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Fannie and Freddie Are Dead. What's Next?

By Morgan Housel – Updated Apr 6, 2017 at 2:16PM

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Housing, sans Uncle Sam.

"This committee will be recommending abolishing Fannie Mae and Freddie Mac in their current form and coming up with a whole new system of housing finance; that's the approach, rather than the piecemeal one." -- Rep. Barney Frank, Jan. 22, 2010.

What if Frank isn't just talking out of his rear, and Fannie Mae (NYSE:FNM) and Freddie Mac are really on a path to being put out of their misery? What would happen?

Your guess is as good as mine. Frank offered exactly zero details. Logically, major overhaul of Fannie and Freddie would either be:

  • A complete eradication of their roles, ending government-backed mortgage securities and loan insurance.
  • A continuation of their current roles, but only after being brought 100% onto the government's books.

Here's a rundown of each possibility.

1. Complete eradication
To the dismay of Randians everywhere, this possibility really seems like a dream. The odds of completely ending Fannie and Freddie's roles in the housing market are about the same as completely ending Social Security.

Why? Because despite the glaring flaws, the fact is there's essentially no functioning mortgage market outside of government-backed issuance. This table gives an idea just how reliant the market is on the two:   

Segment

Share of First Mortgages Outstanding

Fannie Mae

34%

Freddie Mac

23%

Banks and Thrifts

16%

FHA/ VA

13%

Private Label Securities

12%

Source: Freddie Mac.

And that's just the market share of outstanding mortgages. The market share of current mortgage issuance is even more lopsided. Fannie and Freddie combined currently make up about 70% of new mortgage issuance, with the FHA taking up close to 20%, for a total of around 90% reliance on these three government-backed vehicles.

Why such reliance? The best explanation is that large banks -- like Citigroup (NYSE:C), Bank of America (NYSE:BAC), JPMorgan Chase (NYSE:JPM), and Wells Fargo (NYSE:WFC) -- don't have the appetite to lend directly to homeowners after being sufficiently wrecked by housing over the past three years. Also, with the yield curve the way it is, it makes sense for banks with a long-term outlook (I'd like to believe they exist) to invest in short-term Treasury securities instead of longer-term assets like mortgages. Wells Fargo recently admitted it's doing just that.

Second, the market for private securities (like CDOs) packaged by banks like Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS) is virtually extinct compared with prior years, because investors now know how dangerous they can be.

At any rate, know this: If private banks were the only issuers of mortgage funding, the cost (interest rate) would blow up in a big way. To compensate, housing prices would get nuked. For example, a 30-year fixed mortgage at 5% with a $1,500 monthly payment will finance around $275,000 worth of house. The same $1,500 mortgage at 9% will only finance about $185,000.

Few politicians want to explain to their constituents why annihilating home values is worth it -- that's why there's very little chance that Fannie and Freddie's roles will actually be eradicated.

2. Continued roles, fully owned by Uncle Sam
The most likely "new system of housing finance" Frank wants is a continuation of the government-backed mortgage market, but only after Fannie and Freddie's assets and liabilities are brought entirely onto the government's books.

As it stands, Fannie and Freddie are essentially wholly owned wards of the state. But since both still technically hold private company status, the assets and liabilities don't fall directly on public books. Seriously. Even though their balance sheets are funded and guaranteed by the public, the obligations don't show up on budget deficit and national debt statistics beyond the incremental cash infusions given to keep the two afloat. (Everyone, go find an accountant and flip them off.)

Officially bringing these liabilities onto pubic books could increase the national debt (currently $12.3 trillion) by something like $7 trillion -- roughly the amount of mortgages the two hold or guarantee, plus unsecured corporate debt.

This isn't as bad as it sounds because the majority of these mortgages will stay current, or are at least backed by real estate. Nonetheless, metrics that investors and credit rating agencies use to judge the soundness of public finances (like debt-to-GDP and debt held by the public) would explode, possibly sparking a credit downgrade and scaring away the benevolence of foreign investors that trillion-dollar deficits so desperately need.

What do you think about it all? Share your thoughts in the comment section below.

For a great explanation on what Fannie and Freddie really do, check out this classic Bill Mann article.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. The Fool has a disclosure policy.

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Stocks Mentioned

Federal National Mortgage Association Stock Quote
Federal National Mortgage Association
FNMA
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Citigroup Inc. Stock Quote
Citigroup Inc.
C
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Bank of America Corporation
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JPMorgan Chase & Co. Stock Quote
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The Goldman Sachs Group, Inc. Stock Quote
The Goldman Sachs Group, Inc.
GS
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Morgan Stanley Stock Quote
Morgan Stanley
MS
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Wells Fargo & Company Stock Quote
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