Ignoring the Gigantic Subprime Elephants in the Room

The Dodd-Frank Act kicked the can down the road on Fannie Mae and Freddie Mac reform

The financial services reforms of the Dodd-Frank Act were ostensibly aimed at many of the firms Congress sees as culprits in the financial crisis. The systemic risk oversight, trading limits, and compensation rules are largely directed at the big banks that dominate the financial industry. But with all of the focus on the banking sector, there are two gigantic subprime elephants (GSE) in the room that have gone unnoticed: Fannie Mae and Freddie Mac. The omission of Fannie and Freddie reform from the regulatory overhaul bill must be quickly resolved.

The TARP bailout gave Citigroup $45 billion, of which it has returned two-thirds. Bank of America, Wells Fargo, JPMorgan Chase, and Goldman Sachs were bailed out for $105 billion in total, which they have fully returned with $10 billion in collective profit for the government. AIG got the most, a $182.3 billion series of loans and guarantees, and it’s restructuring its whole business to return the money. As it stands now, by the end of TARP the government may not have lost any money on these particular big banks — all of which were targeted by the Dodd-Frank Act.

Yet, government-sponsored enterprises (also, GSE) Fannie and Freddie have already booked $145 billion in losses for the government, with potentially a trillion more in the future. Meanwhile, a second housing bubble is forming as the GSEs, whose business model contributed to the buildup of the last bubble, are financing 98% of the market. Furthermore, the banks would never have had the financing to get themselves in such deep toxic housing debt without the GSEs in the first place. The banking sector certainly needs a regulatory update, but why weren’t Fannie and Freddie reformed first?

The Dodd-Frank Act ignores substantive housing-finance reform almost completely. The most significant change is a requirement that mortgage lenders confirm a borrower’s ability to make payments by checking income, credit history, and employment status. The bill also limits certain compensation practices for mortgage brokers, such as yield spread premiums where the originator gets paid extra fees in exchange for lower upfront costs with a higher interest rate. Beyond this, the reform bill mostly just requires redundant or superfluous studies:

  • It directs the Treasury Department to study how to reform Fannie Mae, Freddie Mac, and the housing finance system as a whole — they’ve been looking at this issue for a while now.
  • It requires the Comptroller General to conduct a study of inter-agency efforts to crackdown on mortgage foreclosure rescue scams and loan modification fraud — this could have easily come from executive order.
  • And it orders the Housing and Urban Development Department to study the effect of Chinese-imported drywall on foreclosures — yes, that’s actually in the bill.

The Dodd-Frank bill does address the GSEs in some indirect ways. Section 1304 says the sale of GSE obligations in the future will go toward deficit reduction, not to pay for other projects (a surprisingly good idea). And Section 619 grants exemption to banking proprietary trading prohibitions if the investment is in US government debt or Fannie and Freddie obligations (an unsurprisingly self-serving idea).

The absence of reform for the GSEs wasn’t a surprise. Treasury Secretary Timothy Geithner testified in April that because Fannie and Freddie were so critical for the housing market today they should be left alone until the housing market recovers. The problem is that this means a “recovery” will be built on the same artificial and unstable foundation as the pre-crisis housing market.

None of the Dodd-Frank bill deals with the actual problems in the housing-finance system. Better underwriting standards are good, but the industry didn’t abandon responsible lending until Fannie and Freddie dropped their standards for conforming loans and incentivized riskier loans. A provision in the bill that allows mortgages to prepay without penalties may be nice for homeowners, but it has the potential to create some significant unintended consequences. One of the main reasons mortgage-backed securities were developed was to help avoid the investment risk of prepayments. The sooner a homeowner pays off their mortgage, the less interest an investor collects. But investing in a pool of mortgages increases the odds of a stable return on investment. Taking away banks’ abilities to charge fees for their services as they see fit will likely send financial institutions on a hunt for new, potentially risky ways of avoiding prepayment risk.

Where Congress missed the mark was in addressing how Fannie and Freddie distort the housing market. By pursuing their federally mandated goal of expanding credit to finance housing over the past decades, the GSEs artificially distorted mortgage prices down across the housing market. Peter Wallison and Edward Pinto estimate the GSEs took on about $1.6 trillion in nonprime debt as a direct result of pressure to meet affordable housing goals. This flood of financing for homes, in turn, put unnatural upward pressure on housing prices. The cheaper a mortgage is, the more demand for housing increases, driving up prices and bloating a bubble. Ironically, this undermines the whole goal of affordable housing.

Unfortunately, the cycle is starting over. Americans should practice responsible wealth-building that may or may not include buying a home with enough cash for a substantial down payment. But instead, there’s still an attitude that homeownership should be pursued at all costs. And this perception is being promoted from Washington. The government has been using fiscal policy to try to boost housing prices through tax credits and federally financed mortgage modifications. But with credit markets frozen, they’ve had to use the GSEs, controlled through conservatorship by the Federal Housing Finance Authority, to act as the sole housing financers on the block.

With Fannie Mae and Freddie Mac as the only source of housing finance available today, the market is essentially completely distorted beyond what it naturally would look like. This means price levels are artificially high, and the demand for homes is inflated because of the unnaturally low mortgage rates. This is setting the stage for another bubble in housing. This is the danger that Congressional reform should address.

This commentary originally appeared at on July 29, 2010: This article is the first in a series of commentaries on the Dodd-Frank Act.