Self Harm from Fannie and Freddie

September 4, 2011: AS BARACK OBAMA casts around for ways to bolster the American economy, one area of focus is a still-moribund housing market. He could start by taking a closer look at Fannie Mae and Freddie Mac, America’s housing-finance giants.

When the two government-sponsored entities (GSEs) were listed companies, they acquired or stamped guarantees on millions of loans that in retrospect were far too risky. Those bad loans drove them to the brink of collapse in 2008, forcing their regulator to take them over. The Treasury has since injected some $140 billion into them to keep them solvent. That matters. In the first half of this year the two guaranteed roughly 70% of all new loans. They have also helped 1.7m homeowners through loan modifications and other measures. Yet although the GSEs are ostensibly government-controlled, they still try to maximise profits and minimise losses.

The GSEs also hamper help for the 23% of homeowners in negative equity, with loans worth more than their homes. According to CoreLogic, a data provider, negative equity totalled $707 billion at the end of April. That number is unlikely to shrink very rapidly, given the pressure on prices from a large “shadow” inventory of housing that is yet to hit the market (see chart) and the glacial pace of foreclosures.

These underwater borrowers find it hard to take advantage of record-low mortgage rates by refinancing. In 2009 the administration sought to address this problem with its Home Affordable Refinance Programme, or HARP, which allowed borrowers with a loan-to-value (LTV) ratio of up to 125% to refinance. It hoped 4m-5m borrowers would qualify but by May only 810,084 had participated, a mere 7% of whom had an LTV ratio of more than 105%.

An important reason for the low take-up is that GSEs charge up to two percentage points of the loan amount to guarantee refinanced HARP loans, even though the refinanced loan is no riskier than before. In addition, the bank handling the refinancing may charge higher fees of its own to compensate for the risk that the loan soon defaults and Fannie or Freddie insists it be bought back. Many potential applicants have apparently concluded that these conditions outweigh the benefits of a lower rate. That blocks one of the channels by which the Federal Reserve’s easy monetary policy is meant to shore up consumer finances.

Refinancing makes negative equity more bearable but it does not reduce it. Writing down the principal would address that problem, but lenders dislike that because they suspect many borrowers can repay what they owe. In 2009 the administration also set up the Home Affordable Modification Programme, or HAMP, to subsidise mortgage modifications, but cuts in principal remain rare, accounting for just 5.5% of modifications in the first quarter. The GSEs are particularly reticent: they reduced the principal on only five loans in the first quarter; private lenders did so on 4,421 loans.

The GSEs and their regulator, the Federal Housing Finance Agency, justify their actions by noting that they are legally required to conserve assets and protect taxpayers from further losses. But in doing so they are working against the Treasury’s broader goals: reducing the chances of foreclosure, cleansing the financial system of bad debts and negative equity, and rejuvenating lending. Despite bankrolling the GSEs, the Treasury has limited authority to overrule their regulator. And Congress is in no mood to give it either the powers or the money for more generous relief for borrowers. Mr Obama’s hunt for a fix for the housing market may be a fruitless one.

Published by Stout Law Firm

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