The Economics of Reform

Fannie and Freddie are in their tenth year of conservatorship, and while their long-term fates remain unresolved, two alternative paths to determining their futures now have emerged and been fleshed out. The first is legislative reform intended to replace or significantly restructure the companies, backed by the large banks and detailed in proposals this summer from the Mortgage Bankers Association (MBA) and the Milken Institute. The second is administrative reform intended to preserve and strengthen Fannie and Freddie, backed by the companies’ investors and community banks and detailed this fall in a proposal from Moelis & Company. Which path we end up taking will depend on the interaction of events and influences in three areas: political, legal and economic.

I view the politics in fairly simple terms. I believe the large banks have the political clout to get their way in any reform legislation, but that the divisions within and the dysfunction of the current Congress make legislation prior to the mid-term elections very unlikely. And on the legal front, it has long been my view that before Congress can pass legislation, some development or developments in one or more of the court cases favorable to the plaintiffs will provide a strong rationale for administrative reform. (I must confess, though, that each legal setback—and in the past eight days the dismissals of the Robinson appeal by judges in the Sixth Circuit and the Jacobs-Hindes case by Judge Sleet in Delaware have added two more to the list—diminishes my confidence in a boost to reform from the legal side.)

The economic aspects of reform—the facts about the plans and facts about the mortgage market—thankfully are less subjective. They also have been much less well publicized than the political claims and the legal news. Yet knowledge of them is critical to evaluating which plan will be better for the mortgage finance system, homebuyers and the economy, and which therefore merits the support of the public and the Trump administration.

 Unless you’ve been following it closely, I suspect you’ll be surprised to learn how greatly the profile of U.S. mortgage finance has changed since Fannie and Freddie were put into conservatorship. From the end of 2007 to the middle of this year (the latest period for which full comparable data are available), there has been a shift of almost $1.0 trillion in long-term fixed-rate mortgages from the books of Fannie and Freddie to the books of commercial banks, and the Federal Reserve has become a mammoth (but temporary) source of mortgage credit. Over the same period Fannie and Freddie credit guarantees actually have declined slightly, while government-guaranteed securities issued by Ginnie Mae nearly tripled. Here are the details:

 Changes in the sources of funding. At December 31, 2007 there were $11.27 trillion in single-family mortgages outstanding. Of these, Fannie and Freddie held $1.42 trillion in their combined portfolios, while commercial banks held $2.98 trillion ($2.02 trillion in whole loan form, and $963 billion in Fannie, Freddie, Ginnie or private-label mortgage-backed securities). The Federal Reserve owned no single-family mortgages in 2007.

At June 30, 2017 single-family mortgage debt outstanding was notably lower at $10.34 trillion, and the holdings of all three groups were considerably different. Under a mandate from Treasury to shrink their portfolios, Fannie and Freddie’s combined holdings of single-family mortgages were almost $1.0 trillion lower, at $454 billion. In contrast, banks’ single-family mortgage holdings were up by over $800 billion, to $3.81 trillion, or 37 percent of single-family mortgage debt outstanding. And at June 30, 2017 the Federal Reserve’s holdings of Fannie, Freddie and Ginnie single-family MBS no longer were zero; they were $1.77 trillion, or 17 percent of single-family mortgage debt outstanding.

There also were significant changes in the mix of bank mortgage holdings during this time. Banks’ $1.64 trillion in single-family MBS at June 30, 2017 constituted 43 percent of their total single-family mortgage holdings, up from 33 percent at the end of 2007. And within the MBS category, banks’ holdings of Fannie, Freddie and Ginnie MBS more than doubled—from $713 billion in December 2007 to $1.58 trillion in June 2017. (Banks’ holdings of private-label MBS were $212 billion lower). Nearly three-quarters of banks’ agency (Fannie, Freddie and Ginnie) MBS were pools of long-term fixed-rate mortgages, as opposed to shorter-term CMOs. Largely for that reason, 60 percent of the single-family mortgages and MBS banks held at June 30, 2017 (or $2.27 trillion) had long-term fixed rates, compared with just 45 percent (or $1.35 trillion) of such loans in December 2007. Since banks finance almost all of their mortgages with short-term consumer deposits and purchased funds, the movement of nearly $1.0 trillion in long-term fixed-rate mortgages and MBS from the books of Fannie and Freddie—who match-fund them—to commercial banks increased the interest rate risk of the mortgage finance system markedly.

The Fed’s emergence as a huge holder of long-term fixed-rate agency MBS was not a positive development either. The Fed, too, short-funds its mortgage holdings; when it purchases mortgages (or other assets), it does so by creating reserves at the seller’s bank, and those reserves pay interest in line with short-term market rates. But the bigger problem is that the Fed is not a natural holder of mortgages. It began purchasing them in January of 2009 to support the market following the crisis, then increased those purchases as part of the “quantitative easing” phase of its monetary policy. Recently the Fed announced its intent to reduce its agency MBS holdings. We do not know how much of its $1.77 trillion it ultimately will sell or allow to run off, but whatever the amount the withdrawal of Fed support will put further stress on an already challenged mortgage system.

