For decades Fannie Mae and Freddie Mac provided an important service to the American economy by providing financing for Americans to buy and refinance their homes and to spur the development of the multifamily housing that is essential for a growing population.
Unfortunately, as a result of changes that occurred in the operation and financing of Fannie and Freddie, they now must be replaced. Though Fannie and Freddie were privatized in the '60s in order to remove their debt from the government's books, the general perception, which was never denied, was that Fannie and Freddie's obligations were guaranteed by the United States government. This belief gave Fannie and Freddie access to inexpensive capital, but it also placed the government in an awkward position when Fannie and Freddie collapsed in 2008, forcing the federal government to bail them out and effectively become their guarantor.
The reasons that Fannie and Freddie failed are many, but the two relevant factors were that Fannie and Freddie became focused on short-term profits for investors; they made credit decisions based on politics rather than on sound banking principles.
Nevertheless, the importance of Fannie and Freddie should not be lost in recriminations over what they did wrong. What they did right was to create a standard for conforming loans, which produced efficiency, availability and pricing stability even during crises when risk spreads widened. There is little doubt that, in order to maintain a robust housing industry, a structure is needed to make mortgages available that is not obliged to lend to borrowers who may not be able to repay the principal or to buy such loans. Such an entity's obligations may not be implicitly or explicitly guaranteed by the government.
Basically, what we have learned in the last few years is that a home financing mechanism must be created that will focus on buying conforming loans from banks and other lending institutions, selling them to the secondary market, when available, and until the secondary market recovers, finding a source for their purchase.
During this crisis, we have witnessed a significant market concentration in which perhaps four originators hold about a 50% collective market share. For this reason, it is essential that community banks have access to 15- and 30-year fixed-rate loans. The growth of Fannie and Freddie was supported by the belief that a large institution is better positioned to tap the capital markets through securitization than smaller players would be, but recent years have shown that bigger is not better.
For the system to work, loans must be conservatively made, properly and uniformly papered and based on sound banking principles. In addition, it is imperative that the mortgage-backed securities market be restarted because the recovery of the housing market and the broader economy requires a dynamic secondary market in which mortgages can be safely securitized. Replacing Fannie and Freddie can go a long way toward achieving that goal. Finally, if the government believes that a particular segment of the population has been insufficiently served, then it should establish a mechanism to supply the lack and not require Fannie and Freddie or their successors to do so.
I recommend that Fannie and Freddie be replaced by cooperatively owned businesses formed and owned by the banks and lending institutions that originate the mortgages. Initially, 12 cooperatives should be formed, one in each Federal Reserve District, with membership open to all the banks and mortgage lenders in each Fed district. After the 12 cooperatives develop an operating history and systems that support the market, additional cooperatives could be formed to serve smaller geographical areas. The several cooperatives would prevent a concentration of power in two entities, which is what led to Fannie and Freddie's failure.
Each cooperative would buy conforming loans from its members and either hold or package and sell them in the secondary market or to investors. Each bank in a Federal Reserve district that wanted to participate would own a stake in the cooperative based on the amount of loans the cooperative had acquired from that member. Each cooperative would be operated by a board of directors elected by its members, based on weighted voting.
The cooperative's members would share the profits or losses of their cooperative on a pari passu basis, and each would either guarantee the first 5% of the loss on each mortgage that it sells to the cooperative or retain a 5% interest in each mortgage in order for the lender to continue having "skin in the game." In addition, the banks would have to supply representations and warranties on the loans they sell to the cooperative. This risk retention would give the securitization market an impetus for recovery.
Securitizations could be done separately by each cooperative or by a master cooperative, whose only role would be to package loans from the cooperatives with all of the income, expense, origination and servicing passing back to the individual cooperatives. In that way the cooperatives could still enjoy the advantages of their aggregating role without any of the attendant risks to the broader economy.
The advantage of having multiple, prudentially operated and carefully monitored cooperatives is that none of them could become "too big to fail," none could control the housing finance market and, if a cooperative had problems, the others could step in and help finance the homes in that district, while the troubled cooperative was placed in a form of conservatorship. More importantly, the 12 cooperatives would be independently operated and could share best practices with each other.
A cooperative would only buy conforming mortgages from its members and would not be permitted to buy products lacking approval of the Federal Housing Finance Agency. Members of the cooperative could make other products available to consumers, but nonconforming products could not be sold to, or securitized by, the cooperative. The FHFA would audit the cooperative and make certain that it did not exceed certain parameters of risk. The FHFA would also stress-test the cooperative's portfolio every year.
It is anticipated that the cooperatives would handle the bulk of the housing market, leaving it to individual lenders and investors to make more creative or exotic loans as their regulators permit. In addition, because the cooperatives' loan portfolios would hold plain-vanilla credits, the mortgage-backed securities that they would underpin would enjoy high credit ratings, reducing the cost of funds and creating savings that could be passed along to consumers.
Because banks would guarantee a portion of the loan, there would be less incentive to make risky loans. In addition, a bank would not want to risk being dismissed from the cooperative for making risky loans or violating any rules. One would assume that a bank not participating in the cooperative would have to pay more for funding. Other than as a regulator, the government would be out of the mortgage business. Unlike Fannie and Freddie, the cooperatives would share profit and loss with member banks rather than third-party investors.
An additional advantage of establishing a dozen cooperatives is that it could facilitate the orderly dissolution of Fannie and Freddie. At present the GSEs must continue supporting the mortgage market because, in the absence of a robust securitization market, there is no alternative. Meanwhile, Fannie and Freddie's future is very much up in the air. Establishing the cooperatives would let Fannie and Freddie cease being the glue that holds together the housing finance market, and the focus then could shift to unwinding their portfolios of assets and liabilities. Once the cooperatives are formed, the government would be better able to deal with these portfolios.
Until the future of Fannie and Freddie is resolved, the housing market, in particular, and the economy, in general, cannot recover. This proposal offers a road map out of the dilemma because it would let housing finance recover without a government guarantee, provide a way to liquidate Fannie and Freddie without disrupting the market and form a basis to restart the mortgage-backed securities market.
