How the Reform of Fannie Mae and Freddie Mac Will Affect You

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On Friday, February 11, 2011, the Treasury Department announced the Obama Administration’s plan to reform the nation’s housing finance system, which entails winding down Fannie Mae and Freddie Mac within the next five to seven years. (See also: Root Cause of the Financial Crisis)

What Are Fannie Mae and Freddie Mac, Anyway?

According to the report, "Reforming America's Housing Finance Market," the Federal Housing Administration (FHA) created Fannie Mae in 1938 in response to mortgage market disruptions, widespread foreclosures, and declining homeownership rates. Fannie Mae essentially provided community banks with federal money to finance home loans in order to raise homeownership levels and increase the availability of affordable housing. Many years later, in 1970, the government formed Freddie Mac in order to expand the secondary mortgage market and provide competition to Fannie Mae, which had converted from a government sponsored enterprise to a private corporation in 1968.

Why Do Fannie Mae and Freddie Mac Need to Be Reformed?

For many years, Fannie Mae and Freddie Mac did what they were created to do — expand access to homeownership, particularly in parts of the country without access to traditional mortgages. Fannie and Freddie did this primarily by creating a secondary mortgage market in which investments were secured by mortgages. In the years leading up to the financial collapse, however, a number of factors (including easier access to credit, the creation of investments that shifted risk away from the mortgage originator, and the assumption that housing prices would rise indefinitely) caused Fannie and Freddie to fail. As a result of declining home prices, Fannie and Freddie experienced catastrophic losses and were ultimately placed in government conservatorship on September 7, 2008. They remain under conservatorship today.

What Reforms Is the Government Proposing?

There are three main paths to reform outlined in the government’s proposal. The first would largely leave the mortgage market to the private sector, leaving only limited programs to aid credit-worthy low- and moderate-income borrowers. The second plan is similar to the first, but it would also include a “backstop” mechanism to ensure continued access to credit in the event of another housing crisis. The final option would add a government reinsurance (essentially, a guarantee) for some mortgage-backed securities. Each of these would, as the report says, “dramatically transform the role of government in the housing market.” Currently, the government insures or guarantees more than nine out of ten new mortgages.

How Will These Reforms Affect You?

Although there are currently a number of unknowns associated with the plan, there are some things we can say for sure:

There will be increased pricing at Fannie and Freddie.

Fannie and Freddie’s implied government guarantee of their securities allowed them to save billions annually in borrowing costs. The new plan will end unfair capital advantages to Fannie and Freddie.

Conforming loan limits will be reduced.

Fannie and Freddie only purchase conforming loans, or loans less than $417,000 (or less than $729,750 in certain high-cost areas). If a loan is not conforming, and it is not able to be purchased by Fannie or Freddie, the lender will hold all risk of default on its books and will price accordingly. In other words, interest rates on those loans will likely increase (on new mortgages only — your fixed-rate mortgage would not change). Conforming loan limits are set each year by the Office of Federal Housing Enterprise Oversight (OFHEO) based on median home prices.

Nearly all lenders will require a 10 percent down payment.

Under the new plan, Fannie and Freddie would only be able to purchase and guarantee loans that had at least a 10% down payment. Lenders, in turn, would likely require at least 10 percent down. In the interest of fully honesty, I can say that I am not sure how the requirement of a higher down payment would affect the various down payment grants available to home buyers.

The maximum loan size that can qualify for Federal Housing Administration (FHA) insurance will decrease.

The main benefit to a homeowner of an FHA-insured home loan is a lower interest rate than might be obtained without the insurance. Decreasing the maximum loan size that qualifies for this insurance will mean that a home buyer’s interest rate on a loan that could have once qualified for FHA insurance, but no longer does, will be higher. The maximum loan size that the FHA will insure is determined by county. In addition, the price of FHA insurance will increase.

Only new mortgages are likely to be affected.

If your mortgage is already sold to Fannie or Freddie, fear not. Your interest rate will not arbitrarily rise before the loan's maturity date. It is likely, however, that your home loan will be sold to another party in the coming years. This is because the government's proposal also stipulates that Fannie and Freddie must sell off their investment portfolios at an annual pace of 10% or more. Check out this piece from the LA Times for insight about what to do if your home loan is sold.

All signs seem to be pointing to higher interest rates for new home loans or refinancings, though. For that reason, you might want to carefully weigh the costs and benefits of purchasing or refinancing your home now versus waiting. Of course, I would recommend doing your due diligence and talking to a knowledgeable lender or financial professional before making that decision.

Those are some of the most noticeable ways in which the winding down of Fannie and Freddie will affect you. The proposal is fairly broad, however, and there will undoubtedly be a number of other effects felt by homeowners, investors, and even renters. Following updates of the progress of this proposed reform will help you to make sound housing decisions regarding homeownership and refinancing.

What effects do you think the Treasury Department’s plan to dissolve Fannie and Freddie will have on homeowners in general, or you in particular? What questions do you have about the changes? Share your thoughts and questions in the comments!