Included in the President’s recommendations to the Joint Select Committee on Deficit Reduction is a proposal to increase the guarantee fees charged by Fannie Mae and Freddie Mac. While the proposal is entirely reasonable as a mechanism to reduce the ongoing federal subsidy for mortgage finance, it requires no Congressional authorization and is inappropriately included in the recommendation for the select committee. Indeed, on the same day the recommendations were released, Federal Housing Finance Administration (FHFA) Director Edward DeMarco announced that Fannie and Freddie would increase guarantee fees beginning in 2012. This essentially renders the President’s proposal moot and makes one wonder how many other gimmicks are included in the package.
According to the FHFA, agencies of the federal government buy or guarantee about 90% of all mortgages and 97% of all mortgages that collateralize mortgage-backed securities (MBS). The main reason the mortgage finance market is dominated by government is because Fannie Mae and Freddie Mac dramatically underprice the insurance that they provide to guarantee mortgage loans. According to Freddie Mac’s most recent quarterly report, the annual fee it charges to guarantee timely payment of mortgage interest and principal averaged 18.9 basis points (0.189%) in the six months ending in June 2011. This means that Freddie collects $415 per year to guarantee a typical $220,000 mortgage. This is obviously not close to being adequate relative to what a private sector financial guarantor would charge. For example, if 1 of every 100 mortgages defaults and the loss rate on those mortgages in the foreclosure process is 20% of the principal balance, the annual loss rate would be 0.2%, or slightly more than what Fannie and Freddie collect in annual fees. If the default rate reaches 1 of every 20 mortgages and prices take another leg down, the loss rate could rise to 2%, or 20-times what Fannie and Freddie collect in fees.
The President’s proposal would increase the average guarantee fee by 0.1%, to about 0.29%. The modest increase generates large sums over 10 years because it would be applied to all new mortgages Fannie and Freddie guarantee. For example, in 2010 Fannie and Freddie combined to guarantee about $1.05 trillion in mortgages. A 0.1% increase in the rate applied for guaranteeing investors’ timely receipt of interest and principal would increase receipts by about $1.05 billion. However, this is an annual fee that would be applied to all mortgages going forward. So, in the second year the GSEs would collect that additional $1.05 billion on all mortgages from the previous year in addition to the additional fees assessed on new mortgages guaranteed that year, for about $2.1 billion in incremental fees. Assuming ten years of 5% growth in mortgage origination volume and a constant market share of 67%, a 10 basis point fee increase could generate $100 billion in incremental revenue.
This $100 billion wouldn’t directly translate to budget savings. The additional revenues would reduce the anticipated future costs associated with delivering below-cost guarantees. As of March 31, the GSEs had combined to borrow $162 billion from the Treasury through the senior preferred dividend agreement. This is the actual amount of cash transferred from taxpayers to the GSEs. However, CBO also estimates an ongoing deficit cost from the below-cost guarantees the GSEs provide on new mortgages. This increases the deficit cost to $291 billion. On an on-going basis, CBO estimates that these subsidies on new mortgages will increase the deficit by $42 billion from 2012-2021. OMB seems to embrace the CBO baseline for this category as part of the President’s recommendations, which means the impact of the fee increase is to reduce the deficit contribution of Fannie and Freddie to about $14 billion over the next ten years.
Reducing subsidies in this manner is a positive step. More aggressive increases in guarantee fees would reduce the government’s market share, as the fees collected would eventually rise above the risk-adjusted cost of providing the guarantees, which would make private sector entry profitable. As FHFA Director Edward DeMarco explains, “a logical next step in conservatorship is to continue down the path already started of gradually increasing guarantee fee pricing to better reflect that which would be anticipated in a private, competitive market.” As luck would have it, in his capacity as FHFA Director, DeMarco serves as conservator of Fannie and Freddie and has the power to make the change now. And, it appears, he’s already decided to do so. In fact, he suggested that the announcement of a “series of periodic, gradual price increases… should be expected in 2012, with some prior announcement as is typically done by each company.”
So while the policy makes sense, it is unclear what, exactly, is left for Congress to decide, or why the net deficit impact of this policy should be credited to legislation that has nothing to do with the policy change itself? Deficit reduction in the mortgage finance space should come from real reform, like a comprehensive plan to eliminate mortgage subsidies entirely.