In an interview on Fox Business on November 30, Treasury Secretary-designate Steven Mnuchin said, “It makes no sense that [Fannie Mae and Freddie Mac] are owned by the government and have been controlled by the government for as long as they have,” adding, “we gotta get them out of government control….and in our administration it’s right up there in the list of the top ten things we’re going to get done, and we’ll get it done reasonably fast.”
While Mnuchin did not say how the Trump administration planned to get Fannie and Freddie out of government control, the fact that he called it a “top ten” priority that he wants to accomplish “reasonably fast” is an extremely positive development.
Mortgage reform has been hung up in Washington for the past eight years, largely because the Treasury Department has insisted that Fannie and Freddie be “wound down and replaced” as part of any reform initiative. To facilitate this goal, Treasury falsely accused the companies of having caused the 2008 financial crisis, and put them into conservatorship against their will and in spite of the fact that they still met their statutory capital requirements. Treasury then directed their regulator, the Federal Housing Finance Agency (FHFA) to book massive amounts of non-cash expenses that forced them to take $187 billion in unneeded, non-repayable senior preferred stock, whose 10 percent dividend required them to pay $18.7 billion after-tax to Treasury in perpetuity. But because the source of Fannie and Freddie’s senior preferred stock burden had been temporary or artificial non-cash expenses booked by FHFA—not operating losses incurred by the companies—the expenses reversed themselves and became profits beginning in 2012. At that point, Treasury and FHFA agreed to the net worth sweep, requiring Fannie and Freddie to remit all their future profits to Treasury—keeping them in indefinite conservatorship while Treasury, its allies and supporters attempted to figure out how to replace them. Numerous lawsuits were filed challenging the sweep, and reform discussions effectively have been frozen as those suits work their way through the courts.
Now the incoming Secretary of the Treasury says he wants to get Fannie and Freddie out of the government. To do that he will need to settle the lawsuits, and to settle the lawsuits he, and the plaintiffs with whom he will be negotiating, will need to decide what they want to do with Fannie and Freddie after the settlement.
Mnuchin ran the mortgage department at Goldman Sachs for five years (during the time I was Fannie’s CFO), so he comes to the fight over Fannie and Freddie with a wealth of knowledge, and brings a fresh perspective to it. He knows the plaintiffs he will be negotiating with—Bruce Berkowitz, John Paulson and Bill Ackman among others—quite well, and they all understand the difference between financial reality and financial fiction when it comes to the companies. Plaintiffs in the lawsuits have had ample time to evaluate the alternatives to Fannie and Freddie that have been put forward; they believe they are unworkable, and will convey that to Mnuchin. On the other side, career officials from Treasury will continue to assert that Fannie and Freddie are a “failed business model” that leads to “private gains and public losses,” but those bromides are unlikely to be persuasive to the pragmatic group of financial professionals who now are in a position to decide the companies’ futures.
Just as Fannie and Freddie were put into conservatorship (and subjected to the net worth sweep) through administrative action, they can be taken out the same way. And moving the locus of the reform debate from Washington to New York will be a welcome reset. The special interests in Washington have had eight years to try to devise a replacement for the companies as the centerpiece of the U.S. secondary mortgage market, and they have failed utterly. That is turning out to be a blessing. Very few on Capitol Hill have more than a superficial understanding of what it takes for a secondary mortgage market credit guaranty operation to function effectively, and having a $10 trillion financial market at the heart of the American economy be at the mercy of lobbyist-drafted legislation always was a frightening prospect. We will be much better off in the hands of Messrs. Mnuchin, Berkowitz, Paulson, Ackman, et al.
For almost twenty years I was responsible for the capitalization, credit risk analysis and pricing of Fannie Mae’s single-family credit guaranty business. When I left at the end of 2004, Fannie was financing more than $2.3 trillion in mortgages, serving an impressively wide range of low- and moderate-income homebuyers, meeting ambitious affordable housing objectives, and charging an average guaranty fee of under 20 basis points while posting a 15-year average annual credit loss rate of less than 3 basis points. This experience gives me a better perspective than most on what the future U.S. secondary mortgage finance system should look like. From that perspective, I have three pieces of advice for the negotiators who must agree on this post-settlement system: pick the best model, get the capital right, and be realistic about the role of government.
I elaborate on each briefly below.
Pick the best model.
The biggest mistake the Obama-administration Treasury made in its stewardship of mortgage reform efforts was its insistence that the mortgage finance system of the future look nothing like the mortgage finance system of the past, with Fannie and Freddie at its center. This doomed its reform efforts to failure, because the Fannie and Freddie model works, while alternatives that reject this model do not.
