Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that have played a central role in mortgage finance. They provide a secondary market for home mortgages—buying mortgages from the original lenders, packaging them into bonds backed by homeowners' interest and principal payments (a process known as "securitization"), and selling these mortgage-backed securities (MBS) to bond investors with a guarantee that interest and principal will be paid on time. Currently, the value of mortgages purchased, securitized, and guaranteed by Fannie and Freddie exceeds $5 trillion, about half of all U.S. single-family residential mortgages. In addition, Fannie and Freddie own about $1.5 trillion in mortgages and MBS, which they hold in their investment portfolios. A healthy secondary market ensures the availability of funds for mortgage borrowing. The source of credit is no longer the local banking industry, which is subject to periodic, cyclical contractions that reduce its ability to lend, but rather the global bond market. Banks are more willing to make mortgage loans if they can sell them into the secondary market rather than bear the risks of long-term lending. It is widely accepted that Fannie and Freddie's operations have made mortgage credit more accessible and affordable. Prior to the financial crisis, there was also a large private securitization market. "Private-label" MBS securitized mortgage loans that Fannie and Freddie's charters prohibited them from purchasing; between 2002 and 2007, private issuers sold more than $3 trillion in MBS. In 2008, that market came to an abrupt halt. Holders of many private-label MBS suffered severe losses as defaults rose and the value of the homes that served as collateral for the underlying mortgages fell. New MBS issues fell dramatically—to only $5.4 billion in 2010. The downturn in the housing market that crippled the private MBS market was also ruinous for Fannie and Freddie. As defaults and foreclosures rose, income from mortgage assets held or securitized diminished, leaving the two firms unable to meet the debt obligations they had incurred to purchase mortgages and MBS in the first place. By September 2008, it was clear that both Fannie and Freddie were insolvent, and the government stepped in to place both firms under conservatorship. As a result, Fannie and Freddie's regulator, the Federal Housing Finance Agency (FHFA), now exercises complete control over their operations. The alternative to conservatorship—to let the firms fail—appeared to pose unacceptable risks to the financial system, which was in deep crisis, and to the housing market. If Fannie and Freddie had ceased operations, mortgage securitization would have dried up, and it is likely that few banks would have been willing to risk making new mortgage loans. Liquidation of Fannie and Freddie would have entailed dumping mortgage assets on the market at a time when many institutions were struggling to cope with losses from MBS and mortgages already on their balance sheets. Prices would almost certainly have plunged, driving up the cost to new mortgage borrowers. Under conservatorship, Fannie and Freddie have continued their MBS issuance and have not significantly reduced the size of their portfolios. Even though both firms are operating at a loss to the government, they are essentially propping up the housing market. Because private capital has not yet returned to the market, over 90% of new mortgages are purchased, guaranteed, and securitized by Fannie, Freddie, or full-faith-and-credit government agencies, such as the Federal Housing Administration (FHA) and the Government National Mortgage Association (Ginnie Mae). Continued support for Fannie and Freddie has been costly. Under the terms of the conservatorship, the Treasury has agreed to inject capital into both firms (in the form of preferred-stock purchases) as necessary to prevent either firm from having a negative net worth. As of the fourth quarter of 2010, these purchases have totaled $90.2 billion for Fannie Mae and $63.7 billion for Freddie Mac. While there are many views on how the housing market should function in the future, and what the government's role should be, there appears to be little support for returning Fannie and Freddie to their pre-conservatorship status. The idea that shareholder-owned firms should use their government-sponsored status to boost profits for the benefit of shareholders, management, and employees in good times, only to shift losses to the taxpayers during bad times, is now generally considered unsatisfactory. In February 2011, the Obama Administration released a report that set out several options for the future of housing finance. "Reforming America's Housing Finance Market: A Report to Congress," the Obama Administration's reform proposal, identifies four principal reasons why Fannie and Freddie failed. 1. Their for-profit structure undermined their public mission, which required them to promote stability in the housing market, as well as provide liquidity to the market. To maximize profits, both firms took on excessive risks. Because of weak regulation, they were not required to hold adequate capital against those risks. 