Attention deficit hawks: How to reform Fannie Mae and Freddie Mac...and cut billions of federal spending

In his March 5 piece, Washington Post columnist Neil Irwin bemoans the lack of legislation to reform Fannie Mae and Freddie Mac, the now-bankrupt federally-backed funders of home mortgages. His point would be further strengthened by considering an additional failure of the organizations, one that, if corrected, could hold the key to reinvigorating housing markets and preventing future mortgage defaults, and at the same time reducing the amount of government spending on bailing out the investors in defunct mortgages.

Mr. Irwin notes that:

"Fannie and Freddie occupied a strange place in the American corporate landscape. They were private companies with shares traded on the New York Stock Exchange, dedicated to maximizing profits for shareholders. Their executives were paid well and they employed scores of lobbyists. But they also had the implicit backing of the U.S. government, ensuring that the millions of home mortgages they packaged were nearly as risk-free as lending to the government itself. Heads, we (Fannie and Freddie shareholders) win. Tails, you (the taxpayer) lose."

He goes on to observe that:

"They have been vilified, particularly by conservatives, [] as being major drivers of the financial crisis (unfairly)."

The reason that he calls this vilification unfair is that neither organization played a leading role in the explosion of sub-prime lending. Both were late arrivals to buying sloppy loans (or bonds supported by sloppy loans) and sub-prime loans were a tiny proportion of their portfolios—clearly not enough to cause the bankruptcies.

So what did cause these bankruptcies that have cost taxpayers the $131 billion that Irwin noted in his article?

There is evidence suggesting that some 1/3 of the defaults were caused by the failure of both corporations to consider systematically the costs of transportation and energy in determining whether a household qualifies for a loan. For a typical mortgage borrower, these two expenses are expected to be more than $375,000 over the 30-year life of the mortgage—almost twice the cost of the loan repayments on the typical house at the height of the housing bubble ($225,000) in exurban sprawl, where much of new housing was being built.

Most importantly, buyers have choices of houses that could require high or low monthly expenses. Depending on the home’s location and energy efficiency, energy costs easily could be lower than $1000 a year or higher than $5000, while transportation costs are often lower than $5000 a year but also may be close to $12,000.

However, the lenders do not take into account this variation, but rather assume an average value for energy costs that is lumped together with other assumed monthly expenses.  Recent evidence suggests that this methodology is faulty and that mortgage defaults are correlated to higher transportation and energy costs. Simple consideration of the cash flow of the prospective homeowner suggested that this failure to account for transportation costs should lead to greater defaults, and recent studies of actual default histories show this to be correct with very high statistical significance.

What have the agencies done in response?

Nothing.

Instead of looking for solutions that do not hurt the economy, they have tightened up their requirements for credit score and income, forcing lots of people, especially the younger generation, out of the housing market. This action has hobbled the housing market’s recovery, killing jobs. Demographic analysis shows that the overwhelming bulk of future housing demand is for energy efficient new houses in compact, walkable, transit-served neighborhoods where homes typically cost a little more to buy. These extra costs are more than compensated in reduced car and utility expenses, but Fannie and Freddie ignore this.

But worse, if you care about wasteful federal spending, this failure to change—and failure to change is the main thrust of what Mr. Irwin’s piece is about—is likely to expose the federal government to further expense, as Fannie and Freddie continue to finance homes with unaffordable transportation and energy costs that are at greater risk of default. Again, the losses are expressed as direct federal spending. Not just spending in general, which at least benefits SOMEONE, but wasteful spending that could be avoided and that does not create jobs or prosperity.

This is a problem that can be solved directly by the Administration, or by legislation. Last session the bipartisan SAVE Act, which would have directed the mortgage agencies to include energy expenses when evaluating affordability, would have done this, at least for energy costs.,

The benefits of doing so would be the expansion of home ownership, the creation of more and less costly housing choice for those people that prefer efficient, well-located homes, with the attendant jobs in the construction industry, less need for driving, which not only saves money for households but also reduces pollution and congestion, and the creation of more stable investment markets for mortgage-backed securities that is not dependent on a blank check from the taxpayer.

On the flip side: what has the nation got to lose?