When running as intended, what cost difference does Fannie and Freddie make to the mortgage payment of the average house?

BY busadmin  September 11, 2008 at 11:31 AM EST

Fannie Mac, file photo

Question/Comment: How do other nations subsidize housing (to the same end that Fannie and Freddie do in the U.S.)?

When running as intended, what cost difference does Fannie and Freddie make to the mortgage payment of the average house?

If the government is the ultimate support for the viability of so many mortgages (I understand not all), why did we get into the trouble of defaults in mortgage markets? Is it simply the non-government backed mortgages of Fannie and Freddie turning upside down or is it all these financial instruments “betting” on the viability that are failing. It seems that it is so confusing that a true valuation isn’t possible until it fails – then it’s by hindsight.

Paul Solman: I was told that other day that during a recent two-week period, 85,000 of you visited this page and stayed here for an average of seven minutes and five seconds. Assuming that it wasn’t 84,999 of you scanning the page for moments and one just ogling my photograph for two weeks, there are a lot of you, and you stick around for awhile.

In the spirit of reciprocation, then, I’m going to try a thorough answer to this question, since it pertains to the economic thunderbolt of the moment: the Fannie/Freddie fiasco.

As to the first part, I’ve made inquiries but haven’t heard back yet. In short, I don’t yet know about subsidized housing elsewhere in the world.

As to the rest of your question, let’s start with “running as intended.” What might that mean? Let me use this part of the question to explain Fannie and Freddie in a more general way. Follow me, if you would, through this little internal dialogue:

Why Fannie and Freddie at all?

To encourage home ownership.

How?

By providing mortgage money and insurance at a lower cost to borrowers.

Why a lower cost?

Because Fannie and Freddie were deemed so safe, they could borrow money at a lower cost, which they could then pass along in the loans and guarantees THEY made.

Why deemed so safe?

Because of implicit government backing.

But wait a second. The government is paying only three percent to borrow money for five years (i.e., five year Treasury bonds are “yielding” three percent, as they were last I looked).

Fannie and Freddie, meanwhile, have had to pay some two percent higher than that. As a result, a five year mortgage is costing home buyers roughly 6 percent a year. So if Fannie and Freddie were deemed so darn safe, how come it cost them so much more to borrow than it costs the U.S. Treasury?

Well, they weren’t deemed COMPLETELY safe. Maybe the government wouldn’t fully back their loans in the event that they ran into trouble. (A highly UNLIKELY event, but hey, the world’s a quirky place.) Safe is “a sure thing.” The closest thing to sure, when it comes to lending, is that the U.S. government will pay you back. That’s why the interest rate it pays is called the “risk-free” rate. Fannie and Freddie were not paying the “risk-free” rate.

So the risk of Fannie and Freddie not paying back its loans was built into their cost of borrowing. Not a whole lot of risk compared to, say, the Ford Motor company, which is paying seven percent more than Uncle Sam to borrow money at the moment – for a mere 90 days at a time.

In other words, investors demand a huge risk premium to let Ford use their money for just three months. And even that is not a whole lot of risk compared to those of you borrowing to bet on next week’s NFL games, say, or take a plunge on the eighth horse at Hialeah. You gamblers could be paying as much as 25 percent a week to the local loan shark. And you’re considered so risky, the lender throws in a bonus incentive: if you pay, he won’t break your legs.

But let’s get back to home mortgage lending. There’s been a two percent spread between what Fannie and Freddie pay to borrow and what Uncle Sam pays. Since F&F borrow the money to, in effect, lend it to you to buy a house or guarantee the mortgage you get from someone else, you’re paying that spread.

But suppose Uncle Sam were to just borrow the money and lends it to you himself? Best case, you save two percent on your mortgage! Mortgage rates plummet!! Houses become cheaper to buy!!! Home buying rebounds!!!! Home prices start to rise!!!!! Housing crisis solved!!!!!! Economy soars!!!!!!! To quote Voltaire’s Dr. Pangloss (and spare you further !s), everything turns out for the best in this, the best of all possible worlds.

Yeah, but then the U.S. taxpayer would be borrowing on behalf of every home buyer who qualifies. And any time a buyer can’t meet her or his payments, it’s the taxpayer who loses. Mortgages become cheaper, alright, as the spread between “Treasuries” (Uncle Sam’s debt) and F&F debt shrinks, but that’s because the home lending industry has been nationalized.

