Payroll Tax Cut Diverts Funds from Fannie and Freddie

The 11th-hour payroll tax cut extension signed into law last week will for the first time divert funds from Fannie Mae and Freddie Mac to pay for general government expenses.

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Washington lawmakers began 2011 with sweeping plans to shrink the government’s role in mortgage finance, but are ending the year with plans to expand it.

Lawmakers also allowed a tax break on private mortgage insurance to expire, and raised loan limits for mortgages insured by the Federal Housing Administration.

Advocates of private mortgage finance are concerned that using fees from Fannie and Freddie is setting a dangerous precedent that could keep the government entangled in the mortgage business for a decade or more.

The Federal Housing Finance Agency, which oversees Fannie and Freddie, today directed the two companies to increase fees on new mortgages by 10 basis points, or 0.1 percent, to comply with the law. The new fees will go into effect on April 1, after which point the additional revenue will be remitted to the U.S. Treasury Department.

Fannie, Freddie, and the FHA currently back more than 90 percent of all loan originations, about double what they did during the subprime lending boom. Earlier in the year, the Obama administration and members of Congress were working on a blueprint to reverse that trend.

In February, Treasury Secretary Timothy Geithner released three options for reducing the government’s role in housing finance. Shortly thereafter, Republicans introduced bills to wind down Fannie and Freddie, which have cost taxpayers about $153 billion since 2008 because of defaults on loans they guaranteed. However, the legislation never advanced because there was no agreement even among Republicans on the best way to proceed.

Then in December, when searching for a means to pay for a $36 billion two-month payroll tax cut, Congress ordered a decade-long increase in the premiums Fannie and Freddie charge lenders to guarantee principal interest on home loans. Lenders typically pass on the cost of premiums to borrowers as higher interest rates.

“In effect, this is a tax on Fannie and Freddie mortgages,” said Bert Ely, a banking consultant in Alexandria, Virginia. “When you go to privatize or take any action to wind them down, you have a budget effect that you didn’t have before.”

Because the move relies on long-term revenues from Fannie and Freddie, two entities that both Democrats and Republicans want to shrink in the near-term, and further, the money won’t be spent to offset the risk of loan defaults, it is drawing heavy criticism.

“It seems to be an inherent contradiction counting on revenue from a 10-year increase in guarantee fees from agencies that might not be around in 10 years,” said Joe Pigg, vice president of mortgage finance at the American Bankers Association.

The controversy over the premiums, known as guarantee fees or g fees, comes on top of other policy changes that housing analysts say could keep the government entrenched in the mortgage market.

The House and Senate voted last month to increase the maximum size of FHA-insured loans to $729,750 from $625,500. Congress also failed to extend a tax break on private mortgage insurance for borrowers with low down payments which will expire December 31. Eliminating the tax deduction raises the cost of private insurance, making FHA insurance a more attractive alternative.

Fannie and Freddie are also implementing plans of their own to raise g fees even higher. They will gradually increase their rates as a way to reduce losses at the companies. While the g fees will limit their cost to taxpayers, they will be passed on to borrowers in the form of higher interest rates.

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