Fannie & Freddie Reforms Won't Save Taxpayers

Taxpayer aid to Fannie Mae and Freddie Mac is already more than $150 billion. But don't expect that number to drop even if Congress passes reforms.

Freddie Mac, the mortgage-finance company operating under federal conservatorship, reported a loss this week of $14 billion for 2010.  No goodwill write-downs or other one-time non-cash charges; Freddie does it the old fashioned way of buying high and selling low.  That a company racking up $14 billion of actual losses in a single year is no longer news should be shocking, but it isn’t when you consider the rest of the story.

Democratic and Republican policy makers are working on plans to wind down Freddie Mac and Fannie Mae and rebuild the US housing system but neither has offered anything new or realistically achievable thus far.  The Republicans, led by Scott Garrett, have pushed for the complete removal of the GSEs from the housing sector and secondary mortgage markets, although this position has softened considerably since the November elections and has become less concrete.  The Democrats have done nothing on GSE reform since the 2008 financial crisis until publishing the Administration’s white paper in February which, while pointing toward a path that limits subsidized lending and GSE guarantees, is even more ambiguous and imprecise than the Republican ideas.  This lack of bold political leadership is reflected in the current budget debates - each side nibbling around the edges (federal payrolls and NPR) but waiting for the other side to dive into the deep end of an empty pool (entitlements and defense). Complicating achieving anything substantive is the fact that the House and Senate are controlled by different parties and there are deep divides within each party. For all the political fanfare generated by the two proposals, the only thing clear is that we are guaranteed a third.

Noticeably lacking from each reform proposal is any substantive discussion of the consequences of removing or reducing the GSE’s future role in mortgage lending and, perhaps more consequentially, the impact of shrinking the GSE’s existing loan portfolios.  If either approach were to be implemented:

1) The Big Four banks are not eager to absorb all of the risk left behind by Freddie and Fannie (unless they become the beneficiary of the government guarantees, something which is gaining favor in certain circles, no doubt advanced by their considerable lobbying resources) and any GSE pull back in new lending would far exceed private capital available to fill the void.  As a result, interest rates would spike and consumer home buying credit would plummet; and,

2) The GSE’s disposition or sales of existing loan portfolios would crush asset prices in the market, potentially triggering another financial crisis down the road.  There is perhaps $30-40 billion in private capital currently available to buy delinquent mortgages.  At the end of 2010, Freddie Mac and Fannie Mae, under the most blissful circumstances, held approximately $200 billion in delinquent loans on their own books.  These figures do not exactly create an equilibrium supply-demand curve.

What becomes of the US housing “recovery” if the GSE’s fade away? I use quotes because the US housing sector is nowhere close to recovery mode as most markets, regardless of GSE reform, will experience an addition 10%+ slide in prices in 2011.  And in 2012 that slide may accelerate.  Reduce GSE conforming loan limits, reduce the government wrap on GSE bonds and “poof” there goes the US housing recovery, and along with it any overall economic momentum.  I use quotes because it wouldn’t happen quickly, it would drag on for years and years. Negative home equity will contribute to vast inventories of foreclosed homes and distressed sales, producing even larger bank losses and consumer pain, which will inevitably lead back to continuing government intervention, borrowing and interest rate manipulation.  Does this sound like Japan in the 1990s anyone?  Pretend and extend (and, if we are really like Japan, eventually default).

Congress and the Obama Administration have had an unprecedented set of challenges before them and GSE reform may prove to be more difficult than health care reform and Dodd-Frank combined.  Ignoring the 2012 political calendar for the moment, how do you actually pass legislation that can reconcile reforming the GSE’s with reducing government borrowing, reducing deficits while promoting economic growth?  There are contradictions at every step.  Taxpayer aid to Fannie Mae and Freddie Mac is already more than $150 billion ($54 billion to Freddie) and could total $224 billion by the end of 2012.  The numbers are staggering and will increase dramatically if no GSE reforms are implemented… and may increase exponentially if they are.

But what is really shocking, or should I say silly?  That the 20% of Freddie Mac that Treasury does not own is still publicly traded (NYSE:FMCC)!  Freddie Mac has a negative net worth of $401 million.  Who is buying this stock?  One would think a company would have to be worth something in order for its stock to trade above $0 but in this era of make believe economies, budgets and balance sheets, anything is possible.  Except getting rid of the GSE’s anytime soon.

Steven Trowern is a partner at MCM Capital Partners, LLC, a residential mortgage investor and advisor.  Formerly he was CEO of Dynamic Capital Mortgage, Inc., a residential mortgage lender.

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