By most accounts, the federally sponsored mortgage giants Fannie Mae and Freddie Mac did not cause the housing and mortgage crisis. But they were a big part of the problem, prompting a taxpayer bailout costing more than $130 billion.

Now, seeking to protect taxpayers from future meltdowns, the Obama administration wants to phase out the two firms over an unspecified period and leave the lion’s share of the mortgage market to private lenders. It would be a dramatic change, given that the private market has shriveled in recent years, leaving Fannie, Freddie and the Federal Housing Administration to back about 90% of all new home loans. The administration also proposes a reduced role for the FHA, one that would focus on providing mortgages for the needy.

How would a phase-out of Fannie and Freddie affect the availability of mortgages, loan rates and home prices? In the end, would such a dramatic change be good for homeowners or not?

Opinions vary, and no one can know for sure. The mortgage and housing markets are complex, and a controlled experiment that removes Fannie and Freddie but leaves everything else the same is obviously not possible, says Wharton real estate professor Todd Sinai. “There’s a debate over whether Fannie and Freddie successfully reduced mortgage rates paid by borrowers, or increased the mortgage availability for borrowers, or whether they just took their implicit [government] subsidy and generated higher returns for shareholders,” Sinai says. “If Fannie and Freddie were successful in making mortgage credit cheaper and more available, then eliminating [them] would have a negative impact on house prices.”

It is not clear that the private market can or would absorb the volume of business done by Fannie and Freddie, which cover trillions of dollars worth of loans, according to Wharton real estate professor Susan M. Wachter. “That’s a good question,” she says, noting that even if the private market were to take over, borrowers would probably not get the attractive deals they can today.

“The 30-year [mortgage] would become more expensive,” she states, adding that some experts predict a three percentage point rate rise. With the 30-year, fixed-rate loan now averaging around 5%, that would take it to 8%, raising the monthly payment for every $100,000 borrowed from $537 to $733. This would make the 30-year fixed loan “noncompetitive” with adjustable-rate loans, Wachter says. ARMs can offer lower rates because lenders face less risk, given that they can raise rates as market conditions change

Jack M. Guttentag, an emeritus professor of finance at Wharton who runs a website called The Mortgage Professor, thinks fixed rates might go up only three quarters of a percentage point rather than three points. But with the two firms’ loan guarantees removed from the market, lenders would probably demand larger down payments than they have in the past, and be less willing to provide loans to those with less-than-stellar credit. Indeed, today’s tight lending standards, a reaction to the recent crisis, could become permanent.

“Things like qualification standards have become extremely strict,” Guttentag says, noting that it is now all but impossible for a self-employed applicant to get a mortgage. “The biggest part of it would be the increase in the down payment; 20% would probably become the minimum throughout the marketplace.”

Larger down payments reduce the lender’s risk because borrowers are reluctant to default if they have equity in the home, and because a smaller loan relative to the home’s value makes it easier for the lender to recover in a foreclosure. Currently, most lenders require 20% down payments; a few years ago, however, it was possible to get a loan with nothing down. The Obama administration wants underwriting standards to require at least 10%, though the FHA would continue to offer low-down payment loans to certain less-affluent borrowers.

Planning a Phase-out

Fannie, the Federal National Mortgage Association, was formed as a government agency in 1938 and was converted to a publicly traded company in 1968. Freddie, the Federal Home Loan Mortgage Corp., is a publicly traded company created by the government in 1970 to provide competition for Fannie. Their primary role is to buy and insure mortgages issued by private lenders. Some loans stay on Fannie and Freddie’s books, but most are bundled into mortgage securities sold to investors like other types of government and corporate bonds. Fannie and Freddie provide investors certain guarantees that interest and principal payments will be made even if homeowners default.

When Fannie was a government agency, these guarantees were backed by the federal government — i.e., by the taxpayer. As publicly traded companies, however, the firms did not have this explicit backing. But investors generally assumed that because Fannie and Freddie were “government sponsored,” the government would make good on the firms’ obligations if necessary.

In the middle of the last decade, mismanagement and the firms’ desire to maximize profits for shareholders prompted them to acquire and guarantee risky mortgages issued by private lenders, including subprime loans to people with poor credit. When the housing bubble burst, homeowner defaults soared, and Fannie and Freddie suffered enormous losses. In September 2008, the government took over the firms, wiping out the shareholders, and provided upwards of $130 billion in bailouts.

Last month, the Department of the Treasury and the Department of Housing and Urban Development sent Congress a proposal with three options for phasing out Fannie and Freddie.

“In the past, the government’s financial and tax policies encouraged housing purchases and real estate investment over other sectors of our economy, and ultimately left taxpayers responsible for much of the risk incurred by a poorly supervised housing finance market,” the report said. “Going forward, the government’s primary role should be limited to robust oversight and consumer protection, targeted assistance for low- and moderate-income homeowners and renters, and carefully designed support for market stability and crisis response…. Under our plan, private markets — subject to strong oversight and standards for consumer and investor protection — will be the primary source of mortgage credit and bear the burden for losses.”

The report insists that Fannie and Freddie functioned well for decades, and failed only because of poor management and regulatory supervision during a brief period. While claiming that bad practices have been curtailed, the report recommends shuttering the firms anyway. The phase-out period is still to be determined, though it most likely would take years. It is not clear when Congress might act on the proposal.

