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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2014

Foretelling A Future Without Fannie And Freddie

Despite their recent profitability, the government-sponsored enterprises may soon depart

Foretelling A Future Without Fannie And Freddie

Although the United States has a free-market economy, its government provides key financial backstops to keep the economy from derailing during a crisis. The Federal Deposit Insurance Corp. guarantees most bank deposits and, in the real estate market, the government assures access to credit, a policy dating back to 1916.

According to the U.S. Congressional Budget Office, as of 2012, more than 95 percent of residential mortgages were estimated to have some form of federal government guarantee. These guarantors of credit are called government-sponsored enterprises (GSEs). Real estate and mortgage professionals are well acquainted with two of them, Fannie Mae and Freddie Mac.

These two organizations have received much of the political fallout for the mortgage crisis, whether fair or not. Never has the government’s hand in the real estate market been more pronounced — for better or worse — than during the burst of the real estate bubble in 2008.

Critics of Fannie and Freddie contend that the two GSEs inflated the bubble by shouldering too much risk with subprime mortgages, but many economists say the provision of credit would have halted completely without Fannie and Freddie’s backing of the already-shaky real estate market. Defenders of the two GSE giants also contend that Fannie and Freddie have facilitated the growth of the U.S. real estate market, particularly by taking on some of the risk of low-to-moderate-sized multifamily housing investments.

Whatever the case, government intervention kept Fannie and Freddie afloat during the recent economic crisis. On Sept. 6, 2008, the Federal Housing Financing Agency placed both GSEs in conservatorship. Since then, the growing sentiment among lawmakers is that Fannie and Freddie need to be downsized, or even more drastically, wound down completely.

Reducing Fannie and Freddie’s role in the commercial real estate market would represent a significant sea change. Although their dismantling would not be a ruinous blow, it would fundamentally change the way commercial real estate investment operates in the United States, leading to more risk and higher investment costs.

GSE history

To appreciate what the mortgage-lending landscape might look like without Fannie and Freddie, it’s crucial to understand exactly what these two GSEs do.

While operating purely as a government agency from its inception in 1938 to 1968, Fannie Mae effectively monopolized the U.S. secondary-mortgage housing market. Fannie Mae was privatized in 1968, and its exclusive hold on the market ended when Congress created Freddie Mac as an identical private corporation in 1970.

Fannie Mae and Freddie Mac primarily purchase and securitize mortgages, which are then sold to outside investors with a prospectus that includes an implied guarantee of full payment of principal and interest that reads, “Neither the certificates nor interest on the certificates are guaranteed by  the United States, and they do not constitute a debt or obligation of the United States or any of its agencies or instrumentalities other than [Fannie Mae or Freddie Mac].”

Fannie Mae began purchasing multifamily loans in 1984, and by 2011, along with Freddie Mac, it accounted for more than 50 percent of the multifamily mortgage market. Although private institutions and investors purchase these investments, they do so expecting government guarantees and regulatory oversight. The end result is inexpensive, secure credit.

Ideally, this quid pro quo greases the wheels of investment, allowing the commercial real estate industry to take on more risk than it would without a federal guarantee. It’s a delicate balancing act, however, and it’s generally agreed that Fannie and Freddie allowed investors to take on excessive risk in the past, leading to an asset bubble that burst in 2006 and contributing to the 2008 financial crisis.

Post-GSE scenario

Pooling commercial property loans with GSE backing has been attractive for buyers in the secondary market. Without these GSE programs in place, secondary-market investors would likely look elsewhere or possibly seek a higher spread, which would impact the cost of funds for multifamily purchases and refinances, although it’s unlikely this would significantly disrupt the market.

Without Fannie and Freddie, much of the multifamily lending sector would be forced to look elsewhere for alternatives as primary sources of capital, such as life insurance companies, banks and the U.S. Department of Housing and Urban Development (HUD). These sources couldn’t absorb the entire demand, however.

