Chapter 7

Charter Repeal Would Hurt Families

Every day and all across the nation, Freddie Mac and Fannie Mae ensure a stable supply of low-cost mortgage funds at no cost to the government or taxpayers, as Congress intended. Charter repeal would hurt families in a number of ways: Mortgage rates would rise and homeownership rates would fall, especially for low- and moderate-income and minority families. Homeownership would be pushed out of reach for one million American families. As more borrowers choose ARMs, defaults would increase and more people would lose their homes.

A. What’s at Stake for American Families

A home is both shelter and investment, representing a major source of wealth for many families. Home equity comprised more than one-half of net wealth for most homeowners in 1992. 1 Approximately 80 percent of all households will own a home at some point in their lives.2 Financing a home purchase with a mortgage allows a household to accumulate equity as the mortgage principal pays down and the home appreciates in value. As homeowners retire and experience income declines, equity accumulation becomes an important supplement to pensions and Social Security income. 3 The median household with a head between the ages of 65 and 70 has liquid financial assets of $10,000, housing wealth of $38,000 and Social Security and pension wealth of $113,400.4

To finance America’s housing, each day numerous types of institutions conduct countless transactions to move billions of dollars from national and international capital markets to a vast array of American homeowners whose single-family homes were valued at approximately $9 trillion in 1995.5 At the same time, this vast financial system channels a vital flow of funds into the housing sector of the economy, which accounted for about 14 percent of the nation’s gross domestic product in 1994.6 Thus, the housing finance system supports a critical source of wealth for American families and a critical segment of the economy.

Charter repeal would shake investor confidence in the strength of this system. This would put people’s homes--and dreams--at risk.

B. Mortgage Rates Would Rise

There is widespread agreement that repealing the charters of Freddie Mac and Fannie Mae would cause mortgage rates to rise.7 Many factors would cause this to occur. The removal of the Freddie Mac and Fannie Mae guarantees would cause the investor base to contract, resembling today’s jumbo market. To meet the demand for mortgage funds, private-label issuance would need to increase 500 percent. Alternatively, as depository activity swelled, banks and thrifts would need to increase deposit rates to attract the needed funds. Borrowers would pay these increased costs in the form of a one-half of a percentage point or greater increase in mortgage rates. This means, for example, that mortgage rates would rise from 7.5 percent to at least 8.0 percent.

Mortgage rates also would rise because of the loss of national diversification. By purchasing loans representing communities across the country, Freddie Mac and Fannie Mae are able to create nationally diversified mortgage portfolios. Diversification reduces the risk of the portfolio because economic downturns and real estate weaknesses in one part of the nation are offset by solid real estate markets in other regions. Geographic diversification represents the least costly way to mitigate risk; a nationally diversified portfolio requires only one-third to one-half as much capital as a portfolio concentrated exclusively in only one of five geographic regions.8 Because risks are lower, less cushion is needed to cover loan losses, which means lower financing costs for homeowners.

Even large depositories would be unable to match the geographic diversification of Freddie Mac or Fannie Mae. Without widespread geographic diversification, depositories would have to add significant amounts of capital to cover the same amount of risk. Higher capital costs, in turn, would increase the rates on mortgages. If depositories were not adequately capitalized against real estate losses, the government would be exposed to more risk.

Higher mortgage rates would substantially increase housing costs for families. For example, the average single-family loan purchased by Freddie Mac in 1995 was $96,000. If mortgage rates rose by one-half of a percentage point, a family with this size mortgage would pay about $12,000 more in interest over the life of the loan. If there were a particularly strong demand for loans, interest costs could rise much higher.

In addition to homeowners, some families would face higher rents. About one-half of renters live in single-family (one- to four-unit) properties. If holders of these rental properties passed through to tenants the one-half of a percentage point increase in the mortgage rate, these tenants would pay about 4 to 5 percent more in monthly rent.9

C. Foreclosure Risk Would Increase

Families continue to show a distinct preference for fixed-rate mortgage loans; approximately three-quarters of all conventional, single-family mortgage debt outstanding is fixed-rate.10 Families generally prefer these loans because of the certainty of the monthly payment obligation and an aversion to bearing interest-rate risk.

