Recall the housing government sponsored enterprises (GSEs)
Fannie Mae and Freddie Mac. At their heart was a simple business: buy
mortgages from banks and other originators and package them into
mortgage-backed securities (MBS); i.e., securities in which investors got
their returns from the mortgage payments of the underlying homeowners.
This provided the banks value by taking the mortgage off their balance
sheet and replacing it with cash that they could deploy to the next
lucrative opportunity. It gave the investors value by providing
diversification across mortgages, regions, and income groups. One could
make a little money doing this. The GSEs made even more money by adding
another service: selling the investors a guarantee that they would make
up for any underlying missed payments by the homeowners. This is risky,
of course, but the GSEs could hold capital against the prospect of any
losses and make good on the guarantee.
But here is where things got interesting. Because of their government
origins, the GSEs were festooned with special features — presidential
appointments to the board, a line of credit at the Treasury, exemption
from SEC securities registration requirements, and so forth. This gave
the impression that the GSEs were part of the government, an impression
that the GSEs were happy to have continue, so that they would have
government backing if they ever got in trouble. The GSE business model
took full advantage of this by holding very, very little actual capital
against the risks they held, and borrowing cheaply (since they seemed to
be practically Treasuries). The highly leveraged structure raised
their riskiness further.
Then the GSE doubled down on this by holding large portfolios of their
own MBS. Notice that if the underlying mortgages went bad, the GSEs got
hit twice. First, they would have to come up with the cash to cover the
guarantees. Second, they would not get income from their portfolios to
cover the costs of the borrowing they did to purchase the MBS. But that
would never happen, right?
Of course, the housing bubble broke in the-mid 2000s, defaults were
rampant, and the GSEs were taken over by the government — put into
conservatorship — in 2008 as the Treasury forked out hundreds of billions
of dollars to fill the financial gap generated by the ill-conceived
business model. They remain in conservatorship today.
Now, once again, there are rumblings that change is in the wind. Politico reports "Joseph
Otting, acting director of the Federal Housing Finance Agency, told
employees last week that the administration would not wait on Congress,
where attempts to overhaul the housing finance system have
repeatedly faltered in the years since Fannie and Freddie were rescued
during the financial crisis, according to a recording of his remarks
obtained by POLITICO. 'In the next two to four weeks you're going to be
able to see some communication that comes out of the White House and
Treasury that really sets a direction for what the future of housing
will be in the U.S. and what the FHFA's part of that will be,’ Otting
said at a Jan. 17 staff meeting."
Taken at face value, this is puzzling at best and shocking at worst. The
administration cannot change the underlying legal structure of the GSEs;
only Congress can do so. So any “plan” would be a de facto decision
to re-embrace the business model that led to failure in the first place.
Not a good idea. Of course, during conservatorship the portfolios have
been run down and are no longer the risk they once were. The Federal
Housing Finance Authority (FHFA) — the GSEs' regulator — could ensure
that they not reappear in the future. But the GSEs would still require
capital to back any guarantee losses and their capital reserves have been
run down as well. Either the Treasury thinks that it can inject hundreds
of billions of additional capital — at the taxpayers’ expense — or it
thinks it will be a promising business venture for Wall Street to do so.
Both seem dubious; the former is politically untenable and the latter
assumes that the GSEs are not instantly designated as Systemically
Important Financial Institutions (SIFIs) by the Financial Stability
Oversight Council (FSOC). They would simply have to be,
putting the GSEs into a stronger Federal Reserve regulatory regime with
substantial additional capital requirements. This should be the road not
taken.
The alternative is congressional reforms. The Wall Street Journal reports "Lawmakers from
both parties plan to take a fresh crack at getting Fannie
Mae and Freddie Mac, two companies that underpin
nearly half of U.S. mortgages, out of government control."
"'All the policy puzzle pieces are out there, what is lacking is the
political will to put them together,' Rep. Patrick McHenry (R., N.C.)
said in an interview, adding, 'Divided government is the best time for us
to legislate.’” This is the sensible policy path: decide what the
government role in mortgage finance should be and reconfigure the GSEs
via Congress to fit into that new schema. If that good policy is now good
politics, the moment is right for Congress to move on GSE reform.
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