Fannie-Freddie Reform Hinges on Keeping Small Lenders Happy

(Bloomberg) -- A decade ago, Brian Koss was a senior vice president at Countrywide Financial who saw firsthand how big lenders muscled out small ones during the housing boom by cutting special deals with Fannie Mae and Freddie Mac. 

Now, as a senior executive at a mid-size lender, he says a positive outcome from the bust is that government policies have mostly leveled the playing field.

U.S. lawmakers largely agree they want to keep it that way. But finding consensus on how to do it could be a sticking point in the latest effort to overhaul the housing-finance system.

On Thursday, a key Senate committee held a hearing on the nation’s system for funding home loans that featured small lenders. It was the third housing-finance hearing held by the Senate Banking Committee this year as Congress takes another stab at figuring out a long-term solution for Fannie and Freddie, which underpin nearly half the mortgage market. The companies have been under the government’s control since the 2008 financial crisis.

Small lenders are seen as a pivotal to the debate because some lawmakers are adamant that consumers and taxpayers benefit when such firms are active in the mortgage market. Small lenders argue that they provide better and more personal service than their bigger rivals. And some policy makers worry that increased market dominance by mega banks will enhance their status as being too big to fail, potentially putting taxpayers at risk should a giant lender run into trouble and need a government rescue.

‘Extra Mile’

Senator Sherrod Brown, the banking panel’s top Democrat, said at Thursday’s hearing that helping small lenders would be one of his primary focuses in any legislation to overhaul housing-finance policy.

“Small lenders are often the only lenders willing to go the extra mile to underwrite mortgages in areas that are too often left behind by Washington and by Wall Street,” Ohio’s Brown said, adding that he believes lenders should not be allowed any ownership in companies that guarantee mortgages.

Fannie and Freddie don’t make loans themselves, but buy them from lenders, wrap them into securities and make guarantees to investors in case the loans default. The companies became a flashpoint of the financial crisis, after being thrown a $187.5 billion federal bailout as the housing market cratered. To reduce the government’s role in the mortgage market, Congress has tried but failed to pass legislation over the past decade that would overhaul or wind them down.

Bank Competitors

This time, some small lender trade groups say they fear the Senate might adopt a plan that shunts more business to big banks. They say that could happen if lawmakers take up a Mortgage Bankers Association proposal that would let lenders invest in new Fannie-Freddie competitors. 

The MBA disputes that. On Wednesday, the trade group sent to lawmakers a letter signed by 110 small and midsize lenders supporting their plan, arguing that the bigger risk to small lenders without a law is that future regulators could reverse the protections they have now.

Another small-lender worry is that a new system will allow big banks to issue mortgages on better terms. The fear stems in part from how things worked before the crisis. 

Fannie and Freddie charge fees to back home loans, which are ultimately passed on to borrowers in mortgage rates. During the housing boom, Fannie and Freddie competed intensely for market share, so they often lowered fees if big lenders agreed to funnel the bulk of their business to just one of the companies.

Because large lenders got such steep discounts, it often made sense for small lenders to sell their loans to the bigger companies rather than directly to Fannie or Freddie. As part of that, small lenders had to give up the process of servicing mortgages, which meant losing an income stream.

Countrywide’s Bidding

“Fannie had to do the things that Countrywide wanted,” said Koss, now an executive vice president at Mortgage Network, a non-bank lender that made about $3 billion in loans last year. 

After the government took over Fannie and Freddie, their regulator, the Federal Housing Finance Agency, stamped out the preferential treatment.

In 2006 near the housing market’s peak, the top 10 mortgage lenders made up more than two-thirds of Fannie’s total business and more than three-quarters of Freddie’s, according to trade publication Inside Mortgage Finance. In the first half of 2017, the top 10 represented less than half.

For small lenders “any change in the status quo brings up the question, ‘How do we know we’re going to be treated equally?’” said Inside Mortgage Finance publisher Guy Cecala.

Bypassing Congress

Some shareholders of Fannie and Freddie, including Paulson & Co. and Fairholme Funds, have advocated letting the companies build up capital and then releasing them to private investors without making major changes to the market. They say a benefit of the plan is that the Trump administration can get it done without legislation. Ron Haynie, an executive with the Independent Community Bankers of America, said that much of one such plan, authored by Moelis & Co., fell in line with his group’s desires.

However, ICBA and other small lender groups such as the Community Mortgage Lenders of America, say that even though they don’t want to see huge changes to the mortgage system, they don’t support releasing Fannie and Freddie from government control without changes that only Congress can make.

While Congress considers reform, Fannie and Freddie should be allowed to build capital, Haynie said.

Representatives from the six trade groups, including the ICBA and CMLA, that spoke at Thursday’s hearing all said Congress needed to keep equal pricing and terms for small lenders in reform.

Even though the FHFA currently forces Fannie and Freddie to keep equal pricing for large and small lenders, for example, that change likely can’t be made permanent without Congress, said Glen Corso, executive director of CMLA, which has about 60 members. Otherwise, those preferential deals or new ones that benefit large banks in other ways could return, he said.

The CMLA’s members “don’t see the advantage in tearing up the mortgage landscape” but believe that under the current system they “can compete with large lenders head-to-head,” Corso said before the hearing.

To contact the reporter on this story: Joe Light in Washington at jlight8@bloomberg.net.

To contact the editors responsible for this story: Jesse Westbrook at jwestbrook1@bloomberg.net, Gregory Mott