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Did the Government Learn Anything From the Mortgage Crisis?

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This may come as a surprise, but for some time now, the Obama Administration and members of both political parties have actually been in sync on a common goal: closing down Fannie Mae and Freddie Mac, the government-sponsored entities (GSE) that Congress bailed out during the financial crisis.

Fannie and Freddie are, for the most part, competitors in the same business. The companies purchase U.S.-based residential mortgages (for single- and multiple-dwelling properties) that have been originated by banks and other lenders. The loans are packaged and sold to investors via the securitizations that Fannie and Freddie structure and guarantee against loss from default. Prior to the financial crisis, investors and creditors expected this guarantee to be backstopped by the federal government.

For years, things went along swimmingly. That is, until avarice trumped reason: fortune-seeking property buyers, permissive lenders and yield-hungry investors all came to believe that home prices would continue upward, defying the gravitational limits of a market-based economy.

So when the defaults began to mount and real estate prices began their free-fall, the GSEs hit the skids. Government officials had to think fast—should the feds make explicit the financial support that the investment community inferred to be in place, or should they let Fannie and Freddie suffer the consequences of their own reckless decisions?

From Crisis to Opportunity

In the end the government blinked, for a couple reasons.

To start, perception had become reality. The magnitude of Fannie’s and Freddie’s contingent liabilities—the $3.8 trillion dollars of corporate guarantees that were outstanding as of September 2008—were beyond Fannie and Freddie’s ability to cover. That coupled with the fact that the feds had done nothing to controvert their implied guaranty left officials with little choice but to intervene, given the systemic threat that a GSE-default posed.

Second, as reckless as Fannie and Freddie may have been, they still served a critically important purpose in the market: ensuring liquidity. The more mortgages these companies purchased, the more loans the originating lenders were able to make—a function that is as true today as it was more than five years ago when the financial system teetered on the brink.

Now that the dust has settled, many politicians would like to see Fannie and Freddie—the poster children for some of the worst financial mismanagement of our time—slip ignobly into the night. But there’s been a hiccup. Apparently, the companies haven’t been doing too badly ever since the feds placed them in conservatorship. In fact, they’ve done so well that they’ve been able to repay nearly all the money the government poured into their operations.

Perhaps that’s why some in D.C. are keen on eliminating Fannie and Freddie in favor of private sector players (which may have something to do with socializing losses and privatizing gains—who knows?). But transition from an operation that’s been blessed by the government without disrupting the flow of affordably priced debt will be hard (if not impossible) to accomplish without the feds’ continued involvement. So the idea is for the private sector to pay for the governmental guarantees that make the system work.

Other than for the part about buying guarantees, if this scheme sounds familiar to you, it may be because it’s exactly the approach the government took nearly 50 years ago with the implementation of the Federal Family Education Loan program.

Lessons Learned?

But it’s not so much that the direction in which Congress seems to be headed is reminiscent of an era that came to an end in 2010, when a Congressional Budget Office study showed that it costs the government more to guarantee the loans made by others than it does to make them on its own. The greater concern is whether lawmakers have learned that making loans is a lot easier than collecting them—that well-intentioned incentives on the front-end can result in undue hardships on the back.

For example, we now know that financially distressed student-loan borrowers have been having a terrible time restructuring their unaffordable loans. The reason for that is plain: none of the stakeholders—originating lenders, after-the-fact investors and loan-servicers—are excited about rewriting transactions for longer terms, at lower rates or, God forbid, for lesser loan values because doing so negatively affects their returns. In fact, why expend any effort to remedy a problem that the government is obligated to cure?

Whether or not Fannie and Freddie come to an end at this time, it’s important that legislators pay serious attention to the back-end of the mortgage-lending process that they are facilitating with front-end incentives. They can do that by requiring that the structures of these loans—securitized or not—are appropriately accommodative to the needs of consumers who experience financial hardship during the life of their loans.

A good way to enforce that would be to limit the government’s guaranty only to those loans that have been restructured by all means possible (term extensions, interest-rate abatements, payment modifications and so forth) up to the point of forgiving a portion of the principal. In other words, the stakeholders would be required to take responsibility for the credit decisions they make and the loan-servicing methodologies they employ before they ask the taxpayers to bail them out again.

It’s food for thought.

This story is an Op/Ed contribution to Credit.com and does not necessarily represent the views of the company or its affiliates.

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