Will "Freeing" Fannie/Freddie Improve Housing Finance?

In a prior article we summarized the options the Trump Administration might utilize to reform the residential mortgage financing system should Congress continue to drop the ball.  Two noted economists, Jim Parrott and Mark Zandi, writing for the Urban Institute, address the notion of shrinking Fannie Mae and Freddie Mac's (the GSEs) footprints and eliminating their cross-subsidy of higher risk borrowers.  This article summarizes their alternatives for ending the 10-year government conservatorship of the two companies.  

The director appointed to replace Melvin Watt when his term as director of the Federal Housing Finance Administration (FHFA) expires next year will undoubtedly reflect the attitudes of the Administration including their claimed commitment to changing the GSEs' status. The authors say one way may be to put the GSEs entirely back into private hands.

This has some practical challenges and the need to overcome them would create the path the GSEs would have to take. First among them is the obligation to taxpayers. In return for a bail-out of the two institutions which, the Bush-era Treasury Department claimed were in danger of imminent collapse, the Treasury Department received options to purchase a 79.9 percent ownership of each, a 10 percent dividend on any GSE profit, and a fee to cover a commitment of additional capital should it be needed.

As Treasury grew concerned that one or both GSEs might be unable to pay the dividend, forcing them to borrow more to pay it, that obligation was changed to a net sweep of the institutions' net worth less a regularly declining cash reserve. This left the two companies, by the beginning of this year, with no capital reserves but with the commitment fee if they fail to pay any sweep installment.

It would be extraordinarily difficult for the GSEs to escape conservatorship carrying these obligations. Further, regulators could designate them as systemically important, requiring them to hold substantial amounts of capital.   While there are many variables in determining this, it could mean the companies would have to raise guarantee fees for the typical borrower by a half to a full percentage point in good times and much more in times of economic stress. The economics of the businesses are unlikely to work unless these burdens are removed.

The authors say it is not at all clear that the government can legally reduce the obligations. Two sections of the U.S. code allow compromising of a debt only when the debtor cannot pay, the cost of collection is prohibitive, or there is significant doubt as to the government's liability to prove that the debt is owed. It would not appear that any of these circumstances apply here.

There is also the possibility of putting the GSEs into receivership to remove the obligations.  FHFA has power to put their existing obligations into a "bad bank" that would go into run-off, freeing a "good-bank" to raise capital and be reprivatized. The bad banks' obligations including its legacy mortgage-backed securities (MBS), contractual obligations to taxpayers, and shareholder interests, would be covered by the revenue stream from the legacy business, sale of assets, and the remaining capital commitment from Treasury. The good banks would be formed as limited life regulated entities with up to five years to raise the capital needed to be released from receivership as privately-owned companies.

This does differ from the pre-conservator system. First, given the economic and political turmoil that followed the bailout the market is unlikely to assume as before that the two have an implicit government guarantee. This will change their underlying economics, forcing them to raise capital and borrower at costs that reflect their risk.  Similarly, only MBS investors willing to assume counterparty and other credit risks will be willing to purchase their MBS and may do so only at a premium. All of this will result in mortgage rates that are much higher and more cyclical, and likely mark the end of the TBA (to-be announced) market vital to long-term fixed rate mortgages.

Zandi and Parrott say if the administration is successful either in scaling back the GSEs' footprints or privatizing them altogether, the economy, housing, and mortgage markets could face significant disruption.

The GSEs provide a taxpayer funded subsidy to homeowners as government support lowers their borrowing costs. Shrinking their market share will reduce the borrowers receiving the subsidy, re-privatizing the GSEs will either force them to pay for the current level of government support or forgo it. Any of these will meaningfully increase mortgage costs for most borrowers.

Higher-risk borrowers currently receive the largest share of the subsidy and the cross-subsidy defined in the first article, so they will see the biggest share of the increases from a shift to full risk-based pricing. The market will see much less long-term, fixed-rate lending, as investors focus on adjustable rate mortgages rather than take both credit and interest risk. The administration is also likely to limit FHA lending when scaling back or privatizing the GSEs to avoid increasing taxpayer risk. This will also disproportionately impact higher-risk borrowers.