In his book On the Brink, Treasury Secretary Henry Paulson said, “Fannie and Freddie were the most egregious example of flawed policies that inflated the housing bubble and set off the housing crisis.” That was complete fiction. The superior performance of the companies was known even before the crisis, and it has subsequently been confirmed: from 2008 to date, the average credit loss rate on single-family loans purchased or guaranteed by Fannie and Freddie prior to the onset of the crisis has been about one-third the average loss rate on comparable mortgages made and held by commercial banks, and less than one-fifth the loss rate on loans financed with private-label securities.
One reason for Fannie and Freddie’s exceptional credit results is their business model. They are specialized institutions, whose only business is financing U.S. residential mortgages. While they hedge their interest rate risk extensively, historically they have retained the bulk of the credit risk on the mortgages they finance. As shareholder-owned companies they have strong incentives to gauge, price and manage that risk prudently. They impose strict underwriting standards on the loans they purchase or guarantee, and benefit greatly from their ability to diversify credit risk by product type, risk category, geography, scale and over time.
Credit guarantors that diversify credit risk at the entity level can weather adverse housing market environments with far less capital (and thus far lower guaranty fees) than structured securities or credit guarantees made at the pool level. In the entity-based model, revenues on good loans from all years, regions and loan types are available to cover losses on any group of loans that happen to go bad. In the pool-based model, each pool has to stand on its own, and the inability to reach beyond that pool for revenues—or to add capital post-securitization, as an entity-based guarantor can—requires substantially greater amounts of capital initially. Across a $5 trillion secondary market, the inefficiencies of pool-based guaranty models add up to tens or perhaps hundreds of billions of dollars in required capital, which simply disappears when those risks are diversified at the entity level. The entity-based model isn’t just marginally better than the pool-based model; it’s overwhelmingly better.
Fannie and Freddie are entity-based guarantors. They exist today, and have a proven track record of success. They should not be “wound down and replaced;” they should be reformed, removed from conservatorship and recapitalized.
As I’ve noted elsewhere—including in an essay titled “Fixing What Works,” done for the Urban Institute (and available on this site)—there are three key reforms to the companies that should be made. The first is to limit their mortgage portfolios to purposes ancillary to their credit guaranty businesses. Those would include holding non-performing loans purchased out of mortgage-backed security (MBS) pools, operating a cash window for whole loans sold by smaller lenders (to be pooled into MBS by the companies), and possibly for the “incubation” of new product types in anticipation of their becoming sufficiently popular to warrant their own MBS prefix. The maximum size of the companies’ portfolios would depend on what is necessary to carry out these activities; I’ve recommended a limit of no more than 10 percent of outstanding credit guarantees.
The second and third recommended reforms to Fannie and Freddie are updating their capital requirements and clarifying their relationship with the government. They are addressed in the next two sections.
Get the capital right.
In his Fox Business interview, Mnuchin said, “we need these entities that will be safe so let me just be clear; we’ll make sure that when they’re restructured they’re absolutely safe.”
The path to determining the amount of capital required to make Fannie and Freddie “absolutely safe” has been open in front of us for eight years. Section 1110 of the Housing and Economic Recovery Act (HERA) of 2008 states, “The Director [of FHFA] shall, by regulation, establish risk-based capital requirements for the enterprises to ensure that the enterprises operate in a safe and sound manner, maintaining sufficient capital and reserves to support the risks that arise in the operations and management of the enterprises.” FHFA so far has ignored this provision of HERA, I believe at the behest of Treasury, which knows that if FHFA does update Fannie and Freddie’s risk-based capital standards it would reveal that the companies need far less capital to operate safely than their critics insist they hold.
When Mnuchin becomes Treasury Secretary he should immediately instruct FHFA to follow HERA and update Fannie and Freddie’s risk-based capital requirements to meet current standards of taxpayer protection. The single-family mortgage standard already has been set: it’s the 25 percent nationwide decline in home prices used in the Dodd-Frank stress tests for banks. To align Fannie and Freddie’s capital with this standard, FHFA would draw on their historical loan performance data to project their cash credit losses, guaranty fees and administrative expenses over a scenario in which home prices fall by 25 percent over some realistic period of time (chosen by FHFA). Fannie and Freddie’s new risk-based capital requirements would be the amount of initial capital, by product type and risk category, necessary to withstand this stress scenario—plus some small additional cushion set by FHFA. (FHFA also will need to update the capital requirements for the companies’ portfolio investment and multifamily businesses, which have risks different from the single-family business.)
The actual risk-based capital requirements that result from this exercise will not be known until FHFA conducts it, but I’ve used the same stress scenario, Fannie’s 2008-2012 credit losses, and its current book of business—which has few of the interest-only adjustable-rate mortgages and “no-doc” loans that caused half its credit losses in 2008-2012—to estimate what Fannie’s single-family credit risk capital might be today. That estimate is not much over 1 percent. The percentage is so low because Fannie’s mid-2016 business mix contains relatively few higher-risk loans. Largely for this reason, I’ve recommended that the companies also have a minimum capital requirement (I’m proposing 2 percent). A minimum capital percentage will benefit affordable housing borrowers by making it impossible for Fannie or Freddie to drive their required capital below that minimum by financing only pristine credits.
