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Killing Fannie and Freddie will be hard

Paul Muolo

Let’s not mince words. On February 11 the White House released its long-awaited plan to revamp US mortgage giants Fannie Mae and Freddie Mac and the verdict was clear – don’t restructure these $5trillion behemoths, just pull the plug.

And so it has come to pass. President Barack Obama, a Democrat – traditionally Democrats love housing – told the housing and residential finance industries to drop dead. In short, a Republican president couldn’t have done it any better. Just kill them.

Of course, it’s easy to just cut the oxygen tube. The reason why the White House did this is clear to industry insiders. Obama’s team at the Treasury Department didn’t have a clue on how to structure and revise them.

Why bother? To date, the two have sucked up $150bn in taxpayer assistance to keep their net worth positions in the black. Why keep their net worth in the black?

Democrats will fight the idea tooth and nail as they still want a government guarantee on mortgages

Answer – no-one would buy their newly issued mortgage-backed securities if they were in the red. And without Fannie and Freddie buying newly originated loans and issuing new MBS, the US housing market would collapse. It’s as simple as that.

But coming up with a master plan to re-do them takes serious thinking. I would venture that given the fact that the US is fighting two wars and is mired in trillion dollar deficits, killing Fannie and Freddie and saying let the private sector handle it is Obama’s way of saying – not tonight, dear, or not next year either. Heck, Republicans have been saying kill Fannie and Freddie for years.

So Obama basically punted, making himself look like a sort of fiscal conservative for a few moments.

But let’s not kid ourselves. Allowing the private sector, the banks, thrifts, credit unions and Wall Street to fill the void sounds nice on paper – getting there will be anything but easy.

First off, many Democrats will fight the idea tooth and nail. They want some type of continued government guarantee on mortgages.

And second, Fannie and Freddie purchase 70% of all new mortgages being funded today.

Over the past decade their combined purchase market share has rarely been lower than 45%. I mean, where are all those loans going to go? On whose books?
Keep in mind that for 70 years Fannie functioned perfectly well with a few hiccups on the way. Freddie, which is younger by 30 years, also did fine. Their job was to purchase and guarantee loans, issue securities and provide fresh mortgage money to firms that were doing the lending to consumers.

They were a sure thing until the mid-2000s, when they started buying sub-prime and alt-A – sub-prime by a different name – MBS from Wall Street.

Yes, they also had turned into arrogant publicly traded bullies, with an implicit government guarantee, but the basic idea worked almost flawlessly for decades. And now it’s over.

The question boils down to this – if they die, and a slow wind-down over a decade is predicted, will banks here step in as both issuers of privately guaranteed MBS or holders of the underlying loans?

The short answer is they might, but don’t forget that Americans believe 30-year fixed rate mortgages are their birthright.

Having a government-sponsored Fannie and Freddie allowed 30-year loans to exist. These two also paved the way for low downpayment loans en masse, something else Americans got used to.

Banks will not be willing to hold 30-year fixed rate mortgages on their books for the simple reason that they use short-term deposits to fund their on-balance sheet assets.

The last thing in the world a financial institution wants to do is to be caught holding a 5% mortgage when rates spike and suddenly deposit costs outstrip the asset yield.

That’s what we call borrowing short and lending long, which is what almost killed the savings and loan industry in the 1980s.

I’m leaving out plenty of details and history on the first thrift crisis, but suffice to say that a Wall Street firm named Merrill Lynch lobbied Congress to create federally-insured money market accounts which eventually hammered the balance sheets of these ’building and loans’.

Bleeding red ink, President Reagan and a willing Congress then deregulated thrifts in 1982.

This proved disastrous because it granted new asset powers that new and old owners abused and misused.

Also, prior to 1982 federally chartered thrifts weren’t even allowed to make adjustable rate loans.

Of course, banks could always stop making fixed rate mortgages entirely and offer only adjustable rate loans that reprice frequently, but like I said, Americans love 30-year fixed rate mortgages.

As that great mortgage patriot Patrick Henry once said – give me a fixed rate mortgage or give me death.

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