Without Loan Giants, 30-Year Mortgage May Fade Away

How might home buying change if the federal government shuts down the housing finance giants Fannie Mae and Freddie Mac?

The 30-year fixed-rate mortgage loan, the steady favorite of American borrowers since the 1950s, could become a luxury product, housing experts on both sides of the political aisle say.

Interest rates would rise for most borrowers, but urban and rural residents could see sharper increases than the coveted customers in the suburbs.

Lenders could charge fees for popular features now taken for granted, like the ability to "lock in" an interest rate weeks or months before taking out a loan.

Life without Fannie and Freddie is the rare goal shared by the Obama administration and House Republicans, although it will not happen soon. Congress must agree on a plan, which could take years, and then the market must be weaned slowly from dependence on the companies and the financial backing they provide.

The reasons by now are well understood. Fannie and Freddie, created to increase the availability of mortgage loans, misused the government's support to enrich shareholders and executives by backing millions of shoddy loans. Taxpayers so far have spent more than $135 billion on the cleanup.

The much more divisive question is whether the government should preserve the benefits that the companies provide to middle-class borrowers, including lower interest rates, lenient terms and the ability to get a mortgage even when banks are not making other kinds of loans.

Douglas J. Elliott, a financial policy fellow at the Brookings Institution, said Congress was being forced for the first time in decades to grapple with the cost of subsidizing middle-class mortgages. The collapse of Fannie and Freddie took with it the pretense that the government could do so at no risk to taxpayers, he said.

"The politicians would like something that provides a deep and wide subsidy for housing that doesn't show up on the budget as costing anything. That's what we had" with Fannie and Freddie, Mr. Elliott said. "But going forward there is going to be more honest accounting."

Some Republicans and Democrats say the price is too high. They want the government to pull back, letting the market dictate price, terms and availability.

"A purely private mortgage finance market is a very serious and very achievable goal," Representative Scott Garrett, the New Jersey Republican who oversees the subcommittee that oversees Fannie and Freddie, said at a hearing this week. "No one serious in this debate believes our housing market will return to the 1930s."

Still, powerful interests in both parties want the government instead to construct a system that would preserve many of the same benefits, with changes intended to minimize the risk of future bailouts. They say the recent crisis showed that the market could not stand on its own.

"The kind of backstop that we have now, if it didn't exist, we would have had a much more severe recession and a much sharper fall in home values," said Michael D. Berman, chairman of the Mortgage Bankers Association, which represents the lending industry.

Hanging in the balance are the basic features of a mortgage loan: the interest rate and repayment period.

Fannie and Freddie allow people to borrow at lower rates because investors are so eager to pump money into the two companies that they accept relatively modest returns. The key to that success is the guarantee that investors will be repaid even if borrowers default -- a promise ultimately backed by taxpayers.

A long line of studies has found that the benefit to borrowers is relatively modest, less than one percentage point. But that was before the flood. Fannie, Freddie and other federal programs now support roughly 90 percent of new mortgage loans because lenders cannot raise money for mortgages that do not carry government guarantees.

One prominent investor, William H. Gross, the co-head of Pimco, the major bond investment firm, has estimated that he would demand a premium of three percentage points to buy such loans -- a cost that would be passed on to the borrower.

Proponents of a private market want the government gradually to withdraw its support, allowing investors to regain confidence. They argue that interest rates would eventually settle into roughly the same patterns that held before the financial crisis.

Some supporters of government backing also like the idea, believing that it will demonstrate the need for a backstop.

"I myself am eager to see whether there needs to be a guarantee," said Representative Barney Frank of Massachusetts, a crucial Democratic voice on housing issues.

Fannie and Freddie also make ownership more affordable by allowing borrowers to repay loans with fixed-interest rates over an unusually long period. A person who borrows $100,000 at 6 percent interest will pay $600 each month for 30 years, compared to $716 each month for 20 years.

The 30-year loan first became broadly available by an act of Congress in 1954 and, from then until now, the vast majority of such loans have been issued only with government support. Most investors are simply not willing to make such a long-term bet. They prefer loans with adjustable rates.

Alex J. Pollock, a former chief executive of the Federal Home Loan Bank of Chicago, said such loans would remain available in the absence of a federal guarantee, but they might be harder to find. And lenders might demand a larger down payment. Or a better credit score.

That would be a very good thing, said Mr. Pollock, now a fellow at the American Enterprise Institute.

Longer terms make ownership affordable only by increasing the total cost of the loan, because the borrower pays interest for a longer period. Moreover, Mr. Pollock noted that over the last several years, borrowers with adjustable-rate loans paid less as interest rates fell, while those with fixed rates kept paying the same amount for devalued homes.

"One of the reasons that American housing finance is in such bad shape right now is the 30-year mortgage," he said, noting that such loans are not available in most countries. "For many people, it's not at all clear that that's the best product."

Fannie and Freddie also allow a wide swath of the American public to borrow money at the same interest rates and on the same terms. Borrowers who did not meet their standards were forced to pay higher interest rates to subprime lenders, but the companies essentially persuaded investors to treat a vast number American families as if they were interchangeable.

They took messy bunches of loans, with risks as variable as snowflakes, and created securities of uniform quality, easy to buy and sell. The result was one of the most popular investment products ever created.

And in its absence, experts on housing finance say that fewer borrowers would qualify for the best interest rates.

Susan M. Wachter, a real estate professor at the University of Pennsylvania, said a new government guarantee was needed to preserve a homogenous market.

"There needs to be a systematic way of preventing" fragmentation, said Professor Wachter. "That's what we need a bulwark against. Because if there isn't, it will occur."

The government seems least likely to maintain a final set of benefits -- leniencies in loan terms that taxpayers effectively have subsidized for borrowers.

Fannie and Freddie slashed the requirements for down payments in recent years, saying that they were helping people with minimal savings become homeowners. Two-thirds of the borrowers whose loans were guaranteed by the companies from 1997 to 2005 made a down payment of less than 10 percent. But borrowers who invest less default more often. The Obama administration has said that it wants the companies to demand a minimum down payment of 10 percent.

A quirkier example is the ability to "lock in" an interest rate. Fannie and Freddie permitted lenders to make such promises at no risk because the companies had already obtained commitments from investors. In the companies' absence, borrowers seeking rate locks may need to pay for them.

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