The Long Goodbye: Letting Go of Fannie and Freddie

The federal government wants to get out of the mortgage business. But new research by assistant professor Manuel Adelino suggests such a move would only hurt the housing market.

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The federal government wants to get out of the mortgage business. But new research by assistant professor Manuel Adelino suggests such a move would only hurt the housing market.

In the boom before the bust, credit was easy and home values appeared bound for the stratosphere. Many analysts assumed the two were in a symbiotic relationship—that credit availability led to rising real estate prices, which then led to further credit availability. Tuck assistant professor Manuel Adelino, an expert in mortgage-backed securities and mortgage renegotiation, has looked at the data. In a paper soon to be presented, he shows a direct causal link between cheap loans and the rise of the housing market.

Adelino’s research is especially timely as Congress considers how to wind down Fannie Mae and Freddie Mac, the largest mortgage companies in the nation. The government took over Fannie and Freddie in 2008, at a cost of $135 billion, and there is broad consensus on both sides of the aisle that it is time to end its involvement. The only questions are how and when to do it.

The problem is that Fannie and Freddie essentially subsidize mortgages, keeping interest rates lower than they would be if the private market were functioning. According to Adelino’s research, if Fannie and Freddie were to disappear, “you would in all likelihood see a drop in housing prices nationwide,” he says.

To see the connection between interest rates and real estate values, it helps to go back to the salad days of 2006. Up until that time, Fannie and Freddie had about 70 percent of the mortgage market share, with the rest gobbled up by private securitization. But by 2006, that ratio had flipped. Private lenders were able to offer lower interest rates to homebuyers, and then sell those mortgages in bundles to investors, because of an implicit guarantee that Fannie and Freddie would cover any defaults. Adelino, who teaches the Futures and Options Markets elective at Tuck, says this credit bacchanal fueled the real estate bubble because zero-down, teaser-rate loans suddenly allowed people to afford more expensive housing.

But when it all came crashing down in the fall of 2008, the private mortgage market vanished, and Fannie and Freddie’s market share swelled to nearly 100 percent. “What that tells you,” Adelino says, “is that nobody else is willing to lend to homeowners at the same interest rate that the government agencies are offering right now.” With Fannie and Freddie at risk of going under, the government stepped in to prevent further damage to the housing market and the economy as a whole.

Just like the tax deduction for mortgage interest, the nationalization of the mortgage market is costing the government billions of dollars per year. Yet both are forms of economic stimulus, in effect making it cheaper for people to buy and own homes. With new home construction at an all time low, and the latest Case-Shiller Home Price Index showing a decline from December’s prices, dissolving Fannie and Freddie quickly could throw the U.S. economy into another recession.

In fact, the timing of the wind-down is one of the key points of disagreement between Republicans and Democrats. House Republicans recently unveiled a package of eight bills that would dissolve Fannie and Freddie over the next two to five years. The Obama administration envisions the process taking up to a decade.

Unfortunately, Adelino says, there will never be a good time to let housing prices drop. “The best case scenario is a gradual removal of the subsidy to try to make it go smoothly and avoid a shock in the market.”