[This article was originally published on Forbes.com.]
Mortgage loan limits can affect home prices. They’re an important — but often forgotten — part of the story behind The Great Real Estate Bubble and current high home prices.
During the real estate bubble of the 2000s, Fannie Mae and Freddie Mac were involved, one way or another, in 44% of all U.S. mortgage debt outstanding. Both companies were originally created by the U.S. government but somehow the government decided they were private and gave them a lot of free rein.
Fannie and Freddie could borrow money cheaper than authentically private mortgage companies because Wall Street assumed (correctly, it turns out) the government would bail out Fannie and Freddie if they got into trouble. Some estimate when Fannie and Freddie borrowed money they’d be charged an interest rate that was around 0.2% to 0.3% less than other mortgage companies would have to pay.
The result of this “implicit government guarantee” was that Fannie and Freddie could lend money to homebuyers at lower interest rates than other mortgage companies. That’s why they grew so large.
More Money Chasing Homes
Because Fannie and Freddie were so large it’s easy to imagine they could move the real estate market and home prices when they changed their lending policies.
If they lowered the minimum down payment, more money would chase homes. If they decided to lend money to people with lower credit scores or to lend more money to buyers with a given amount of income, more money would chase homes. And more to the point of this article, if they bought larger mortgages (increased their loan limit), more money would chase homes.
More money chasing homes means higher home prices. Unlike most other products, the amount of money chasing homes often isn’t determined by how much money buyers want to spend of the money have in the bank but by how much money buyers can borrow from banks and companies like Fannie and Freddie.
Over the last 30 years, Fannie and Freddie loan limits have increased dramatically, reinforcing and encouraging high home prices.
[The graph above was updated in November 2021 with the latest data adjusted to 2020 dollars but the inflation-adjusted examples in the text of this post continue to use 2017 dollars as in the original post.]
In real dollars, loan limits have increased far faster than inflation. The typical Fannie and Freddie loan limit increased 80% faster than inflation from 1980 to the peak in 2006. The highest loan limit from 1980 to 2017 increased about 125% faster than inflation.
If the Fannie and Freddie conforming loan limit in 1980 had only been increased by the rate of inflation, the limit at the peak of the bubble in 2005 would have been $280,000 instead of the actual limit which was $450,000 (in 2017 dollars).
Would the real estate boom have gotten as large as it did, if the loan limits weren’t increased significantly more than inflation over all those years? More stable real loan limits would have likely led to more stable home prices and a smaller real estate bubble.
The U.S. economy as a whole would have benefited from more stable home prices, however, Fannie and Freddie shareholders and executives would have likely earned far less.
Just Too Big
In the end, the implicit government guarantee for Fannie and Freddie allowed them to become so big their mortgage policies could move the housing market and home prices. Policy mistakes that would have been self-correcting and self-regulating when made by a smaller lender often were not self-correcting when made by the enormous duo.
By comparison, the mortgage industry in Germany is dominated by hundreds of small banks and Germany didn’t have a real estate bubble in the 2000s. It avoided that huge economic trauma and has done very well economically the last 10 years.
Future Of Fannie And Freddie
Ten years after being taken over by the federal government Fannie and Freddie are still in conservatorship with no end in sight. And they’re both still a huge part of the U.S. mortgage system.
1. One path favored by many of their shareholders and many in the real estate industry is for the federal government to recapitalize Fannie and Freddie (“loan” them a ton of money) and let them go back to being private companies similar to how they were before 2008.
2. Another path discussed is for Fannie and Freddie to be combined into one explicit federal government agency, sort of like an FHA but for people with higher incomes.
3. A third path is to wind down the companies by gradually reducing the Fannie and Freddie loan limits to zero over many years. The wind down would need to be slow enough to allow current and new mortgage lenders to completely replace the shrinking Fannie and Freddie market share until the two companies are memories.