Now if that’s the right way to finance home buying, why not have the government borrow so we can buy all sorts of things? Why not have the government back our credit cards, for example, on which right now we’re paying – on average – 14 percent a year? Or lend to those of us who bet on the NFL. Cut those rates to two percent — the interest rate Uncle Sam is paying to borrow for a year – and you’d have a world so good, even Dr. Pangloss would be speechless.

Unfortunately, you might instead have runaway inflation, a dollar that knows no bottom, and an economy in tatters. Because if the government simply borrows on behalf of every purchase its citizenry indulges in, you haven’t got a financial system anymore. Uncle Sam would simply have taken on all the risks of all borrowers. And under those circumstances, who would lend to Uncle Sam? Or better, at what price? What do you suppose would happen to U.S. interest rates?

Okay, back to the present and the original question: When Fannie and Freddie are “running as intended,” what is the cost difference to the average house? (And by the way, this is a great question, even if it’s taken me the entire 7:05 to get to it.)

My way to answer this is to ask a further question: What would the average homeowner have to pay if there WEREN’T a Fannie or Freddie? Or, in terms of the discussion above, how much more than Uncle Sam’s “risk-free” rate?

In the glorious world of ever-rising U.S. home prices, maybe only a few percent more, since the collateral would never lose value. But in today’s world, ask yourself this, and answer honestly: How much would you want in interest from someone you don’t know for a loan to buy a house? How much would you insist they themselves invest as a down payment? What kind of collateral, besides the home itself, might you demand? What co-signers? Etc.

Whatever the difference is between the price a prudent lender would demand and what home buyers can actually get from Fannie and Freddie (or F&F-guaranteed loans) is the cost difference F&F represent. They were “intended” to make a difference, remember, to facilitate home buying: that’s their whole reason for being. But how much risk do taxpayers take on in order to make home buying more affordable? That was always the implicit question when the U.S. was “sponsoring” these “enterprises.” It’s the explicit question now that the U.S. has taken them over.

Oops, our seven minutes are up. But for you speed readers with time to burn, there’s still the third part of the question. I understand it to be: If the government was implicitly supporting F&F, why were they in danger of default?

This is a contentious issue. I’ve seen some suggest that F&F could have stayed in business. Most experts I respect agree with infinitillionaire Warren Buffett, however: the government had no choice and did the right thing.

One initial skeptic of the government’s action, the eminent Cal-Berkeley economist Brad DeLong, responded to a question from me asking if I could cite his skepticism:

“Fine—but please add: ‘If only spreads between Treasury and GSE debt had stayed at normal levels, FNMA and FHLMC could have stayed in business together earning perhaps $15B a year—and there would then have been no reason to worry about their future. Only the fact that spreads were and stayed abnormally large created any reason for spreads to be abnormally large…’”

It’s a genuine multiple-equilibrium situation here. We thought that it would be resolved by last month’s bill—Paulson thought it would be resolved. And we are all surprised that it wasn’t.”

Brad is a really smart guy who really knows his economics. (And by the way, his blog is worth checking out). Leaving the “multiple-equilibrium situation” explanation for another day, what he means is that when Secretary Paulson SAID the government was backing F&F last month, the spread between Uncle Sam’s interest cost and F&F’s was expected to shrink. Less risk lending to them, right?

Instead, it widened. That meant F&F were paying MORE money to stay in business. That meant not only potentially higher mortgage rates, but LOWER PROFITS for F&F, since their main expense was rising. Or no profits at all.

Floyd Norris in the New York Times Sunday, Sept. 7, explained the horns of the dilemma (and explained them well).

In Monday’s Times, Andrew Ross Sorkin skeptical of Secretary Paulson’s quite possibly political approach.

The point is F&F were having trouble borrowing because investors were afraid: Would Uncle Sam really back up their debts if too many of their mortgages went bad and stopped paying? But, thought the government, if investors stopped lending to F&F, there’d be no money to relend for more mortgages and the giants might fail, thus freezing the financial system. Same fear as with Lehman Brothers today, Bear Stearns months ago, Long-Term Capital Management a decade ago.

Reread the paragraph with all the exclamation points, going in reverse, and you see the nightmare scenario for politicians as variously hued as Hank and Frank (Paulson and Barney). Yes, ultimately it was the markets, betting on default and in so doing, making it more likely. That’s how markets work – for better and worse.