More Hurdles for Home Buyers

Uncle Sam is backing away from a big part of the home-loan business in a slow retreat that will ultimately make mortgages more expensive. The trade-off is that taxpayers won't bear the cost -- or not as much of it -- if the housing market implodes again. It will take years to wind down Fannie Mae and Freddie Mac, the infamous failed mortgage giants now in conservatorship. But we're already getting a taste of what life will be like without them.

For decades, Fannie and Freddie formed a vast, secondary market for mortgage loans by standardizing terms, then packaging loans into securities that carried a payment guarantee. Investors who bought the securities provided cash for new mortgages. It worked well until home prices collapsed and Fannie and Freddie were undone by loans that turned out to have been too risky. So far, the government has provided more than $130 billion to honor their debt and loan guarantees.

In a rare instance of like-mindedness across the political spectrum, most everyone agrees that Fannie and Freddie have to go. For now, the aim is to shrink the market in government-backed loans by making them less attractive relative to still-scarce private-label loans. To that end, the limits on loans that Fannie and Freddie will guarantee are slated to fall to a maximum of $625,500 as of October 1, from $729,750 now, making loans more costly in expensive housing markets. Down-payment minimums are headed toward 10% (minimums are officially 3% now, although in practice today's borrowers pay more). Recently, Fannie and Freddie raised fees for most loans with terms longer than 15 years, even for borrowers with perfect credit scores and 25% equity (see Expect to Pay More for a Mortgage).

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The debate on how to restructure the mortgage market for the long term has just begun, and a number of proposals are on the table, including a trio from the Obama administration.

The first would privatize the mortgage market completely, except for Federal Housing Administration and other insurance programs aimed at low- and moderate-income borrowers. The second would add a government guarantee for mortgage securities that would be activated only in times of crisis. The third option -- the one gaining traction -- proposes that a group of private companies provide investors with guarantees on mortgage securities. Uncle Sam would provide re-insurance, with a guarantee that would kick in only after the first line of private guarantors was wiped out.

Depending on what replaces Fannie and Freddie, they may be sorely missed. Without them, rates would likely be at least a quarter of a percentage point higher, with investors demanding higher yields for loans with no implicit government guarantee. Similarly, lenders would likely demand larger down payments or better credit. The traditional 30-year fixed-rate loan might become a rarity (as it is outside the U.S.), and prepayment fees could come back, with banks or investors unwilling to bear the risk of rate fluctuations. Without the standardization of mortgages that Fannie and Freddie provide, borrowers could face an array of shifting terms and conditions. In that world, clear, readable mortgage disclosures would be more important than ever.