lowering the maximum amount of mortgage she could guarantee by 20 percent a year.
Mr. Wallison was a Republican member of the Financial Crisis Inquiry Commission and wrote a dissent to its report this week, blaming Frannie for the crisis, in large part because she bought a lot of private-label securitizations as a way to meet targets for putting money into affordable housing. He very much wants to get rid of her, and his proposal would do it.
I asked him this week about Mr. Hempton’s idea, and he responded that his idea was simpler.
It also strikes me as riskier. He assumes the private market will step up if it knows the change is coming. I hope he is right, but there is no evident fallback if he is not.
The other idea seems to have the most traction, and is remarkable because it makes no real effort to reduce government involvement. There are various permutations, but the basic idea is to create private-sector companies that will compete with each other to guarantee mortgages for investors. All of them would have a federal guarantee to back them up, and thus would leave Frannie’s uncle — Sam — holding the bag if they blew it.
Mr. Hempton sees no advantage to such competition. The winner would be the one that charged the least for the insurance, which would create an incentive to cut prices. All that would restrain the competition is the wisdom of the bankers running the insurers — who would lose their investment before Uncle Sam had to pay — and the effectiveness of the regulators overseeing the new bodies.
I should note that Mr. Hempton stands to benefit if his idea works out. Presumably it would increase Frannie’s profits while it was raising rates and still writing a lot of insurance, and they might be high enough for long enough to allow it to buy back Uncle Sam’s ownership. If that were to happen, and the profits kept coming, Frannie might be able to pay dividends on preferred shares that were sold long before the crisis erupted. Those dividends are not cumulative, meaning that there are no back payments owed, but simply resuming them would be a windfall for Mr. Hempton, who bought some of those preferred shares for about a penny and a half on the dollar.
That could happen, and probably is more likely than the possibility that I will win the Powerball lottery next week. But perhaps not by much.
The mortgage industry, and much of Wall Street, wants to keep a government guarantee available for nearly all mortgages. It will be interesting to see whether the Obama administration, and the Congress, are willing to seek a way to avoid that.
By FLOYD NORRIS, THE NEW YORK TIMES