Remodeling The Housing Finance Industry

By Denise Finney AAA

History suggests that Fannie Mae (FNMA) and Freddie Mac (FHMLC), along with the less popular Government National Mortgage Association (GNMA) and Federal Home Loan Banks (FHLB), should have limited-life charters as government-sponsored enterprises (GSEs). These GSEs were created by the United States government to respond to specific problems in the housing finance markets that existed at certain times.

However, these organizations continue to exist - and there's some dispute as to whether this is a good thing. Here we'll look at how the current system came about as well as what the future holds for housing finance. (Looking to buy? Check out Top Tips For First-Time Home Buyers.)

In the Beginning
Fannie Mae was created in response to the Great Depression when the economy made it difficult for homeowners to meet mortgage terms. Fannie Mae purchased and securitized Federal Housing Administration (FHA) and Veteran's Administration (VA) mortgages to inject liquidity into the mortgage markets. GNMA, or Ginnie Mae, was created thereafter to guarantee receipt of principal and interest payments on securitized loans. Freddie Mac was created along with GNMA to provide another type of securitization further enhancing liquidity. Similarly, Federal Home Loan Banks were created to provide liquidity directly to lending institutions that fund mortgage loans. Once these problems were effectively solved and the goals were achieved, government-sponsored enterprises should have continues as wholly private businesses without the special privileges afforded by government charter status.

Balancing Risk and Reward
What is the rationale behind limited-life charters for GSEs? Simply put, the primary goal is to facilitate privatization and increase competition in the secondary mortgage market. One of the primary structural problems with GSEs is the risk-reward balance. With the exception of contributions to affordable housing initiatives, the government has minimal share in the profits of GSEs while bearing the majority of risk associated with maintaining their existence. (Find out what went wrong with this set-up in Who Is To Blame For The Subprime Crisis?)

This risk is ultimately absorbed by taxpayers who fund the government that charters and supports these GSEs. Privatization shifts risk management back to shareholders and managers of GSEs, and away from taxpayers, legislators and government bureaucrats. Engaging in business activities that produce revenues and profits, instead of relying on legislation to ensure funding guarantees, will ensure survival of individual companies and draw new companies into the market mix that will guarantee the long-term survival of the housing finance industry. (To learn more about the benefits of privatization, take a look at Why Public Companies Go Private.)

Limited but Proactive Approach
Previous markets were characterized by residential mortgage backed securities (MBS), a type of security that relied on the past trend of rapidly increasing house values and income generated from high interest rate mortgages. Throughout the history of U.S. real estate lending, the government as well as private companies in the market adjusted to change by modifying their products and services. Through legislation, the government modified institutions like FNMA, FHLMC and GNMA to provide liquidity and availability of funds to private lenders. Meanwhile, private lenders modified underwriting guidelines and created designer loan products to meet and/or create greater demand for residential mortgage loans. (Learn about one of the factors behind housing prices in How Interest Rates Affect The Housing Market.)

The conservatorship of Fannie Mae and Freddie Mac in 2008 was a critical and essential strategy for solving the specific housing and mortgage problems that have prevailed through the early 21st century. The terms of conservatorship allow Fannie and Freddie to continue extending mortgage loan guarantees, but limit their investment activities in purchasing and holding loans in a portfolio. Instead, the U.S. Treasury will directly purchase more mortgage-backed securities. This step does something to spread the risks associated with investing in the housing market and related securities, but is insufficient without strategies to support private sector activities and investments.

Future Trends
What does the future hold for the mortgage industry and the secondary mortgage market? Even with the housing and mortgage crisis that has lasted through the first decade of the 21st century, financial creativity will not cease. Rather investors will focus less on direct investment in residential mortgages and more on activities including land acquisition, real estate development, construction and commercial lending. This change should neither hinder the path to homeownership nor reduce homeownership rates. It will, however, change the nature and landscape of homeownership. As a result, the new path to homeownership may be characterized by various rent-to-own or lease-purchase options as a prerequisite qualification for mortgage borrowers. (Learn about some of the issues in Rent-To-Own Real Estate Full Of Pitfalls.)

Why is this a necessary consideration? Availability of consumer and residential mortgage credit will continue to decline, or at least will not increase in the first few years of the second decade of the 21st century. Subprime loans with low to no down payment requirements will be difficult for buyers to come by with even the best credit and income. Those with marginal credit and income histories will be even further affected. Rent or lease options may be used to satisfy the down payment requirements associated with historical and re-emerging mortgage loans requiring as much as 20% down payments.

What Does It Mean for Investors?
How does this affect investors? Simply by changing the underlying assets that make up the securities they invest in. Investment in credit obligations will be "secured" by corporate cash flows based on business activity derived from receiving rental payments from home buyers instead of relying solely on individual consumers' ability and willingness to repay high rate mortgage loans.

Customized Service
Why does this work better than direct-to-consumer mortgage lending? When an individual borrower defaults on a mortgage loan, the lender's only option is foreclosure on the property. The lender cannot step in and manage the borrower in a way that can produce income to help the borrower keep up with the mortgage payments. (Foreclosure is not always bad for investors. Learn more in Foreclosure Opens Doors For Real Estate Investors.)

However, an investor in corporate securities could effectively assume and manage the business operations in a manner that could increase revenues and cash flows. Investors will invest in companies that earn revenue and cash flow from business activities that create stable homeownership opportunities. This does not completely eliminate the residential mortgage loan, but will redirect the borrowing process in a way that will diminish some of the detrimental risk associated with subprime lending and mortgage derivative securities.

The Final Analysis
If history has taught us anything, it' that housing and homeownership are staples of the U.S. economy and way of life. Both public and private sectors will continue to play a critical role in maintaining the housing finance industry. Government sponsored enterprises were created and exist to solve current problems in the housing and mortgage finance markets. Private businesses and corporations exist to maintain the markets once these issues are addressed.

As housing prices have declined and the greater economy has suffered, the government has spent the early part of the 21st century finding solutions to the total of economic concerns that accompany declines in the housing finance markets. However, the ball will soon be back in the private sector's court. The businesses that survive the next phase of transition in the housing and mortgage industry will be those that focus on developing new and non-traditional paths to homeownership as opposed to simply creating new forms of mortgage securities to sell in the secondary markets. (There are many ways to get into the housing market. Learn about them in Simple Ways To Invest In Real Estate.)

Learn more about these GSE's in How Fannie Mae And Freddie Mac Were Saved and Fannie Mae, Freddie Mac And The Credit Crisis of 2008.

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