Lenders that are well-versed in commercial mortgage-backed securities already have a system in place to sell commercial mortgages on the secondary market that would help absorb some of the demand for multifamily loans if Fannie and Freddie were to go away. Also, many life insurance companies and banks that now find it difficult to compete with  government-aided Fannie and Freddie would look to increase their percentage of multifamily loans; they too, however, could not absorb all the demand.

Inevitably, a less-diversified portfolio of options will lead to higher costs, fewer choices and a purer market, one that’s free from government intervention and the pricing advantages that Fannie and Freddie have when competing for multifamily loans. This sector would feel the shift most acutely. It benefited most from the GSE credits, which ensured cheaper loans and aggressive underwriting.

The alternative options for other sources of mortgage capital, however, along with a strong need for multifamily housing stock in the wake of the Great Recession, should mean that even the multifamily market will eventually be able to weather the storm.

Uncertain future

A good deal of uncertainty remains about Freddie and Fannie’s future. Although lawmakers on both sides of the aisle agree that moving away from Fannie and Freddie as pillars of the real estate market is necessary, there is no consensus about a surefire way to do it without causing another collapse in the real estate industry.

Ideally, any move to wind down the two GSEs must allow the federal government to secure long-term loans —  such as the ever-popular 30-year mortgage in residential single-family housing — without shortchanging investors or taxpayers.

Interestingly, with efforts to wind down Fannie and Freddie underway, they are now profitable enterprises, and the government is gaining on its original bailout package for the GSEs. The bailout terms called for Fannie and Freddie to send all of their profits back to the U.S. Treasury in the form of dividends, and these dividend payments have already surpassed the amount of the government bailout. This return to profitability has many larger investors calling for the preservation of the GSEs.

Fannie Mae reported its ninth-consecutive quarterly profit this past first quarter, with a net income of  $5.3 billion. Fannie’s net revenues included $4.1 billion in settlement agreements during the quarter relating to the purchase of private-label mortgage-related securities. During the same period, Freddie Mac reported a $4 billion net income — its 10th-consecutive quarter of positive  earnings —  which included $4.9 billion  ($3.4 billion after-tax) related to private-label securities litigation.

The combined first-quarter dividends for Fannie and Freddie to be paid to the Treasury were expected to total $10.2 billion, according to Reuters. As of this past June, the two GSEs will have paid back an estimated $213.1 billion to the government.

Efforts to dismantle

Despite this recent return to profitability, efforts to dismantle or otherwise reorganize Fannie Mae and Freddie Mac are underway. One Senate proposal, the Johnson-Crapo housing-reform bill, would wind down Fannie Mae and Freddie Mac and replace them with a new government agency, the Federal Mortgage Insurance Co. (FMIC), which would be intended as a strong regulator.

The FMIC would administer a special fund to cover losses on mortgage-backed securities, essentially taking over the GSEs’ implied-guarantee function. Private companies would then function as guarantors and would be required to hold 10 percent of the capital that must be depleted before the FMIC would cover any loss.

Winding down Fannie and Freddie is a hot-button issue in this midterm election year. Adding fuel to the fire, some Fannie and Freddie shareholders are upset with lawmakers and regulators for revising the terms of the $189 billion GSE bailout in 2012, a dispute which may take time to work itself out in the courts.

Notably, this past April, a group called the Coalition for Mortgage Security, led by a former HUD undersecretary, argued that lawmakers unfairly moved to claim 100 percent of the profits of Fannie and Freddie with the revised payback terms, while still allowing private investors to maintain a 20 percent stake of private ownership in the two GSEs. Multiple lawsuits have since been filed.

• • •

It is unclear what the fate of Fannie Mae and Freddie Mac will be, although some level of reform seems assured. What is clear is that sweeping government changes occur slowly, and any major restructuring of these massive institutions will take time. There may not be an answer to the future of Freddie and Fannie this year, meaning mortgage professionals and investors will continue to do business in a world where the two GSEs exist, while at the same time preparing to operate in one without them.  •

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