If Obama eliminates Fannie Mae, Freddie Mac, will mortgage rates go up?

Republicans and Democrats don't see eye to eye when it comes to the economy, but in one area, at least, they've reached broad agreement: Fannie Mae and Freddie Mac, the mortgage finance giants bailed out by the government in the wake of the housing crash, have to go.

President Obama nudged the idea forward this week in a speech in Phoenix, one of the areas hardest hit by foreclosures and depressed housing prices in the aftermath of the real estate bubble.  

Reform should "lay a rock-solid foundation to make sure the kind of crisis we went through never happens again. And one of the key things to make sure it doesn't happen again is to wind down these companies that are not really government, but not really private sector; they're known as Freddie Mac and Fannie Mae," Mr. Obama said. “For too long, these companies were allowed to make big profits buying mortgages, knowing that if their bets went bad, taxpayers would be left holding the bag," he said, referring to the firms’ implicit government backing that inculcated them from risk in case loans went sour. "It was ‘heads we win, tails you lose.’ ”

But in pushing to eliminate Fannie and Freddie, reformers face a problem: Whatever they do is likely to raise mortgage interest rates, especially for lower income Americans, which would be politically unpopular. 

“In almost all of these [proposals] because there is no government guarantee, it’s likely that mortgage rates will be higher,” says David Berson, an economist with insurance company Nationwide and former chief economist for Fannie Mae. “That means there will be some creditworthy people who will have to pay more, or may not get a mortgage a all. That makes it harder for lower income buyers.”

Further privatizing and reducing the role of Fannie and Freddie has been a popular DC notion for the past few years, so the reaction to Obama’s speech was largely positive. “I was trying to get rid of them in 2004 and 2005, so I see this as a sign of progress,” says Mark Calabria, director of financial regulation studies at the Cato Institute, a libertarian think tank based in Washington. “Now we recognize their tremendous failures. The consensus is that these institutions should go away.”

But there is much debate over how to go about the transition. In June, Sens. Bob Corker (R) of Tennessee and Mark Warner (D) of Virginia introduced a bill aimed at shifting the lending risk to private capital and set up a new government agency, the Federal Mortgage Insurance Corporation. The FMIC would regulate mortgages and insure banks against catastrophic losses, but private lenders would assume the first 10 percent of losses on individual mortgages. The bill also assesses a fee on every mortgage, which would fund affordable rental housing and home loans for low-income and minority families.

Meanwhile, a Republican plan passed by the House Financial Services Committee last month would shut down the mortgage backing giants without replacing them with a government entity.

In his Phoenix speech, Obama said that any measures he signed into law should “preserve access to safe and simple mortgage products like the 30-year, fixed-rate mortgage.” But Mr. Berson and other experts worry that without government backing, that could prove difficult. “It’s hard to asses the risk of a long life bond,” he says. “Banks don’t want them. Mortgage lenders would ask for a large fee upfront or very large rates to offset that risk. “

Mr. Calabria counters that the 30-year fixed rate will still be available in the private market: “What Fannie and Freddie provide is a credit guarantee. Getting rid of them will not get rid of the 30-year fixed rate. You can get one on the jumbo market. The interest rate risk must be borne by somebody. It will still be available in the US. To me, there’s very little evidence that suggest otherwise.”

He adds that there is still federal involvement in housing through a number of agencies, including the Federal Housing Authority, and any market shift would be gradual. Plus, he adds, after a period of record low interest rates and an economy in the dumps, “inflation itself is creeping up. We are entering a higher interest rate environment anyhow, better to take that hit now than later. We need to do this now, before housing is the only thing carrying the economy."

Still, Berson maintains that an interest rate spike, especially with a still fragile economy, could be a bitter pill for homeowners and potential homeowners.  The more you’d like the mortgages to look like they do today, the less the system can change,” he says.