This article examines the presence of Fannie Mae and Freddie Mac in the housing industry, yesterday, today and the changes ahead.

Fannie and Freddie: a history

Fannie Mae and Freddie Mac, also known as the government-sponsored enterprises (GSEs), are the backbone of U.S. homeownership. They’ve stood the test of time, but talk of reform puts their future in question.

Fannie Mae (short for the Federal National Mortgage Association) was founded in 1938 as part of the New Deal, FDR’s solution to the Great Depression. Prior to Fannie Mae’s existence, homeownership was reserved for the wealthy, or those able to put down 50% or more as down payment. Back then, the mortgage market had no guarantors. Lenders originating a home loan were on the hook for losses when the homeowner defaulted on their mortgage. Therefore, higher credit standards and mortgage terms with bigger cushions were required.

Enter the secondary mortgage market. Under this structure, lenders were able to loosen the reigns and allow more homebuyers to qualify at lower interest rates.

Here’s how the secondary mortgage market and Fannie Mae and Freddie Mac work:

When a homebuyer takes out a mortgage, the lender who originates the mortgage chooses to sell it to Fannie Mae or Freddie Mac about 60% of the time. All the mortgages sold to Fannie Mae and Freddie Mac are bundled together into mortgage-backed securities. Fannie Mae and Freddie Mac sell these securities to investors in the secondary mortgage market, who profit.

This system increases the pool of money available for lenders to issue mortgages. Without it, there may be less money to go around, making homeownership less accessible for homebuyers reliant on mortgage financing.

But there is some risk involved — if a homeowner defaults (or if many default, as occurred during the 2008 financial crisis and following recession), the mortgage-backed security decreases in value. Fannie Mae and Freddie Mac suffered huge losses when this occurred during the recent recession, which landed them in big financial trouble.

The federal government had two choices: let Fannie Mae and Freddie Mac fail — and likely see the end of the American Dream of homeownership — or bail them out.

The government chose to step in and bail them out, taking over operations. In 2008, Fannie Mae and Freddie Mac were placed under conservatorship of the U.S. government. The Federal Housing Finance Administration (FHFA) has authority over the GSEs and has the final say on critical matters.

GSEs face reform

U.S. Treasury Secretary Mnuchin names 2018 as the year for GSE reform. According to Bloomberg, Secretary Mnuchin does not believe the GSEs will be released from government control just yet. But an overhaul is likely.

What’s wrong with the current way Fannie Mae and Freddie Mac run under the FHFA?

One major pitfall comes to mind with the way the GSEs are currently set up, as they are, to spell it out, government-sponsored enterprises. Taxpayers are responsible for any losses the GSEs incur, as, even though the GSEs are still technically owned by private shareholders, the government is ultimately on the hook. Further, beginning in late-2017, the GSEs were given the go-ahead to keep some of their profits earned. The saying “private profits, social losses” comes to mind.

Another aspect of the GSEs that bothers conservatives in particular is the government authority over privately-owned entities.

One way reform might occur is for conservatorship to rollback, allowing Fannie Mae and Freddie Mac to return to their former setup where they had more autonomy.

Inching Fannie and Freddie out from under their governmental umbrella will have the positive effect of the GSEs focusing more on cost-saving measures and taking on more of the risks associated with mortgages. For example, GSE expenses increased 36% from 2012 through 2016, as they have little incentive to retain profits since all profits (until very recently) have been sent straight to the Treasury.

On the other hand, pushing the GSEs out from under the umbrella too quickly will have the opposite effect, leaving homebuyers (who are also taxpayers) high and dry. That’s because, without some semblance of government guarantee, Fannie Mae and Freddie Mac will likely lean away from the purchase of 30-year fixed rate mortgages (FRMs), returning to early-20th Century mortgage norms when private lenders held all the risk.

The impact of GSE reform

Without knowing what type of reforms Congress has in mind, it’s hard to say what impact GSE reform will have on the housing market, if any.

We do know that Fannie Mae, and in 1970, Freddie Mac, together helped boost California’s average homeownership rate from 44% in the 1930s to the current homeownership rate of 54%. Historically, the GSEs have made homeownership more attainable across the U.S.

But there might be a way to satisfy both homebuyers, who want the low rates and stable mortgage products made more prevalent by the GSEs’ existence, and taxpayers, who don’t want to be stuck with the $200 billion bill (the amount the U.S. Treasury committed to the GSEs in 2008) the next time the housing market crashes.

One potential reform under consideration at the FHFA is to replace the GSEs with several private guarantors.

Then, it’s up to lawmakers whether they want to stipulate any housing goals for the private guarantors. For instance, they may require the private guarantors to guarantee a number of affordable housing loans — or they may simply provide incentives for doing so.

Another matter to consider is whether they will require the private guarantors to serve all markets, as Fannie Mae and Freddie Mac are currently obligated to, or allow them to serve whichever markets are in their best interests.

Under the current administration’s hands-off approach to financial markets, the most likely move will be away from government regulation and towards self-regulation of private companies. But the details are anyone’s guess.

Interested in how GSE reform will play out in 2018? first tuesday will continue to post updates as they occur.