Banks have been persistent and vocal critics of a risk-based capital standard for Fannie and Freddie’s credit guaranty business for over three decades. Because of the scope and complexity of banks’ permitted business activities, their regulators have had no choice but to subject them to static, ratio-based capital standards for broad categories of the various types of business they do. Banks’ opposition to custom-tailored capital standards for Fannie and Freddie rests on the “level playing field” argument that the companies should have the same arbitrary and inefficient capital standards for mortgages they have. Yet that would cause homebuyers to pay unnecessarily high guaranty fees for no good purpose. More capital for Fannie and Freddie is not better. The objective should be the right amount of capital—one that strikes a careful and deliberate balance between taxpayer protection on the one hand and the cost and breadth of access to mortgages on the other.
Be realistic about the role of government.
With new, much more rigorous and transparent risk-based capital standards set by FHFA and endorsed by Treasury, I believe Fannie and Freddie’s credit guaranty businesses would be able to operate without an implicit or explicit guaranty from the federal government. (The companies’ portfolios would need to either shrink or be sold off to the point where they could comfortably be financed with debt that is a general obligation of the companies, combined with derivatives.) Mortgage rates, however, would be higher. The yields on Fannie and Freddie’s MBS would rise by some unknown amount, and the market for their MBS would be considerably less broad and deep than it is now.
To prevent these adverse effects, it would be much better public policy for the companies to have some form of recognized support from the federal government. In my “utility” model, I have proposed that in exchange for Fannie and Freddie’s accepting a stringent risk-based capital standard, tighter supervision and regulated returns on their business, the government would put in place a formal agreement to extend short-term repayable loans to them in the remote event that their (new and much tougher) capital standards prove insufficient. With such an arrangement, the government would convey a valuable benefit to low-, moderate and middle-income homebuyers—through the lower Fannie and Freddie MBS yields that would result—at no perceptible risk or cost to taxpayers.
The concept is simple, and I think compelling. Once the government has picked the stress standard it wants Fannie and Freddie to be able to protect against, it then becomes in the government’s best interest to extend short-term repayable credit to the companies in the remote chance this standard (which it set) proves insufficient. Any consequent moral hazard or perverse incentives should be minimal. Beyond the companies’ having regulated returns, in a scenario that triggers government support Fannie and Freddie’s shareholders would lose nearly all of their capital, the stock price would plummet, noncumulative preferred dividends would cease, and top management would lose their jobs. And once the companies recovered, they would have to replace their lost capital by issuing new shares of common stock at very low prices, badly diluting the value of existing shares. The mortgage finance system, and homebuyers, would benefit from the backstop arrangement far more than would the companies or their executives.
There are numerous precedents for the federal government conveying benefits to particular industries or sectors of the economy for the public good, at negligible risk to the taxpayer. An excellent example is federal deposit insurance. FDIC insurance already is in place, so we tend not to notice its systemic benefits. But imagine what would happen were those who insist that the secondary mortgage market be “fully private” to make the same demand of commercial banking, and require that FDIC insurance be replaced by private deposit insurance, backed by private capital.
Implementing this would have three major effects. First, banks would pay far more to private deposit insurers than the actuarially determined fees they pay the FDIC, because private insurers would have to hold significant amounts of risk capital and would price to earn a market return on that capital. Second, consumers would demand substantially higher rates on privately insured bank deposits than they do on FDIC-insured deposits. Third, private insurers would exercise considerably more discipline over what banks can do with their insured deposits than the FDIC now does, limiting banks’ revenues from risk-taking. The total costs to the banking system of private versus FDIC insurance—through higher insurance fees, higher deposit rates, and restrictions on risk-taking—would be enormous, and the bulk of them would be passed on to banks’ customers. By corollary, the avoidance of those costs through FDIC insurance is a government benefit of an equivalent amount.
No one advocates replacing FDIC insurance with private deposit insurance, yet many do assert that any form of government support for the secondary mortgage market—even one with no hard-dollar costs—is anathema. That is an indefensible double standard. Policymakers must recognize it as such, and not penalize mortgage borrowers by forcing them to bear an ideological burden from which customers of banks have been exempted.
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Pick the best model; get the capital right; be realistic about the role of government. That’s the easy part. Following these steps, settling the lawsuits, and getting Fannie and Freddie “out of government control” and back supporting the mortgage market as shareholder-owned companies is the hard part. That, however, is the expertise of the people who now will be taking the lead on mortgage reform. We all should wish them well in the task that lies ahead of them.