The Equity Sharing Solution to the Fannnie/Freddie Morass

Revisiting “Capped Upside, Unlimited Downside”

[Note to Readers: this post originally ran Christmas Week, when it was read by . . . no one. In the wake of Barney Frank’s announced plan to abolish Fannie Mae and Freddie Mac, I’m “popping” it to the top of the list.]

If you lend someone 97 cents to buy an asset that costs $1, what happens if the value of that asset falls to 95 cents?

How about 90 cents? Or 70 cents?

What if the borrower then loses their job?

Add eleven(!) zeroes . . . and you have the plight of Fannie Mae and Freddie Mac in a nutshell.


One way or another, these so-called Government Sponsored Entities (“GSE’s”) — and now FHA — provide the bulk of the capital that finds its way into the U.S. housing market.

That capital takes the form of loan guaranties, mortgage origination, secondary market loan purchases, etc.; cumulatively, the foregoing aid — investment, if you prefer — amounts to hundreds of billions annually.

When dropping home prices — and now, recession-induced job losses — blow multi-billion dollar holes in these entities’ balance sheets, what should the government do?

It would seem to have three choices: 1) shovel more money in; 2) require higher downpayments, to provide for a higher margin for error; or 3) get out of the housing subsidy business altogether, and pull the plug on the GSE’s.

Option #3 has seemingly been taken off the table, because of the threat it would pose to housing prices generally.

Option #2, much less draconian, would also seem to undermine already shaky home Buyers’ purchasing power, and therefore has also been rejected.

Which leaves option #1: support the GSE’s with unlimited, open-ended capital infusions.

In fact, the government just decided to do exactly that, in an announcement purposely released on Christmas Eve to minimize scrutiny (“Fannie & Freddie, Uncapped“).

High Costs, Dubious Benefits

Unfortunately, simply shoveling more money into these GSE black holes may be the worst strategy of all.

In the short run, it turns would-be home Buyers into armchair economists, trying to guess what the government will — or won’t — do next to support home prices.

In the long run, massive government housing aid distorts prices, crowds out private lenders, and risks debasing the U.S. dollar — thereby ushering in runaway interest rates.

If you think housing prices are under pressure now, just wait until long-term interest rates — now around 5.25% for a 30-year mortgage — hit 8%. Or 15%-plus, as happened in the early ’80’s.

Option #4

So what is the way out of this morass?

Go back to what happens to Fannie and Freddie as home prices fluctuate.

When housing prices fall, the GSE’s suffer major impairments to their capital as borrowers default.

However, when home prices rise (yes, that can actually happen!), the most they stand to recover is the amount they originally loaned.

Heads, borrowers win; tails, the government loses (sound familiar?).

Instead, the GSE’s should insist on sharing in any upside that borrowers enjoy.

The Stanford Model

Stanford University long ago established a similar housing subsidy for faculty struggling to afford expensive Bay Area housing.

In return for down payment assistance and low-cost mortgage money, the University effectively becomes a “partner” with the faculty-homeowner, enjoying a cut of the appreciation when the home is sold.

Emulating Stanford’s approach not only would help the government’s balance sheet, it would relieve pressure on foreclosures while putting borrowers on notice that there’s no free mortgage lunch.

Over time, one might expect that realization to curtail their appetites . . .

About the author

Ross Kaplan has 19+ years experience selling real estate all over the Twin Cities. He is also a 12-time consecutive "Super Real Estate Agent," as determined by Mpls. - St. Paul Magazine and Twin Cities Business Magazine. Prior to becoming a Realtor, Ross was an attorney (corporate law), CPA, and entrepreneur. He holds an economics degree from Stanford.

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