Fannie & Freddie: Phase-Out or Fallout?

The Obama administration has proposed phasing out the government-backed mortgage agencies Fannie Mae and Freddie Mac, as reported last week in the Los Angeles Times. A recent Wall Street Journalarticle and an opinion piece in the New York Times both provide a thoughtful analysis of this situation. 

Approximately $7 billion, or 60%, of the $12 billion in loans that were in question when the market froze in 2007 were funded through these two organizations. Even in 2008 and 2009, they were still funding more than 70% of the loans for single-family residences. Phasing out Fannie and Freddie could mean a large shift in how the  loan market operates. For instance, it is currently easier to get a loan for less than $417,000, because that loan can be sold off to Fannie very easily, with a ready buyer on the secondary market. 

What this means in the long run is unclear. If you read the WSJ article comments, you'll see a mixed bag. Some responses say it is good to get the government out of the housing loan business (although FNA and FMA are not government-owned, they are government-backed). Others believe it is beneficial because all the best loans were going to Fannie and Freddie, leaving the more unsavory loans for the banks to handle. Another school of thought is that this will be a complex process that creates higher interest rates across the board. 

In my opinion, phasing out Fannie Mae and Freddie Mac will likely result in a combination of the good, the bad and the ugly.

Doubtless, this would be a complicated deal that could dramatically destabilize the economy if not carefully implemented. Dumping a large quantity of loans onto the secondary market at the same time is not a great idea; supply and demand requires them to be sold at a discount, but I assume the government is smarter than that. I am more worried about what the loan market would look like without the high qualification standards of Fannie and Freddie. 

When the industry followed Countrywide, which lowered the standards for "qualified" applicants, the market did not fare well, and we are still living with that huge fallout today. That said, Fannie and Freddie were not completely blameless in the mortgage meltdown. Because they chose to lower their standards along with the industry, the consequences were more devastating than they would have been otherwise.

In short, I don't really trust the banking industry to set its own criteria on what constitutes a safe loan or qualified applicant. My prediction is that the banking industry is likely to cover its own self-interests and raise lending rates. In addition, we may face a tough period with a lack of consistent standards in the lending field; we might see high interest rates with high standards from one bank and high interest rates with low standards from another. This would be hard on consumers and will negatively impact the sales of mortgage-backed securities on Wall Street, which was already hesitant to buy them, even under Fannie's and Freddie's stricter standards.