A couple of weeks ago, I was on CNBC’s Squawk Box talking about the secondary mortgage marketplace and the state of conservatorship of Fannie Mae and Freddie Mac. Some may have misunderstood, so it’s time I clarify.
The GSEs are systemically critical providers of capital for both single family and multifamily mortgages, and the health of the real estate markets are in jeopardy as long as these two companies remain in their current state of conservatorship. The resolution of this conservatorship is vital to a functioning housing finance system that will be durable for the generations ahead.
Where are we today? We’re in the same place we were 7 years ago – Fannie and Freddie remain in perpetual conservatorship; they are still private companies being run by the government. Permanent conservatorship is not healthy for the market. The GSEs remain at risk because they have veritably no capital buffer to prevent draws on their line of credit with Treasury. And to be clear, the likelihood of one or both GSEs needing a draw from the Treasury department at some point in the future is almost a certainty. While the treasury line is certainly large enough to support any draw, the political risk of taking a draw threatens the entire system.
So what to do?
We cannot return to the old system of relying on implicit guarantees, and one that created a misalignment of incentives between shareholders and taxpayers. We need an outcome that protects the critical role these two firms play, and one that maintains the federal support behind their mortgage backed securities, but a system that also protects the taxpayer and eliminates some of the too big to fail concerns as well.
Last year Congress made a valiant effort toward passing reform legislation and resolving conservatorship, but ultimately came to a stalemate. Since then, what’s changed?
More voices are now calling for the government overseers to allow the GSEs to recapitalize and return to their prior status. These voices include:
- Groups representing discrete sectors of the industry
- GSE shareholders who stand to make a significant financial gain if recapitalization occurs
- Some consumer advocates
A recent article from Seeking Alpha clearly demonstrates the GSE shareholder bias of recap, release and operate without a government guarantee. They seem to care only about their profits and far less about the mortgage market and consumers.
How some consumer advocates can side with this view is remarkable. It’s all about shareholder returns – that’s it. In my view, this cannot be the ultimate objective. A successful and sustainable housing finance system should be the goal and nothing more.
And this one point in the article says it all:
"Of course, the most influential members of the mortgage banking lobby might not want the government to exit their position with Fannie and Freddie. Why? Because right now, the credit quality of mortgage backed securities matches that of U.S. Treasuries. They benefit from an explicit guarantee created by the Treasury's Senior Preferred Stock Purchase Agreement."
Let's be clear, the explicit guarantee brings liquidity to the MBS market. Private capital needs to come back as well, but not at an exorbitant cost to families hoping to buy a home. The explicit federal guarantee benefits consumers and that cannot be easily replaced. Only Congress can reassert the guarantee, absent the Treasury support in the current state.
Whether you’re for or against it, recapitalization of the GSEs is extremely unlikely given the provisions of the Preferred Stock Purchase Agreement, the ongoing shareholder lawsuits, and the practical difficulties of returning Freddie and Fannie to their prior state. Moreover, most analysts estimate that it would take a decade or more of robust retained earnings coupled with a generous interpretation of the pre-crisis Federal Housing Finance Agency capital requirements to allow FHFA to release the GSEs from conservatorship.
So what are the possible paths forward? Those who care about a stable, liquid mortgage market must:
- Work with Congress on solutions that could be accomplished now and remain beneficial in the long run.
- Encourage the GSEs and the regulator to conduct new pilots to require credit enhancement on all loans with LTVs of 50% or higher. This change would effectively institute first loss risk sharing, thus reducing the taxpayer’s exposure to mortgage credit risk.
- Facilitate efforts to speed the progress toward a GSE single security and the development of the common securitization platform (CSP). This needs to happen in months, not years. Institutional focus and discipline will fade if this is not implemented soon. To be clear, a single mortgage backed security is critical for liquidity and competition.
- Develop language for a simpler housing finance reform bill that would focus on the core elements required for an efficient secondary mortgage market, but one that protects the critical elements of these two institutions; their people, processes, and systems.
- Work to build coalitions across a broad set of stakeholders to bridge key policy divisions.
Right now, Fannie Mae and Freddie Mac are providing liquidity in the secondary market for residential mortgage in the absence of private capital. The unbalanced dependence here puts the entire system on untenable ground and presents enormous risks to taxpayers. Protecting what Fannie Mae and Freddie Mac do in support of the housing market and making sure the system protects taxpayers has to supersede the narrow, profit-focused motives of the shareholders of these two companies.
(Based on an initial post on David Stevens' LinkedIn.)
