The current plan to wind down Fannie Mae and Freddie Mac would result in lower housing prices for everyone. It would harm the United States economy by lowering growth. It would increase unemployment.
Despite this probability, the president and Congress seem to be intent on killing these companies - and the media and public do not seem to care. The prevalent belief is that these are failed companies with failed structures that exacerbated the American housing crisis that flared up in 2008 and therefore they must be expunged from the system.
In fact, the opposite is true. For eight decades, the system that they represent was successful in allowing tens of millions of Americans to own their own homes. The system was abused by politicians, regulators, and bankers beginning in the mid-1990s and this led to the downfall of these two giant companies. It was not structure but political and financial interference with proper underwriting that created their difficulties. The reaction to these misdeeds is to eliminate these companies without considering what this will do to housing and beyond housing, the economy.
Consider the current proposals, in Washington D.C.:
- One set of ideas would result in the elimination of the 20- and 30-year self-amortizing mortgage.
- Another concept would result in increasing the federal debt ceiling by more than $5.3 trillion and maintaining pressure to keep raising it going forward.
- Another option would wipe away $350 billion of tax payer equity.
- Other ideas would result in the complete nationalization of the housing finance industry.
What is certain is that under every one of the proposals, the concept of every American owing his or her own home is now gone. The result will be to create neighborhoods of rental units - or in my view, instant slums. Given the risks implied by the current proposals, one would think that Americans would want to know more about what is happening to home finance or, more specifically, the price of their homes. To date they are not interested - and neither is the media.
It is probable that the housing industry in the United States is the nation's most subsidized sector. The problem, of course is how do we get from the most heavily subsidized system of home finance in the western world to a system that is not subsidized at all? Clearly if the transition is not handled properly, major dislocations will emerge and these dislocations will be very painful to all Americans.
If the current plan from the U.S. Treasury clears Congress and the courts, two things will happen: Fannie Mae and Freddie Mac will stop functioning on January 1, 2018; they will then enter a liquidation phase that may take at least 10 years.
This will not be good for anyone in this country. If there is no Fannie Mae and Freddie Mac, no bank will be willing to make 20- or 30-year self-amortizing mortgages. I have spoken to at least a dozen banks who feel very strongly about this issue - they just don't view mortgage lending as the profit center it once was in the past. It's more of a loss-leader to attract customers and cross-sell them other products.
Banks will simply be unwilling to put 30-year self-amortizing mortgages on their balance sheets, particularly at today's interest rates. They will be willing to make 10- and 15-year adjustable-rate loans. The math here is frightening. The median income of American households is approximately $51,000. Under the new qualified mortgage rules, if you want to buy a home:
- You must make a down payment equal to 20 percent of the value of the home to be purchased.
- You are not allowed to pay more than 40 percent of your household income to meet principal and interest payments.
So, if the homeowner obtains a 30-year mortgage at a 4.25-percent fixed rate, then he/she/they can afford a home worth approximately $435,000. Conversely, if all they could get was a 10-year adjustable-rate mortgage at 6.25 percent (the average over the past 20 years), they could only afford a house worth $345,000 - a drop of $90,000.
You can play with the numbers any way you want but the bottom line is always the same: Affordability drops. Housing prices must come down. Moreover, if the American banks adopt the mortgage systems widely used in Canada, the 3-5-year balloon mortgage will be back.
Of course, no one believes that this will ever happen. However, they need to think again. The program to eliminate Fannie Mae and Freddie Mac is already in place. Unless Congress acts or the courts throw out the U.S. Treasury's plan, the price of every home in the United States is about to fall. After the fact, people will care and the media will awaken from its somnolent state.
What should be done
To me it is very clear that the following should be done to minimize the impact of the government's withdrawal from the home finance industry.
- The conservatorship controlling Fannie Mae and Freddie Mac should be eliminated.
- The companies should be returned to private sector ownership.
- The government should exercise its warrants and sell the stock in the open market.
- The dividend on the Series A preferreds should be returned to 10 percent.
- The two companies should have as their mission:
1) The elimination of their owned portfolios
2) The expansion of their insurance roles without the full faith and credit of the nation behind this insurance
3) The requirement that they give preference to insuring long duration fixed rate mortgages
- The Senior Preferred Stock should be placed in a new trust dedicated to funding low-income housing.
None of this requires congressional or court actions. The president is able to do it by fiat. There is no massive government takeover of the housing finance industry and more importantly no massive bureaucracy created. It is simple, low cost, and would avoid disrupting the American public by forcing the prices of their homes lower.
- By Richard X. Bove
Richard X. Bove is an equity research analyst at Rafferty Capital Markets and the author of "Guardians of Prosperity: Why America Needs Big Banks," which is due out on Dec. 26.