The debate about the future of Fannie Mae and Freddie Mac is far more than a mere academic discussion for bankers. Access to a secondary residential mortgage market is vital to banking, and for a half-century Fannie and Freddie have been synonymous with secondary residential mortgage markets. My own experience reinforces that point.
In 1976 I returned to my hometown of Fergus Falls, Minn., to be president and CEO of a small community bank that my father had started 19 years earlier. Security State was the smallest and newest bank in the community, and gaining market share was a challenge. Like all newcomer banks, we had to continually fight the "adverse selection" inevitability that goes with being a new institution; we were constantly approached by marginal borrowers that other banks had rejected. We didn't want the other banks' rejects as customers. We wanted our share of the quality customers.
At the time, Fergus Falls was enjoying a consistent in-migration of new families and new businesses, and I found that we were successful in attracting more than our share of the quality new customers who were moving into town. But that approach only worked if we offered a competitive mortgage product to help them buy a home, and like all community banks, we quickly recognized the perils of being a portfolio mortgage lender. Mortgage loans not only cause asset/liability mismatches, they are also balance sheet eaters. When banks make lots of mortgage loans, there is little room left on the balance sheet for any other types of loans and investments.
For a community bank to offer a viable first mortgage product, it was important to have a consistent, appropriately priced, well-funded secondary market outlet. So in 1978, I promoted my administrative assistant, Valerie Fick, to a mortgage loan officer and tasked her with finding and maintaining a secondary market source for our loans. We did not sell our loans directly to Fannie or Freddie, but instead worked through mortgage brokers and upstream correspondents. But we were well aware that the availability of our secondary market was heavily dependent on Fannie/Freddie underwriting standards and funding. To this day, Val Fick (now a vice president) makes mortgage loans in that community and sells most in the secondary market.
Within the past five years, Fannie and Freddie have gone from being dominating political forces to struggling entities in conservatorship with doubtful futures in the hands of Congress. At a recent conference on their future, I heard arguments from liberals and conservatives alike that it may be time to end both the government-sponsored enterprise format and move entirely to the private sector for secondary market mortgage financing.
To put the issue in perspective, a bit of history is in order. The necessity of a secondary market has been recognized since early in the last century. Fannie Mae and Freddie Mac (formally, Federal National Mortgage Association and Federal Home Loan Mortgage Corp.) were chartered by Congress in the 1930s as government-sponsored enterprises. Thirty years later, the charters were amended to allow private ownership. The GSE designation allowed them to issue debt offerings, which the market priced at rates close to federal government obligations. Private ownership moved the debt outside the government for debt ceiling and budget purposes. At that point, Fannie and Freddie enjoyed a roughly 50-basis-point advantage to the market on its debt obligations and virtually unlimited capacity to borrow. A more attractive charter is hard to imagine. For decades Fannie and Freddie enjoyed strong support, particularly from Congress, as they expanded the availability of home mortgages and therefore the desirable societal value of homeownership. Though critics worried about the growing exposure of their ever-increasing debt, little was done to rein them in.
Then cracks developed. In 1992, the charters were altered to require the companies to help achieve "affordable housing goals." As a result, Fannie and Freddie expanded the risk parameters on their mortgage underwriting. Also, as a means of providing strong returns for shareholders, an increasing percentage of these loans were held on their respective balance sheets, which created still greater risks. These actions came back to haunt the two institutions when the real estate bubble burst and foreclosures began to occur. With widened underwriting parameters, more balance sheet exposure, questionable accounting treatment and inadequate internal controls and infrastructure, Fannie's and Freddie's regulator, the Federal Housing Finance Agency, tossed both into conservatorship in 2008.
Now Congress is debating their future. As mandated by the Dodd-Frank legislation, the Treasury secretary recently submitted a report to Congress on the housing finance market that detailed weaknesses in the current system and suggested three alternative approaches that Congress could consider. All three would make private markets the primary source of mortgage credit. The three options range from providing a backstop only in times of crisis to providing continuing support and insurance for targeted borrowers. The third option is a hybrid of the two.
The report is receiving mixed reviews on Capitol Hill, as few lawmakers want to risk serious damage to the nation's housing sector by making an abrupt change in a system we have relied on for most of the last half century. We certainly have seen the last of Fannie and Freddie as we have known them, and the private sector is likely to become an increasingly important source of secondary financing.
This discussion may or may not result in immediate legislative change, but bankers have an important stake and need to be thoroughly involved. While it may be necessary to change the fundamental structure of the secondary mortgage market, the need for the market, especially for community banks, remains significant.
