Why Saudi Arabia Requires Fannie Mae and Freddie Mac?

Mortgage penetration rates (mortgage debt as a percentage of GDP) in Saudi Arabia are low at 2%, compared to 5-10% in the neighboring GCC countries. In contrast, developed countries like the US and UK, have mortgage penetration rates of more than 70%. However, various efforts such as introduction of mortgage law, tax on vacant land and establishing Saudi Real Estate Development Fund (REDF) to increase home ownership helped mortgage loan book to grow by about 40% annually between 2011 and 2014. However, the requirement of a 30% down payment by the buyer on a property’s value introduced in late-2014 almost dried up demand for mortgages. In response, Saudi Arabia’s central bank slashed the down payment needed by half to 15% for house buyers to obtain a mortgage. Though this is a cheering move, the attractiveness of this benefit could be curbed by factors such as potential higher cost of borrowing for borrowers due to ongoing liquidity tightening faced by the regional banks. Moreover, the affordability of  the 15% down-payment limit can be debated considering the disparity between the average home costs and average national salary.

Taking into account the challenges hampering KSA’s vision to increase the level of home ownership amongst its citizens, KSA’s move to start a state-owned mortgage firm similar to the U.S. Fannie Mae and Freddie Mac could be a game changer. Though these government-sponsored enterprises’ (GSEs) are criticized for being responsible for the 2008 financial crisis, their role in fulfilling the “American dream” of owning a home is undeniable.
An assessment of the role of these institutions in the U.S. market would lend better perspective in understanding the need for similar enterprises in Saudi Arabia.

The role of Fannie Mae and Freddie Mac
Fannie Mae and Freddie Mac were created for the important role of supporting and enhancing the U.S housing finance system. The primary objective of these government-sponsored enterprises’ (GSEs) is to provide liquidity, stability and affordability to the mortgage market.

Liquidity
They provide liquidity to the banks, savings and loans, and mortgage companies that make loans to finance housing. These GSEs provide liquidity or in a way fund these mortgages by purchasing loans directly from primary market mortgage originators, such as banks and mortgage companies, and holding these loans in portfolio, or by acting as a channel and issuing mortgage-backed securities (MBS), which are then sold in the capital markets to a wide variety of investors. Lenders use the cash raised by selling mortgages to these GSEs to engage in further lending.

The GSEs’ purchases ensures stability to the mortgage industry by providing ample liquidity to the mortgage lenders. The spillover effect is that individuals and families looking to buy homes and investors that purchase apartment buildings and other multifamily dwellings have a continuous, stable supply of mortgage money.

Secondary Market and Reduced Cost of Borrowing
The federal guarantee backing these GSEs provides investors a lot of confidence in the packaged mortgage securities offered by these institutions and thus increasing the attractiveness of these MBS instruments. The assurance of timely payment of principle and interest has attracted investors who might otherwise refrain from investing in mortgages, thereby expanding the pool of funds available for housing. The liquidity enjoyed by these instruments coupled with federal credit guarantee reduces the investor’s return expectations and thus lowering the interest rates paid by homeowners and other mortgage borrowers.

Promoting Affordable Housing
Besides encouraging a stable supply of mortgage financing, federal housing policy aims to make home ownership more affordable for low and moderate income households. The government subsidizes the cost of housing through its support of the secondary mortgage market by being willing to purchase and guarantee mortgages. They have passed a mortgage interest rate subsidy of 25–50 basis points to homebuyers through their interventions in the housing market (The Role of GSEs in the Housing Market (Heritage.org)). The federal government has also tried to improve access to mortgage financing through annual targets for the percentage of mortgages bought by Fannie Mae and Freddie Mac that were made to low and moderate income borrowers(Fannie Mae, Freddie Mac, and the Federal Role in the Secondary Mortgage Market). Additionally in an effort to increase lending to low income and first time home buyers, Fannie Mae and Freddie Mac are backing mortgages with down payments of as little as 3% of the home’s price( CNNMoney).

KSA – Precautions to be adopted
Fannie Mae and Freddie Mac are criticized for creating the demand for subprime loans which was the root cause for the financial crisis. As of June 2008, the 78% of the 31mn risky subprime loans were on the books of these GSEs. These GSEs prior to 1992 were only accepting prime mortgages in which the borrower had a FICO credit score of 660 and above,  made a down payment of 10%-20% and had low levels of debt to income. However, with the affordable housing goals program adopted in 1992, these GSEs were mandated to acquire 30% of loans made to borrowers below 80% and 60% of median income. Between 1993 and 2000, The Department of Housing and Urban Development (HUD) raised the 30% goals to 50%, and between 2001 and 2008 it raised the goals to 56%. Considering the challenge to meet these quotas, Fannie Mae and Freddie Mac started accepting increasing numbers of subprime mortgages.

The relaxing of underwriting standards to meet the affordable housing quotas by GSEs was subsequently adopted by other mortgage lenders. This liberalization of lending norms led to loans getting approved with zero down payment. All these factors collectively led to creation of the housing bubble which then culminated into one of largest global financial crisis. A surface level assessment substantiates the role of these GSEs in facilitating mortgage lending in the US market by addressing the core issues such as liquidity and affordability. Establishing similar institute is the answer to achieve the goals of improving higher levels of home ownership and affordable housing. However, the mortgage company should avoid the error in the form of excessive liberal underwriting process motivated by aggressive affordable housing goals committed by the US GSEs.