Freddie Mac and Fannie Mae, through their superior access to capital markets, are effective in attracting investors for long-term fixed-rate mortgages. Congress has recognized the important role played by Freddie Mac and Fannie Mae in making 30-year fixed-rate mortgages widely available. The legislative history of the Secondary Mortgage Market Enhancement Act notes that:

Traditional mortgage lenders, thrifts and banks are less willing or able to hold long-term fixed-rate mortgages in an uncertain interest-rate environment. While these institutions continue to originate and service mortgages, a large portion of the mortgages they originate are sold to [Freddie Mac and Fannie Mae].

Charter repeal would remove the tools the companies use to support a vibrant market in long-term fixed-rate mortgages. In a post-repeal housing finance system, interest rates on fixed-rate mortgages would rise more than ARM rates, reflecting the traditional reluctance on the part of depositories and other institutions to invest in long-term fixed-rate mortgages. As the difference between interest rates on fixed- and adjustable-rate products increases, consumers would be more likely to choose ARMs.12 In this way, the post-repeal conventional market would come to resemble the jumbo market.13

In choosing ARMs over fixed-rate mortgages, families accept the risk of rising mortgage interest rates. Widespread movement into ARMs would shift aggregate interest-rate risk away from institutional investors to families who are generally less capable of managing this risk. Because ARMs experience higher foreclosure rates than fixed-rate loans, more Americans would lose their homes.

D. Required Down Payments Would Rise and Homeownership Rates Would Fall

Many families, especially first-time buyers, choose low-down-payment loans to finance their home purchases. For example, 13 percent of Freddie Mac’s 1995 purchases were mortgages with down payments of 5 percent. The supply of low-down-payment conventional loans would contract in a post-repeal mortgage market, as it would begin to resemble the current jumbo market. As one recent study noted, “Investors generally require greater equity in nonconforming than in conforming loans.”14 Thus, borrowers would experience greater difficulty finding lenders who would offer low-down-payment loans without government insurance.

Higher mortgage rates and higher required down payments would reduce homeownership opportunities for lower-income and minority families and delay ownership for many renters. As shown in Exhibit 24, families buying homes in lower-income and higher-minority neighborhoods more often choose low-down-payment loans. Today these loans are widely available; with charter repeal the supply of these loans would decrease substantially. Furthermore, to the extent that lower-income and predominately minority neighborhoods are characterized by low levels of competition among financial service providers, loan rates and fees could rise even more in these neighborhoods.

A recent study estimated the impact of repealing the charters on homeownership rates (Exhibit 25). 15 The study concluded that not only would mortgage rates rise, but low-down-payment loans either would become difficult to obtain or simply unavailable. Aggregate homeownership rates would decline by about 2 percent. That means homeownership would be pushed out of reach for about one million families. Homeownership rates would drop far more sharply for African-American and lower-income families--by 5 to 6 percent. Younger families would experience even larger declines in homeownership rates because of the importance of low-down-payment loans to this group.

Today, the government and the private sector are working together to expand homeownership opportunities for minorities and low- and moderate-income families. Particular attention is being paid to closing the homeownership gap for African-American families. Charter repeal would deal a setback to these efforts.

Freddie Mac and Fannie Mae currently have statutory housing goals to purchase loans that support housing for low- and moderate-income families and housing in lower-income and higher-minority neighborhoods--areas with unmet credit needs. During 1993-95, Freddie Mac and Fannie Mae purchased more than $420 billion in loans that met the housing goals. Charter repeal would eliminate these statutory goals.

E. Property Values Would Decline

A jump in mortgage rates from charter repeal would cause a one-time drop in property values. 16 This decline in house values would occur at a time when house prices in some neighborhoods are barely keeping up with general inflation.

