Unfinished business

THE hefty financial overhaul that Barack Obama signed into law on July 21st (pictured) left behind one big piece of unfinished business. In 2008 Fannie Mae and Freddie Mac, mortally wounded from losses on loans acquired during the bubble, were placed in “conservatorship”, a halfway house between bankruptcy and outright nationalisation. There they remain, their losses duly covered with new injections of capital by the Treasury—$145 billion so far. Tim Geithner, the treasury secretary, has promised to address the matter of Fannie and Freddie by early next year but so far he has no answers, only questions (literally so: in April he asked the public to comment on seven of them).

The hesitancy is understandable. Millstones though they are, the two firms remain critical to the economy. In the first quarter they and Ginnie Mae (which unlike Fannie and Freddie has always enjoyed the explicit backing of the state) guaranteed 96.5% of all newly originated mortgages, according to Inside Mortgage Finance, a newsletter.

It is almost certain that the companies will no longer be allowed to hold a substantial in-house portfolio of securities. Yet the Treasury must still decide what to do with the $5 trillion in mortgages the companies guarantee. It could continue to pump money into the companies to cover losses on the loans as they mature; it could take explicit responsibility for them, inflating the national debt; or it could sell them to private investors.

The cost is apt to be high, regardless. Most of the losses of Fannie and Freddie result from mortgages originated before 2008. Mortgages originated in 2006 and 2007 account for 24% of Fannie's business but 67% of its credit losses.

In 2008 both firms began tightening their underwriting criteria and raising the fees they charge to guarantee mortgage-backed securities (MBS). Between 2007 and 2009 the proportion of their loans with a loan-to-value ratio of 70% or less rose from 31% to 49%, while the share with a loan-to-value ratio above 95% fell from 10% to 1%, according to the Federal Housing Finance Agency, their regulator. At Freddie Mac 3.9% of mortgages originated in 2008 were at least 90 days delinquent at the end of March 2010. For mortgages originated in 2009, the equivalent figure was barely 0.1%, although renewed signs of weakness in the housing market may yet cause that figure to worsen. “We'll be paying for the sins of the past for a long time, even though the current book of business is generating positive economic value,” says one official.

If Fannie and Freddie are making money now that they are pricing their insurance differently, this suggests that the private sector could do their job. (Ginnie Mae would continue to back loans to low-income families.) Michael Lea of San Diego State University notes in a recent paper that most other countries get by with far less government backing of mortgage finance, yet their home-ownership rates are not appreciably lower and none suffered as bad a housing crash (see table).

Most reform proposals to date, however, still envisage a permanent federal backstop. Donald Marron and Phillip Swagel, two economists who served in the administration of George Bush, say the federal government should sell an explicit guarantee at a rate designed to recoup future losses to Fannie, Freddie or a purely private competitor. Wayne Passmore and Diana Hancock, economists at the Federal Reserve, similarly propose a government insurance fund that would sell guarantees for any asset-backed security. The Mortgage Bankers Association, a trade group, proposes that the government charter a new set of purely private mortgage insurers who would then have to buy backup federal insurance.

In America 60% of mortgages are securitised rather than kept on banks' balance-sheets. That partly reflects Americans' preference for 30-year fixed-rate mortgages that can be pre-paid without penalty—a difficult sort of asset for banks to hedge. The securitisation rate is more than twice as much as that in Canada, Spain and Britain, the next-highest countries. Defenders of a federal backstop say this leaves the American system uniquely vulnerable during a crisis, when investors will refuse to buy any MBS that lacks a government guarantee. Mr Swagel and Mr Marron argue that investors will, probably correctly, assume that the government will always intervene, so it makes sense to charge for that guarantee explicitly.

Ruling out a private-sector solution may be premature. Guy Cecala of Inside Mortgage Finance says the government could start to revive the private-label MBS market by gradually rolling back expanded limits on the size of loans it will guarantee. Other changes to the mortgage market, such as better underwriting, greater use of covered bonds and more adjustable-rate mortgages, would help reduce the need for a guarantee. That said, the private sector is too weak to do much right now. However unnecessary in the long run, the government's dominance of the mortgage market will not end soon.

For further discussion of Fannie and Freddie, visit Economist.com/economics