Why I Support Reforming the GSEs, Not Eliminating Them

A lot has been said on the subject of Fannie Mae and Freddie Mac. Many speeches have been given, articles written, and op-eds published on the subject of how to resolve the unsustainable conservatorship. Like others with opinions, I have one too.

As background, I worked at Freddie Mac for the better part of a decade in the late 90s/early 2000s, overseeing the company’s Single Family business. I later served as the Assistant Secretary of Housing and Federal Housing Commissioner in the midst of the housing crisis and the nation’s worst recession since the Great Depression. I’ve also worked for lenders large and small – I’ve been involved in this housing finance system from all sides.

Today, I run the Mortgage Bankers Association. We have over 2,000 institutions representing banks, credit unions, community banks, independent mortgage bankers and service providers all involved in financing commercial, multifamily, and residential real estate, both rented and owned. No matter any outcome, our members will finance every property in the nation. I am not saying I own exclusive rights to the correct view, but I am saying my opinion is well informed.

I want to also clarify something. I am not a shareholder of either company and not involved with any of the lawsuits around shareholder’s rights. Importantly, I am truly indifferent to the shareholder cause. Whether the lawsuits succeed or fail, I only care about the long term viability of a vibrant and sustainable housing finance system.

The most important element here is to recognize that conservatorship is not a long term solution, and in the current state may be the riskiest position of all. The GSEs do not have the capital to withstand the next housing downturn and the taxpayers do not want to be on the hook again if the companies falter. Setting a long term pathway forward that offers structural reforms to the current companies and their operations, ends the conservatorship and opens the door for new entities to possibly compete with the legacy GSEs, is absolutely critical for our next President and Congress and should be a part of the candidates’ platforms.

I am not calling for the elimination of Fannie Mae and Freddie Mac. I’m advocating for reform of Fannie and Freddie as part of re-envisioning the government’s role in the mortgage market, keeping in mind the following principles:

The role the GSEs play in supporting an affordable and sustainable housing finance system is absolutely critical to this nation. The GSEs take large numbers of home mortgages originated by lenders, put them into government-guaranteed mortgage backed securities and sell them to investors around the globe. This function provides a steady flow of capital to the US housing market and ensures the availability of the 30 year fixed rate mortgage for American homebuyers in all geographies of the country.

Some might argue that this function could be replicated by other parties, private capital alone, or some new model. The fact is we need some form of government entity in the mortgage market.  Investors don’t like uncertainty – this why the vast majority of them will not buy any mortgage security that is not explicitly backed by the US Government.

Under their original charters, prior to their collapse, the GSEs operated with an “implicit” guarantee. While the US Government bailed them out once, there is absolutely no certainty this would happen again. For that reason, if these two companies were simply released from conservatorship, with nothing more than the implicit guarantee, mortgage rates for American homebuyers would inevitably rise as investors around the globe would not trust that the US Government would bail them out if anything were to happen again.An implicit guarantee vs. an explicit one is a big deal – and it’s why I believe that any exit from conservatorship has to involve legislation to establish an explicit guarantee behind these mortgage bonds. In short, the GSEs cannot be rolled back out with their former implicit guarantee and to get an explicit guarantee requires an act of Congress.

Protecting the infrastructure of Fannie Mae and Freddie Mac should be a priority, because any transition to a new system will need to retain and redeploy key aspects of the GSE’s current systems and talented employees. Why reinvent the wheel and start from scratch when you already have so many of the necessary pieces in place?

Reforming the GSEs will require revising their charters, confirming the role of a firm regulator, and either releasing them from conservatorship or establishing new corporate identities. The companies have no capital, and until exiting from conservatorship will be subject to intrusive Congressional intervention, like the recent efforts to try to pay for other unrelated legislation via new fees charged on mortgages and restrictions on executive compensation.

Allowing these two companies to continue supporting the system must also come with a new charter that maintains the bright line between the primary and secondary mortgage markets, limits their portfolios and restricts the products they can buy to core, sustainable mortgages, all in an effort to ensure they best serve the broad housing market and can never again make the mistakes that contributed to the housing crash.

The GSEs in any new system should have a clear mission. Prior to conservatorship, the GSEs had misaligned incentives. As companies that operated with an implicit government guarantee, Freddie Mac and Fannie Mae could operate with an enormous market advantage and use that advantage to extend their reach far beyond the original intent of their founders. As shareholder-owned, private companies, the relentless drive for returns and to compete fueled all sorts of bad decision making, which fed their massive portfolios with subprime, alt-a, and other unsustainable products.

In the end, the drive to benefit shareholders and to compete with other market players was paid for by taxpayers when the government was forced to bail them out. The government funneled close to $200 billion into them and then helped nurse them back to health via programs like QE, HAMP, and HARP; federal programs that allowed homeowners to refinance at low, subsidized rates, or modify their mortgage if they were in trouble.

Any future system should price mortgages based on actual credit risk and not market share or unsustainable credit risk trades. The GSEs grew far too fast on unsustainable programs often fueled by their portfolios and credit waivers.

The quest for market share drove these companies to give sweetheart pricing deals and credit waivers to lenders that could deliver more business in exchange for exclusivity. Just these elements – pricing and credit waivers and special deals – created significant advantages for some lenders, making it really difficult for small banks, credit unions, independent mortgage bankers to compete. It forced many to sell their loans to aggregators instead of directly to the GSEs.  And when it all collapsed, many that had the sweetest deals of all, led the fall.

To move this effort forward, we need to resolve what needs to be fixed.

  • Reduce risk to the taxpayer by having the explicit guarantee back only the mortgage securities and not corporate entities. The U.S. Government should charge a reasonable fee in exchange for this guarantee.
  • Fix the incentive conflict by limiting what businesses Freddie and Fannie can engage in. Eliminate the GSE retained portfolios for all but a few specific short term programs to support the cash windows and multifamily aggregation prior to sale into the markets.
  • Eliminate the competitive difference between the Fannie Mae and Freddie Mac mortgage securities. Creating one single security will both enhance market liquidity of the security and put Fannie and Freddie into a more balanced market position. It will also more easily allow for the entry of additional entities in to the system, should Congress move in that direction.
  • Reduce differences in data disclosure and improve transparency and investor confidence in the mortgage securities by adopting a common securitization platform. This will also allow for new entities to more easily enter the system and could also be used by the private securitization market.
  • Ensure the American taxpayer is at risk only in the event of a catastrophic market collapse by deepening the level of responsible private capital taking first loss risk in their transactions.
  • Ensure a robust supply of affordable rental housing by maintaining the GSEs’ multifamily programs.
  • Finally, with a strong regulator, establish clear policies about how the GSEs sustainably serve lower and moderate income earners in a manner that is effective, but also does not contribute to any future housing crisis.

Clearly, this is not a simple issue and everything I have laid out here warrants a far more robust discussion, including the appropriate role of government in the housing market, a debate that should include the proper size of the conforming loan limits and the multifamily caps. At my organization, the MBA, we have laid out extensive position papers on most of what I have discussed here. While this involves changes to their charters, their governance, and some operational improvements to reduce risk and improve liquidity, it’s a future that would keep what most Americans want to protect — the thirty year fixed rate mortgage — and continue a liquid flow of capital into all U.S. mortgage markets.