Earlier this month, the Treasury released their proposal for reforming Fannie Mae and Freddie Mac. There is a broad consensus in the market that the current model is unsustainable, but most of the market is also in agreement that the current state of the housing market is hardly capable of weathering any significant reform at the current time. The Treasury broke their suggestions into three main options, each having a slightly different role for the government going forward.

Option #1

This option would decrease the government’s role in the mortgage market to only “FHA-like” programs targeting lower income and first-time borrowers, a portion of the housing market that under normal circumstances is very small. This goes about changing the landscape by essentially abolishing Fannie Mae and Freddie Mac in their current form, in favor of a fully privatized market that would handle almost all of the conventional mortgage market.

Pros

1. Taxpayers would no longer be on the hook for the majority of the mortgage market.
2. A properly functioning fully private market (profit seeking) would most likely price risk better than any government guaranteed market.

Cons

1. The housing market is worlds away from absorbing the increase in financing cost associated with a plan like this, and reform is needed sooner.
2. Homeownership rates would decrease drastically. I’m not saying that a structural change in homeownership rates is necessarily a bad thing, but it’s just unlikely to gain any real traction in congress.

Option #2

This option is very similar to the first, but instead the government would step in during crisis times to backstop the market. The government assisted market would scale up when the private market is unable to function, and be more or less invisible during normal market conditions.

Pros

1. Makes you feel all warm and cozy on the inside knowing that the government will step in a fix everything. (sarcasm)

Cons

1. Government subsidized lending would only be operating at the worst times possible, and would have no reserves, built up during the good times, to cushion against losses.
2. It will be difficult for the market to price itself correctly because congress will be urged to step in at the sign of any little correction.

Option #3 – Most Realistic

This option would form new “private mortgage guarantor companies”, except this time with an explicit government backstop, making only loans within a strict set of guidelines, without their own investment portfolios. The model will charge a higher fee, which would allow for the agencies to build reserves during good times, but the agencies would also cushion against losses with private capital that would have to be wiped out completely before the government’s backstop was utilized.

Pros

1. Reduces risks taken by the agencies, by preventing them from having investment portfolios, while giving them a way to reserve against losses adequately by increasing the guarantee fees.

Cons

1. Fannie and Freddie were “private guarantor companies”, so in a way this option just gives them new names and recapitalizes them. The level of oversight isn’t specified, but would have to be much improved from the old model in order to much of an improvement.

The pros and cons I list are based on my opinion and the validity of the options presented by the Treasury is likely to be debated for some time still. This is the most significant opinion issued to date, but any action still appears to be far off.

It’s also worth noting that these options released by the Treasury are aimed at reforming Fannie and Freddie for the future. They do nothing to change the status of existing debt and MBS and they aren’t meant to. The Treasury has pledged to cover unlimited losses for both GSEs through 2012, and until reform passes that paints a clear picture of the future we expect existing and new bonds issued by Fannie and Freddie to continue to trade without a premium for credit risk, as they are now.

I always try to cut things down to a manageable length, but for the primary source lovers our there the link below will get you to the Treasury’s report. It’s not too technical, just long.

http://www.treasury.gov/initiatives/Documents/Reforming%20America%27s%20Housing%20Finance%20Market.pdf

Have a great weekend. 

Cliff J. Reynolds Jr., Investment Analyst