Fannie & Freddie Get a Stay of Execution... for Now

Yet another ideological tug-of-war is happening in the Senate.

This one has to do with what was billed as a bipartisan effort to eliminate the Federal National Mortgage Association and Federal Home Loan Mortgage Corporation (Fannie Mae and Freddie Mac) in favor of a private market solution for residential-mortgage loans.

A group of Democratic senators — Charles Schumer (N.Y.), Jack Reed (R.I.), Jeff Merkley (Ore.), Elizabeth Warren (Mass.), Robert Menendez (N.J.) and Sherrod Brown (Ohio) — say they will not support the legislation to wind down the agencies introduced by Sens. Tim Johnson (D-S.D.) and Mike Crapo (R-Idaho) as it’s currently drafted, even if both the House and the Obama administration are receptive to it.

Fannie and Freddie, as you may recall, are among the poster children for financial mismanagement in the run-up to the recent economic collapse. The companies were kept afloat with nearly $200 billion in taxpayer-backed loans that, to the two companies’ credit, have been fully repaid. And then some.

The great concern of the renegade senators is that the Johnson-Crapo bill falls short when it comes to helping lower- and moderate-income earners become homeowners. They also worry that the enhanced eligibility requirements the legislation prescribes would make mortgages more expensive for those who are able pass muster.

To the extent that home ownership continues to be a national priority — a debate that creeps onto op-ed pages whenever there’s talk about curtailing the tax deduction for mortgage interest — those concerns should certainly be addressed.

There is, however, another matter that deserves equal consideration. It has to do with the manner in which mortgages are financed by lenders after the fact.

The prospective legislation provides for government guarantees of the loans that financial services companies will be originating in Fannie and Freddie’s stead. But don’t confuse loan guarantees with loan funding. That money has to come from someplace — whether from bank customers whose deposits are used for institutional lending activities, or, more likely, from the capital markets in the form of structured-finance transactions, such as securitizations.

As we know from our experience with federally-guaranteed student loans that were originated in the private sector and later sold to others, investor interests are often at cross-purposes with those of borrowers. Financially distressed consumers, for example, need their loans to be restructured or modified in order to stave off default. Investors, on the other hand, are less than eager to embrace any arrangement that has the potential to diminish their rates of return. Consequently, the loan servicers, which are paid by the investors to administer these transactions, are unwilling to take remedial actions that conflict with the objectives of their benefactors.

The government, however, has a pretty big chip in this game: the value of its guarantee.

So why not call in that marker and require securitization structures to allow for loan modifications by distressed borrowers? In fact, wouldn’t it also make sense to preclude lenders from making claims against the government (and, by extension, the taxpayers) unless they have first done all they should to keep their problem loans afloat?

Sure, troubled-loan workout arrangements often will negatively affect investor rates of return. Then again, the value of the government’s ultimate backstop is what differentiates this investment from most others.

As lawmakers continue to debate the legislation that’s before them now, someone better have the guts to address the back-end of a process many seem hell-bent on changing.

Otherwise, these post-Fannie and Freddie residential mortgages will be second in line for the next round of bailouts. Right after student loans.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.