The entire structure of the nation’s housing finance system is up for play as Congress begins its debate on the future of Fannie Mae and Freddie Mac. But the next generation of housing finance will be forged at a time when partisan divides are as deep and heated as at any time in recent history.

“The mood on Capitol Hill is one of tension, and sometimes bordering on hysteria, about the GSEs,” said Doug Bibby, president of the National Multi Housing Council, as he kicked off "The Government, the GSEs, and the Future," a keynote session at the 2010 Apartment Finance Today Conference.

The panelists—which included former Fannie Mae multifamily head Thomas White, former Fannie Mae Chief Credit Officer Ed Pinto; Wood Partners Chairman Jerry Durkin, and the head of PNC Real Estate’s multifamily division, Thomas Booher—began by discussing who was to blame for the housing bubble before delving into what the future may hold for the giant entities.

A Look Back
In Congress, Republicans generally believe that Fannie Mae and Freddie Mac led the charge in the booming subprime business and were major drivers of the system’s failure. The Democratic line of thought is that Wall Street (and the private MBS market) was the main force behind the subprime explosion, and that the GSEs were lured into it long after it had blossomed.

But ask Pinto, and he'll say the Federal Housing Enterprise Safety and Soundness Act of 1992, which freed up the GSEs to compete with the FHA on single-family housing business, was the main culprit. Within a year of the Act, the GSEs were lending at 97 percent loan-to-value (LTV), which eventually led to “no money down” loans. “Leverage became the name of the game,” Pinto said. “They were doing 3 percent down loans, zero-down loans, and the private sector started following. But what really transpired was the politicization of lending.”

The affordable housing goals that HUD instituted in 2000 also contributed to this politicization, according to Pinto. “I call it reverse earmarks, which is what it really became,” Pinto said. “Congress got enamored with the trillions of dollars that Fannie and Freddie could bring to affordable housing, and Congressional members got credit for it, and that’s really what poisoned the well.”

But according to White and Booher, it was a broader cultural issue, an unbalanced federal housing policy that stressed homeownership at the expense of rational underwriting. “I believe that the deception of our culture, that money grows on trees, that there can be action and no reaction, is so prevalent that we live in a fantasy world,” White said. “And members of Congress were the ultimate actors there.”

That unbalanced housing policy was prevalent on the operations side as well. "The problem really starts with a culture that’s increasingly looking for something for nothing,” Durkin of Wood Partners explained. “That permeates our housing policy.”

A Look Ahead
One of the most important questions in determining the next generation housing finance system is what role the private sector can play—or what role the federal government must play to pick up the slack. Banks continue to struggle with impaired balance sheets; life insurance companies have limited allocations for multifamily; and while the CMBS industry is once again showing signs of life, it’s a shadow of its former self.

One idea gaining traction on the Republican side is to phase out the GSEs and replace them only with covered bonds, which is currently a $1.8 trillion business mostly occurring in Europe. Covered bonds are debt securities backed by cash flows from mortgages. They’re similar to mortgage-backed securities, with one huge difference: Covered bond assets remain on the issuer’s books as opposed to being passed off to investors.

“The problem with covered bonds is that the banks have to carry them on their balance sheets,” Bibby said. “And bank balance sheets are already hugely encumbered with real estate.”

There seems to be some consensus on Capitol Hill that the next generation of housing finance entities need to be smaller, and there needs to be more of them. This would eliminate the “systemic risk” dynamic that comes with putting most of the industry’s eggs in just two baskets.

But “the devil is in the details,” as White puts it, and there are significant differences in the competing proposals. Many Republicans want the next generation of entities to have no portfolio capacity, while Democrats often believe there should at least be some limited portfolio activity.

White, who was a driving force behind the creation of both the DUS and the MBS programs, says that both are necessary for different parts of the cycle. When one side booms, the other can go dormant, allowing the entities to evolve as the market changes. “I hope they would be able to keep a mix of both,” he said.

The portfolio is particularly important for many multifamily executions, especially in the affordable housing realm. Forward commitments for low-income housing tax credit deals, for instance, remain a balance-sheet execution at the GSEs today.

The Center for American Progress, a Democratic think-tank that has the Obama Administration’s ear, is advocating a separate role for the portfolio, specifically as it pertains to multifamily. And the NMHC is advocating a similar stance for portfolio executions but at a much-reduced level from their current state.

“There’s a lot of feeling that the portfolio was a big part of the problem, and I tend to agree,” Pinto said. “But there’s also this feeling that if it has any relevance, it may be in the multifamily area.”

The most likely scenario includes some kind of federal support to ensure liquidity in good times and bad, to provide countercyclical capital. “As they’re redesigned, we’ve got to have both the incentive and ability to stay in these markets, not just when it’s particularly profitable," Booher said. “I think we’ve seen that over the past 18 months that you’ve got to have capital sources even in down times, and I don’t know how you can incent the private sector to do that entirely.”

But one thing is certain: The restructuring of Fannie and Freddie is likely to be a long process. A day after the panel, the Obama Administration published seven questions to solicit public input on the way forward for the housing finance system. And if the current climate is any indication, those questions will generate a cacophony of opinions.