2. Their "government-sponsored" status conferred unfair competitive advantages. Market participants viewed Fannie and Freddie securities as backed by the government, despite the lack of a formal full-faith-and-credit guarantee. As a result, the firms were able to borrow at lower rates and they were able to operate with more leverage and less capital than their private competitors. The growth of their investment portfolios was an aggressive strategy to maximize the monetary value of the implicit government guarantee. 3. Capital standards were unfair and inadequate. Low capital requirements allowed Fannie and Freddie to charge artificially low fees to guarantee mortgages, effectively giving them a monopoly in the conventional mortgage market. 4. Regulation was weak and ineffective. Before the FHFA, Fannie and Freddie's regulator did not have authority to constrain excessive risk taking. Aggressive lobbying by both firms prevented efforts to impose stricter regulation. Rather than address the identified problems through specific legislative or regulatory proposals, the Administration proposes to wind down Fannie and Freddie's participation in the housing market. This would be done by removing their competitive advantages and further restricting the kinds of mortgages that they are allowed to purchase. To accomplish this, the Administration sets out five specific mechanisms: 1. Require Fannie and Freddie to raise their guarantee fees to what those fees would be if they were held to the same capital standards as private banks or financial institutions. This would allow private firms to compete on more even terms, and should reduce Fannie and Freddie's market share over time. 2. Encourage Fannie and Freddie to obtain credit loss protection from private insurers. 3. Reduce the size of investment portfolios, which had the effect of allowing Fannie and Freddie to operate as hedge funds whose losses would fall upon taxpayers. Under the terms of the Treasury support agreement, Fannie and Freddie should reduce the size of their portfolios by 10% per year. 4. Allow the current conforming loan limits to expire. During the crisis, Congress raised the ceiling on the size of mortgages Fannie and Freddie are allowed to purchase. If Congress allows these emergency increases to expire as scheduled on October 1, 2011, the loan limit will fall from $729,750 to $625,500 in "high-cost" housing areas (and lower elsewhere). 5. Gradually increase the size of the required down payment on mortgages purchased by the two firms. The Administration proposes to increase the minimum down payment to 10%, which would reduce the number of mortgages that Fannie and Freddie are allowed to buy. None of the above proposals requires congressional action. The Administration's report does not set out specific timetables, but notes that reducing Fannie and Freddie's role depends on the return of private capital to the housing market. In congressional testimony, Treasury Secretary Timothy Geithner has estimated that the process may take five to seven years. The Administration's report does not discuss the ultimate disposition of Fannie Mae and Freddie Mac. The logic of the proposals suggests that the GSEs should eventually become equal competitors with Wall Street firms in the secondary mortgage market, without any significant advantages conferred by government charters. This presumes that market participants will no longer view the GSE charters as conferring an implicit federal guarantee and that investors will evaluate the riskiness of Fannie and Freddie securities on the same basis as private securities. To revoke Fannie and Freddie's charters and fully privatize the two firms would require an act of Congress. The Administration's report sets out three long-range scenarios for the future government role in the housing market. The options involve tradeoffs among four factors: improving access to mortgage credit (which may expose the government to risk); providing incentives for housing investment (which may divert resources from other productive uses); protecting taxpayer from loss (which may conflict with the two factors above); and financial and economic stability (government responses to crises may create moral hazard and encourage excessive private risk taking). Table 1 below presents the basic components of the Administration's three options. None of the three envisions Fannie and Freddie remaining in their current roles. Roughly speaking, options one through three represent an increasing government presence in housing finance. Option 1 insulates the government from losses during a crisis, unless one assumes that government will respond to political pressure and in some way cover private losses rather than let the mortgage market come to a standstill. The absence of an explicit guarantee shifts risk to the private sector, and one would expect mortgage lenders, guarantors, and insurers to charge more to cover that risk or to reduce the supply of mortgage credit to borrowers perceived as risky. Option 3 exposes government to more risk than the first two, and has more potential to distort private economic decisions than option 1 or option 2. The regulated mortgage insurers to whom the government would provide mortgage reinsurance may be subject to some of the same conflicts and incentive problems that afflicted Fannie and Freddie.