The future of Fannie Mae and Freddie Mac, the two secondary market behemoths that became wards of the Federal Government in September 2008, is in limbo. Virtually all politicians on the national scene would like to get rid of them, none more than their previous political champions for whom their continued presence is a source of embarrassment. But because they purchase more than half of all new mortgages, shutting them down would cripple the mortgage market –- perhaps start a second round of home price declines. As a result, nothing is done.
While virtually everyone would like an expansion of private sector lending that would permit a phase-out of Fannie/Freddie, there is no strategy in place to bring that about. Three possible strategies are examined in this series: expansion of portfolio lending, revival of the private secondary market that collapsed during the crisis, and development of a different type of private secondary market.
Expanding Portfolio Lending
When the lender who originates a loan retains it instead of selling it, we call it portfolio lending. Before World War 2, virtually all mortgage lending was portfolio lending, and in most other countries this remains the case. In the US today, however, only about 5% of new loans are retained. The lenders are depository institutions including credit unions. The rest are securitized with guarantees of the Federal Government.
There is no prospect that existing depository institutions in the foreseeable future will be able to expand their portfolio lending to the degree needed to offset a phase-out of Fannie and Freddie. Most of the mortgages purchased by the agencies have fixed interest rates. Even if the industry of depositaries grew to twice its current size, it could not absorb these mortgages without exposing itself to the same kind of interest rate risk that devastated the savings and loan industry in the 1980s.
In addition, the recent financial crisis demonstrated that home mortgages carry substantially more default risk than previously thought. Portfolio lenders now realize that home prices can fall as well as rise, which reduces the value of the collateral securing home mortgages. They also realize that when home prices drop in a weak economy, default rates can balloon to double digits, and they will not have the staff to acquire and dispose of collateral quickly, which further reduces collateral values. Finally, lenders are now aware that when the system is stressed. Government will blame lenders for the plight of borrowers, and will intrude themselves into the collection process in numerous ways that raise lender costs.
In short, reflecting both the direct impact of the financial crisis, and the punitive actions of Government stimulated by the crisis, portfolio lending has become increasingly unattractive to depository institutions. The mortgages they want to hold today are primarily large ones made to existing customers.
Reviving the Private Secondary Market
Secondary mortgage markets allow investment in mortgages by firms without the capacity to originate them, and they allow firms to originate mortgages without having permanent funding sources. The private secondary market that developed in the US was modeled on those developed by Fannie and Freddie, which included the fashioning of multiple securities, designed to meet the diverse needs of investors, from a single pool of mortgages.
However, the private mortgage securities differed from those of Fannie/Freddie in one critically important way. The Fannie/Freddie securities were liabilities of the issuers whereas the private securities were not. Every individual mortgage security was a stand-alone entity secured by whatever reserves or insurance protections were embedded in that security. If these reserves turned out to be superfluous, as they always were before the crisis, they were paid out to investors who owned a residual claim to them. These were often the firms that had issued the security. While these firms had the right to remove unneeded reserves, they were under no obligation to provide additional reserves if this proved necessary.
Since the surpluses on one security were not available to meet deficiencies on others, and since no one was obliged to provide additional reserves if this became necessary, the entire market was a house of cards. When some securities did run into trouble and were downgraded by the credit rating agencies, fears about the status of others ran rampant and the entire house collapsed.
Investors in private mortgage securities suffered extremely heavy losses. Investors included many foreign firms, and also Fannie Mae and Freddie Mac which had purchased substantial amounts of AAA-rated securities issued against sub-prime mortgages.
The prospects for a revival of this market are nil. There may be a few small securities issued against the highest-quality mortgages, but the volume needed to offset a phase-out of Fannie/Freddie will not happen, Nor should we want it to, because the stand-alone model is inherently weak. What is needed is a strategy for developing a more robust secondary market. The good news is that a tested model exists in Denmark. The challenge is in developing a political strategy to implement it in the US. This will be discussed next week.
Jack M. Guttentag, now Professor of Finance Emeritus, formerly Jacob Safra Professor of International Banking, at the Wharton School of the University of Pennsylvania. Earlier he was Chief of the Domestic Research Division of the Federal Reserve Bank of New York, on the senior staff of the National Bureau of Economic Research, and managing editor of both the Journal of Finance (1974-77) and the Housing Finance Review (1983-89).