A decline in property values would have three deleterious side effects. First, it would lead to an increase in foreclosures because when homeowners try to sell a house that has lost value, they may not be able to repay the principal balance. Federal mortgage insurance and guarantee programs and federally insured depositories would face additional losses, thus increasing potential taxpayer liability. Second, a decline in housing wealth could cause consumers to reduce their other spending, with corresponding effects throughout the economy. Third, the reduction in real estate values would reduce property-tax revenue to local governments, necessitating a reduction in government services or an increase in tax rates.17

F. Outstanding Securities Would Lose Value

Today, investors in the global capital markets have absolute confidence in Freddie Mac and Fannie Mae securities. These securities are often exempt from investment limits imposed by pension funds, depositories and other investors.

Freddie Mac and Fannie Mae have approximately $1 trillion in mortgage-backed securities outstanding and more than $200 billion in long-term debt outstanding. 18 These securities are held by depositories, insurance companies, pension funds, mutual funds and other investors (principally foreign investors, securities dealers, and private individuals) as shown in Exhibit 26. Freddie Mac and Fannie Mae also have $200 billion in short-term debt outstanding.

Charter repeal would create numerous uncertainties in the securities markets. Even in the U.S. Treasury market, uncertainty can shake investor confidence.19 The effect of charter repeal would depend on how Congress chose to treat existing Freddie Mac and Fannie Mae securities. Congress could choose to extend a full-faith-and-credit guarantee on the securities, comparable to Ginnie Mae and Treasury securities. While this would protect investors, it would also increase the direct taxpayer obligation.

At the other end of the spectrum, Congress also might choose to do nothing. This could precipitate a large sell-off of Freddie Mac and Fannie Mae securities as investors reduced their holdings to meet state- or investor-imposed limits on concentration of investments. Lack of information or misinformation about the post-repeal securities would exacerbate this problem.

In this case, investors would require higher yields to compensate them for the greater risk. If they require a one-half of a percentage point increase in yield, security values would fall by approximately 2.0 to 2.5 percent. Security values could fall by a larger amount in the wake of such a major market change.

A 2.5-percent decline in security values means that banks and savings institutions could experience losses of $11 billion, insurance companies $4 billion, pension and mutual funds combined $6 billion, and other investors $8 billion, based on their current holdings. For depositories these potential losses would total about 2.5 percent of their aggregate capital; institutions holding disproportionately more securities would face higher loss rates.20 Because losses erode capital, some institutions likely would restrict lending temporarily as they replenish their capital bases. Losses borne by depositories, which benefit from federal deposit insurance, could result in a significant drain on the insurance funds for banks and savings and loan institutions.

Investment losses to individuals also would be significant. Currently, 20 percent of Freddie Mac and Fannie Mae mortgage and debt securities are held in pension and mutual funds. Following charter repeal, individuals saving for education and retirement would stand to lose $6 billion if the value of these securities declines.

Because Main Street is vitally connected to Wall Street, homeowners also would lose. As the yields investors required to hold mortgage-backed securities increased, so too would home mortgage rates.

G. American Families Would Lose

Families are borrowers, property owners or renters, investors and taxpayers. If Freddie Mac’s and Fannie Mae’s charters were repealed, families would lose in each one of these capacities:

• As borrowers, families would pay higher interest rates, have less opportunity to obtain the long-term fixed-rate mortgages they prefer, and be forced to shoulder more interest-rate risk and make larger down payments. One million families would be deprived of homeownership opportunities.
  

• As property owners, families would suffer an erosion of the wealth they have established in their homes, coupled with the prospect of higher property tax rates or reduced government services.
  

• As renters, families would face higher monthly rent payments as investors in single-family properties pass increased mortgage costs along to their tenants.
  

• As investors, families would face losses in their pension, mutual fund and other individual investments.
  

• As taxpayers, families would bear increased risk as more mortgage lending migrated to government programs that are explicitly backed by the full faith and credit of the U nited States and to depositories with government-insured deposits and low-cost FHLB advances.
  

All this would occur to reduce the taxpayer risk posed by two companies that, by the admission of every reputable expert on their finances, pose no measurable risk to the government and have been increasing their capital substantially on their own initiatives.

Charter repeal is a losing proposition for American families.

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