The authors proposed "the extreme scenario" where the GSEs are reprivatized as shareholder-owned institutions without a government backstop. They estimate mortgage rates would rise for typical borrowers by 90 basis points; much more in stressed economies and for high risk borrowers. Simulations by Moody's Analytics says annual sales of new and existing homes would fall approximately 7.5 percent to 450,000 units. Projected existing-home prices would decline by 6 percent and the homeownership rate drop by about 0.75 point.  It would ultimately adjust, but in Year One, real GDP growth would fall 0.8 percentage point, pushing unemployment up 0.4 point.

A better approach, the authors say, would be reducing the GSEs' centrality to the system by providing a better process of credit risk transfer (CRF), expanding the common securitization platform (CSP) into a market utility and increasing the GSEs' transparency. These changes would lessen their too-big-to-fail risk and make it easier for Congress to pass legislation establishing the future system without reducing their footprint or re-privatizing them.

CRT, now five years old, is bumping against its economic boundaries.  It could be expanded to include more institution-based sources of private capital rather than relying on capital market investors. It has been highly successful in part because of strong global capital markets, however, conditions will worsen at some point, and those investors will demand a higher return. This could force the GSEs to either absorb the cost, pass it on to borrowers, or pull back on risk-sharing when the risk is most critical to share. To ensure that the CRT process survives the cycle, a significant portion of risk must be shared with institution-based capital, such as reinsurance, lender recourse, or deep cover mortgage insurance.

FHFA should continue to develop ways that allow institutional equity to compete effectively. This would help stabilize the effort over time and give policymakers a better idea of what structural mix is needed for the long-term health of the housing finance system.

The next FHFA director should also expand the effort to build out the common securitization platform. The CSP is being developed to support a single security issued by Fannie and Freddie which will further entrench their dominance with an advantage over the rest of the market. The objective should be a platform that is open to other issuers, acting to reduce rather than increase GSE dominance.

Opening up the CSP would in effect turn it into a market utility, reducing barriers to entry for new issuers to compete with Fannie and Freddie or merge them into the utility to more evenly spread market power and risk.

To maximize it as a market utility, the CSP should be expanded to handle GSE functions that would pose barriers to entry in a reformed system such as the GSEs' use of automated underwriting systems.   Lenders have integrated the two different systems into their lending processes to such a degree that many would be unlikely to adopt a competing model unless given little or no choice.  Harmonizing the two systems into a single one for the CSP and making it available to new entrants would make it much easier for lenders to move from the GSEs as the market develops, differentiates, and competes across underwriting systems.

Making CSP a market utility would also allow policymakers to open it to the private label securities market which currently faces an inability on the part of investors and issuers to develop a set of standard contract terms, forcing each party, still wary after the financial crisis, through a gauntlet of negotiations for each transaction.

The next FHFA director should also require the GSEs to be more transparent, first around their capital framework and pricing. The GSEs set their guarantee fees as if they are holding a certain level of capital, yet it is unclear both how much implicit capital they are holding and what the implicit return they require on this capital is. Their opaqueness over capital and pricing solidifies their control over the system, since it is all but impossible to assess the appropriateness of the rules and standards they effectively set for all the stakeholders in the system.

Parrott and Zandi conclude that, with a new director at the FHFA potentially arriving next year, there is likely to be a meaningful shift in the GSEs' role, including a reduction of both their footprints and the cross-subsidy they provide. It may also mean an attempt to get the GSEs out from under the government's wing altogether. Any of these is bound to mean higher mortgage rates, less access to credit, and disruption to the housing and mortgage markets and broader economy.

If the next FHFA director were instead to expand the GSEs' current credit risk transfer process to more sources of private capital, expand the common securitization platform into a more robust market utility, and make the GSEs more transparent, it would ready the nation for transition to a housing finance system in which mortgage credit is as available as it is today but in a way that poses less risk to taxpayers and the economy.