Commentary: Overhaul State-Backed Mortgage Giants? It's About Time

THE Obama administration is set to discuss the future ofFannie Maeand Freddie Mac, the mortgage giants that largely escaped reform in the financial overhaul of the Dodd-Frank law, at the Treasury Department on Tuesday.


It’s about time: the government’s role in housing finance has ballooned since the start of the mortgage crisis. Despite their central roles in the housing bubble, the Federal Housing Administration, Fannie Mae and Freddie Mac now back more than 95 percent of new mortgages. In 2006, at the height of the housing boom, the F.H.A.’s share of the mortgage market was 2 percent; today it’s around 30 percent. Given that the agency’s requirements on down payments and creditworthiness have been less stringent than Fannie Mae’s, that should concern all taxpayers.

Just about everyone agrees that the government’s extraordinary role in supporting the housing finance market should be curtailed. Most government officials, however, insist that the time for serious reform will be when “the housing market is clearly recovering,” as the former Treasury Secretary Henry M. Paulson Jr. recently put it.

But by waiting for a recovery before reforming the government’s mortgage-backing trio, we are getting things backward. Far from being the last bulwark supporting the housing market, the F.H.A., Fannie and Freddie are very likely holding back the private loan industry. And, unfortunately, a little-noticed provision of the Dodd-Frank act threatens to undermine efforts at rebuilding an innovative and healthy private sector for mortgages.

Under Dodd-Frank, financial firms that securitize mortgages are required to retain 5 percent of the risk of those securities. The goal, a laudable one, is to encourage companies to more closely monitor the quality of the mortgages they securitize. But it is also likely to increase the cost of affected mortgages, because banks will seek to pass on the costs of that risk to home buyers.

The Housing Fix -- A CNBC Special Report >> See Complete Coverage
The Housing Fix -- A CNBC Special Report >> See Complete Coverage

Mortgages guaranteed by the F.H.A., however, are exempt from the 5 percent risk-retention requirement. This means that lenders will find that it costs far more, and involves more risk, to offer mortgages they back themselves than those covered with a guarantee from the agency. There’s little doubt this will lead to a huge increase in the volume of business done by the F.H.A., as banks creating securities will seek out mortgages on which they don’t have to cover the risk. Purely private mortgages will quickly be pushed out of the market.

This crowding-out effect will be magnified if, as many in the industry expect, regulators also exempt Fannie- and Freddie-backed mortgages from the 5 percent requirement, if only to prevent the F.H.A. from being overwhelmed by demand. Unbelievably, the two entities whose mortgage market follies led to their collapses may well be given a pass when it comes to managing risk.

Under this scenario, the private sector will continue to wither. Even before the crash, banks were finding it hard to compete with quasi-public agencies that could borrow near the federal government’s interest rates. The proposed risk-retention double standard is another nail in the coffin.

To some, that may not seem to be a tragedy. Banks were as culpable in the financial meltdown as Fannie and Freddie. But the scenario ignores what many analysts and policy makers have held out as a silver lining of the crisis: that the private sector would be forced to come up with more innovative, and less risky, forms of mortgages that would spur the housing market without endangering the overall economy or putting taxpayers at risk of bailouts.

The dominance of the government-backed institutions has led to some promising innovations being largely ignored. They include mortgages in which a bank takes an equity share in the home — thus sharing in the risks and rewards of price declines and increases — and covered bonds, which are pools of mortgages that are managed by (and kept on the books of) banks, which can modify the loans to maintain the bonds’ quality. Other countries are far ahead of us in recognizing the problem: the European Union, for instance, outlawed governments from backing mortgage companies — avoiding entirely the implicit guarantees that let Fannie and Freddie grow without credit market discipline.

You may have noticed that our largest banks don’t object to the dominance of the government-run mortgage giants. That’s because there is profit in securitizing morgages guaranteed by the F.H.A. or selling mortgages for Fannie and Freddie. The status quo provides a barrier to innovation that serves the interests of the very largest financial institutions, who know that upstart competitors trying new approaches will face steep costs. Many large banks are backers of extending the F.H.A.’s exemption to Fannie and Freddie.

What can be done?

The first fix is rather simple: the Obama administration should declare that it will not exempt Fannie- and Freddie -backed mortgages from the 5 percent rule. Then it should push Congress to amend the Dodd-Frank Act to put F.H.A.-backed loans under the same risk-retention scheme as other mortgages.

Bankers and bureaucrats will no doubt object that this will raise the cost of lending. That’s possible, although if all lenders were subject to the same rules, free-market competition might lower costs to consumers in the long run. If asking banks to keep a larger share of risk on their balance sheets is a good idea, we should not allow a government-approved brand that flouts the new risk-retention rule.

- John Carney is an editor at