Fannie and Freddie as Risk Transfer Mechanisms

Richard Green:

What has been the real benefit of Fannie and Freddie?, Richard Green: It is almost certainly not homeowning, and it is almost certainly not funnelling money into underserved neighborhoods or toward underserved borrowers.

Rather, is has been the transfer of interest rate risk from households to investors. So far as I know, the US is the only country in the world with long-term, fixed-rate, 95 percent LTV loans that do not have prepayment penalties. When interest rates rise, borrowers are protected; when they fall, they are not made immobile by yield-maintenance and lockout clauses. The low down payments (and five percent equity seems to be OK) effectively give households with modest incomes access to capital markets. I have written elsewhere that I believe that the peculiar structure of Fannie and Freddie has helped bring about the unique American mortgage.

One could argue that the current environment shows that none of this has been worth it. But I would disagree with that argument.

Comments

[Winslow R.]

The whole interest rate risk transfer mechanism has been a boon for the finance industry as long-term rates have been falling (almost the last 30 years). Not so much when long-term rates increase (see S&L bailout)

The refinance industry does well as do the banks as people pay above market rates in return for the protection against a potential 70's style explosion in short-term interest rates.

For those of us that lived through the 70's, we wouldn't dream of having anything but a fixed rate mortgage. Is it really in our interest to have fixed rates loans?

For the last few decades, no.

Consumers need to be tied to short-term rates in order for the Fed mechanism to work properly. We need to rethink the mortgage origination process. Why? Because the monetary tool is worth having.

[Patrick]

Rubbish. Historically Fannie and Freddy had very little to do with making home ownership possible. Until relatively recently, it was the fact that America was a nation of savers, with high employment and good wages. People could save a downpayment, and lenders could assume that a anyone who saved the downpayment was likely to stay employed, and thus have the means to pay off the debt. What the author refers to as the 'American mortgage' is a recent creation and it has been a disaster. It has fueled a huge bubble that sucked trillions of dollars into the least productive asset imaginable. It has spurred the expansion of unsustainable, soul sucking suburbs. And to top it off, securitization of mortgages has wrecked the financial system and left behind a smoldering pile of ruins.

[dWj]

The 30-year fixed-rate callable loan was the standard in this country well before securitization took off in a big way. The transfer of convexity has been to investors from banks and S&Ls.

[btg]

"Consumers need to be tied to short-term rates in order for the Fed mechanism to work properly."

Well, high interest rates have done little to deter consumer spending as of late - particularly evidenced by the massive amounts of credit card debt that people have been running up.

having floating rate mortgages will penalise people for decisions they made previously - when the house they bought several years before suddenly become unaffordable, and so the market gets flooded with resale homes - creating the current sort of spiralling decline - the new home/construction market also gets affected, but it is a very inefficent way to influence the inflation rate.

here in canada, used to be that banks had reserves, and when the BofC wanted to slow the economy down, they could effectivle force the bank to call in "demand loans" - so that people who willingly took risks on short term borrowing were the ones effected - either individuals or corporations. seems far more just, and effective.

[Robinia]

The scale of the system changed-- as dwj says, going from local banks and S&Ls to larger-scale investment markets. In this transition (mightily helped along by the original fraud-based bubble that created the S&L crisis), we lost all local knowledge of either the fitness of the borrower or the fitness of the asset. Such local knowledge (as well as the prudent outlook of the local banker as a character trait) were productive components that helped ensure the efficient operation of the US mortgage system. Time to look for other approaches... the Fannie/Freddie privatized-but-government-backed securitization model is proven unworkable. I'm from time to time a back-to-the-future fan on this: reinstate Glass-Steagal and revive the local banker.

[Transfer]

"Rather, is has been the transfer of interest rate risk from households to investors. So far as I know, the US is the only country in the world with long-term, fixed-rate, 95 percent LTV loans that do not have prepayment penalties."

The transfer of default risk has been from investors to the taxpayers. The 95% LTV doesn't exist in other places because it is not a workable model. Default rates are too high.

[baileyman]

The primary effect of FRE and FNM has been to free up lending capacity at the banks and savings & loans. And interestingly, that was the objective to start with. Who'd a thunk?

[Kadın]

The transfer of default risk has been from investors to the taxpayers. The 95% LTV doesn't exist in other places because it is not a workable model. Default rates are too high
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Rather, is has been the transfer of interest rate risk from households to investors. So far as I know, the US is the only country in the world with long-term, fixed-rate, 95 percent LTV loans that do not have prepayment penalties."