The first option, the report noted, would “dramatically reduce the government’s role in insuring and guaranteeing mortgages, limiting it to FHA and other programs targeted to creditworthy lower- and moderate-income borrowers.” Private lenders would be expected to provide most mortgages. The second option is similar except that the government would provide a “backstop mechanism to ensure access to credit during a housing crisis.” The third option also mirrors the first, but adds a “reinsurance program” to back a private insurance program to support “securities of a targeted range of mortgages.”

During the phase-out period, the government would stiffen various requirements for loans backed by Fannie, Freddie and the FHA, essentially making those loans less attractive in order to drive borrowers to the private market. Fees would go up, for example, while maximum loan amounts would go down.

Fannie and Freddie’s critics often note that other developed countries do not have such entities, but Wachter says many do have some sort of government involvement in the mortgage market. “In most other economies, there is a substantial role for government in housing finance — specifically, in implicitly keeping big and small banks from failing,” she notes. “In most markets, banks provide mortgages. When interest rates rise and mortgage defaults rise in consequence, banks are prevailed upon to [give borrowers breaks] to prevent foreclosures, and they do so.”

Finding a New System

If Fannie and Freddie were to close, what would be the result?

In theory, the guarantees from Fannie and Freddie made their securities safe enough that investors settled for lower interest rates than they would have otherwise. That savings resulted in lower mortgage rates, making it cheaper for people to buy homes. Whether this really happened is debatable.

The two firms, however, are widely thought to have assured the availability of the 30-year, fixed-rate mortgage, which provides the borrower an unchanging payment for the life of the loan. Other developed countries do not have firms like Fannie and Freddie, and generally do not have long-term, fixed mortgages. Instead, borrowers get adjustable-rate loans with interest rates that reset at regular intervals, causing payments to go up or down. Fixed-rate loans are risky for lenders, but safe for borrowers; adjustable loans are safe for lenders and risky for borrowers.

Wachter believes the 30-year loan could survive, but would become so expensive that borrowers would turn to ARMs, which generally carry lower rates at the time they are approved. That puts the homeowner at much greater risk, because ARM rates typically adjust every 12 months. When prevailing rates rise, these adjustments require bigger monthly payments, which can upset household budgets.

“ARMs offload interest-rate risk to households, which is not a problem in a declining interest-rate environment, but which may be for households, and economy-wide stability, in a rising interest-rate environment,” Wachter notes.

Greater changeability in mortgage payments makes home prices more volatile. Low rates allow borrowers to borrow more, which causes them to bid up prices, while high rates have the opposite effect. Wachter believes the wide availability of 30-year, fixed-rate mortgages dampened uncertainty and reduced home-price volatility, helping to keep the economy on an even keel. Indeed, the recent financial crisis was sparked by higher payments when ARM rates adjusted higher, pricking the home-price bubble.

Currently, ARMs make up only a sliver of new mortgages because borrowers prefer to use fixed-rate loans to lock in today’s low rates for the long term. If ARMs dominated the market, a spike in interest rates could quickly cause home prices to fall, according to Wachter. She notes that some countries where ARMs dominate are working to expand the role of fixed-rate loans to make their markets more stable. In the United Kingdom, she says, the government is “pushing for the development of secondary markets to increase the availability of fixed-rate mortgages to help mitigate against payment shock in the event of a rise in interest rates.”

Greater volatility in home prices would be yet another reason for lenders to be more restrictive, Guttentag adds. “When home prices are rising, it doesn’t matter what kind of loan you write,” he says, because rising values make it likely the lender can foreclose for enough to cover the debt. “During a period when expectations are that home pries will go down, you will have the opposite [effect].”

Why do homeowners constantly root for home prices to rise? One reason is that rising home values make homeowners feel wealthier, though rising prices are clearly not good for renters who want to become owners, Sinai notes. In fact, the sense of growing wealth is something of an illusion, because the homeowner’s next home is becoming more expensive as well, soaking up any gains made on the current one. Home equity is money in the pocket only when one “downsizes” to a less expensive property, as some retirees do.

But there is another reason homeowners root for rising prices: “House prices matter a lot when people have mortgages,” Sinai points out. If a borrower puts 20% down, a 10% drop in home values would wipe out 50% of the investment, while a 10% price rise would produce a 50% gain.

Without Fannie and Freddie to convert mortgages into securities, what would take their place? The Obama Administration assumes the private securitization market, vibrant a few years ago but moribund today, will return to health.

In addition, Treasury Secretary Timothy F. Geithner argues that the U.S. should create a system of “covered bonds” to finance mortgages. This system, used in some European countries, bundles mortgages into securities sold to investors, somewhat the way Fannie and Freddie do. But in the case of covered bonds, the issuer keeps obligations on its own books rather than washing its hands of them after the securities are sold, as has been the system in the U.S. Covered bonds are therefore thought to give issuers stronger incentives to be careful when approving mortgages.

Guttentag favors a system like that in Denmark, where lenders put mortgages into bonds sold to investors. As with covered bonds, the Danish bonds remain on the lender’s books, giving the lender an incentive to make loans carefully. The chief difference is that in Denmark, the lender continues to service the loan, avoiding the conflicting interests that can arise between servicers and the owners of mortgage-backed securities. Guttentag says the Danish system also makes it easier for borrowers to shop for the best deals.

Wiping out Fannie and Freddie, even if done gradually, could be risky if there is no clear plan for the system to follow, Guttentag warns. “They are just too critically important for holding up the market,” he says. He suggests having the firms compete to take on a Danish-style system, with the winner surviving and the loser being phased out.

“To just talk about getting rid of Fannie and Freddie without talking about creating some structure to take its place is weak,” he says. “I don’t think we want to go down that road.”