Winding Down Fannie and Freddie Starts with Loan Limits

There is probably no better representation of the insanity that swept the nation during the housing mania and just after the collapse than the treatment of the conforming loan limit.

To recap, let’s recall that the “conforming” loan limit sets the maximum loan amount, for which the GSEs (Fannie and Freddie) are allowed to purchase an individual loan.

If a loan is larger than this limit, it is considered a “jumbo” loan and is automatically disqualified from being sponsored by Fannie and Freddie, thus it would have to be handled by the private market (private banks/lenders).

This was a simple enough system whereby one basic piece of underwriting criteria was one of several (there are many other bits of criteria that qualify a “conforming” loan… here we are just concerned with the loan size limit) straightforward qualifying factors dictating whether the government would sponsor a home loan or not.

Now, using the system that was in place before the collapse, this limit would be recalculated once a year using source data from the FHFA… in short, the FHFA would take the October median sales data and use it (along with other procedures) as the basis for the conforming loan limit for the following year.

This meant that, in theory, the conforming loan limits could rise and fall based on the trend of the FHFAs median home price… in theory that is…

Throughout the boom the median prices were rising substantially year after year and, like a good little policy mechanism, the conforming limit was being adjusted up to match the historic run-up in prices and by the peak the limit stood at $417K.

When the housing market soured in 2006 and 2007 though, OFHEO (the Office of Housing Enterprise Oversight… the former regulator of Fannie and Freddie) had to face up to the task of decreasing the loan limit as median prices fell nationwide.

Well, as is typical of this period and of government in general, OFHEO was unable to stand the pressure coming from misguided lawmakers and those with private real estate interests, and simply choose to postpone and decision leaving the conforming loan limit at the prior level.

Then from this point on things really ran amuck… OFHEO came up with a series of haphazard procedures that somehow justified the current limit and stalled further any downward adjustment.

Then, to make matters worse, lawmakers simply refashioned the whole process dismantling the original mechanism entirely and installing a different system whereby a different limit was set for each metropolitan area in the country.

By this point there were areas across the country that had loan limits well over $700K…

So, the dilemma started with OFHEO needing to reduce the limit from $417K and after Washington lawmakers got through with it, the limit was increased to over $700K.

This was a prime example of policy gone wild… While regulators were happy to raise the limit with accuracy each year as prices were rising, they had flatly refused to decrease it as the market soured and finally completely went haywire as the housing collapse stirred panic.

Lawmakers and regulators might say that they were doing the work of the people, stepping in to fill the shoes of a private Jumbo market that refused to lend as the housing market crumbled.

I counter that they worked to encourage the boom by increasing the loan limit (thus pushing up conforming and jumbo loan sizes) continually and supplying endless liquidity for speculators (typical homebuyers and investors) to use to sink themselves in mountains of debt and needlessly inflate the prices of an essential service.

When the market turned, which simply represented reality re-materializing, the housing markets didn’t need more liquidity, they needed less.

The whole public government sponsored scheme of housing debt markets has been an abysmal failure and the conforming loan limit tomfoolery outlined above is but one example of government idiocy run amuck.

The Obama administration is doing the right thing in proposing the winding down of the GSEs and coming out in favor of allowing the elevated conforming loan limit policy to expire this fall.

Lower limits will mean higher interest rates for many homebuyers, particularly those buying homes in excess of $500K, but the intention of the original GSE policy was never to liquefy the top of the market, it was supposed to bring liquidity to the middle class and below.