Changes in the sources of credit guarantees. During the time Fannie and Freddie have been in conservatorship there have been enormous changes in the sources of credit guarantees as well. Most obvious has been the virtual disappearance of guarantees provided through structured transactions, following the disastrous performance of private-label securitization during the crisis. Less well publicized is the pronounced shift from Fannie and Freddie guarantees of conventional mortgages to guarantees of FHA and VA mortgages in securities packaged and issued by Ginnie Mae.

At December 31, 2007 Fannie and Freddie guaranteed the credit risk on $4.78 trillion of single-family mortgages, either for the loans they held in portfolio or for MBS held by other investors. On that same date there were $637 billion in FHA and VA loans packaged in government-guaranteed Ginnie Mae MBS. At June 30, 2017 Fannie and Freddie’s $4.72 trillion in single-family credit guarantees were down somewhat from nine and a half years earlier (with a shift in their guaranty mix away from portfolio loans to MBS held by others), while over the same period Ginnie Mae securities financing FHA and VA loans rose by $1.21 trillion, to $1.84 trillion. This dramatic market share change was particularly ironic in light of the constant claims by Fannie and Freddie’s opponents and critics that legislative reform is essential to bring private capital into the mortgage market. Fannie and Freddie were backed by private shareholder capital, and would be again if recapitalized and released. Yet while they’ve been kept in conservatorship, more than all of the $1.14 trillion net increase in agency credit guarantees has come from a near tripling in the amount of guarantees backed not by private capital, but by the federal government.

All three of the negative developments detailed above—increased interest rate risk from the strong growth in bank holdings of long-term fixed-rate mortgages funded short, $1.77 trillion of the same types of mortgages now in relatively weak hands (the Fed’s), and the effective freezing of the conventional mortgage credit guaranty function coupled with the unsustainably rapid growth of government mortgage guarantees—are by-products of the decision by the Treasury to seize Fannie and Freddie in 2008, and the subsequent policies of Treasury and FHFA to decapitalize the companies and run them with a view to ultimately replacing or substantially restructuring them.

The single-family mortgage market has not fared well during the conservatorship period. From its overheated peak of $11.34 trillion in the first quarter of 2008, single-family mortgage debt outstanding fell by 13 percent to a low of $9.91 trillion in the second quarter of 2014 (a decline of 2.1 percent per year). Since then, though, it only has been able to rebound by 5.2 percent, or at a rate of 1.7 percent per year. That is a very tepid recovery, and the crippled state of the conventional secondary mortgage market almost certainly is a primary reason.

It is clear from the current state of our mortgage finance system that we need to make changes to it, but even more clear that we need to make the right changes. And that is where the two alternative paths to reform—the legislative proposals from the MBA or the Milken Institute, and the Moelis administrative proposal—differ so starkly. The Moelis administrative plan will benefit homebuyers, because it is designed to make Fannie and Freddie (and the secondary market) as efficient as possible to maximize the value of the companies for their existing shareholders, including Treasury as holder of warrants for 79.9 percent of Fannie and Freddie’s common stock. In contrast, the MBA and Milken plans, like all legislative reform plans to date, are deliberately engineered to make the secondary market less efficient, to benefit large banks.

All recent proposals for legislative mortgage reform impose on credit guarantors a fixed “bank-like” capital ratio that is invariant to the risks of their guaranteed loans, and also provide for an explicit government guaranty on their securities. Coupled with an idiosyncrasy of the Basel III bank capital standards—they are based solely on credit risk and do not take into account differences in interest rate risk-taking—these two features of secondary market reform would produce a profit “superfecta” for banks: lower credit losses on the whole mortgages they keep in portfolio; a zero Basel III capital requirement on any MBS of Fannie and Freddie (or their successors) they own; wider funding spreads on both their MBS and whole mortgage holdings, and no capital penalty for the interest rate risk they take in funding long-term fixed-rate mortgages or MBS with short-term consumer deposits and purchased money.

Applying banks’ high, fixed-ratio capital standards to credit guarantors would lead to guaranty fee pricing that may be reasonable for lower-quality mortgages but would be far too high for better-quality loans. Banks thus would be able to hold down their single-family credit losses by keeping their best quality mortgages in portfolio as whole loans, while swapping their worst quality loans for government-guaranteed MBS, which they could either sell or keep in portfolio, as they wished. The zero Basel III risk-weight on guaranteed MBS, coupled with no Basel III capital consequences for short-funding long-term fixed-rate mortgages, would give banks a strong incentive to continue to add these loans in large quantities to their balance sheets. And the high average guaranty fees secondary market guarantors would be forced to charge because of unnecessarily high capital requirements would push up the interest rates on all mortgages, resulting in wider spreads on the mortgages and MBS banks fund with their FDIC-insured consumer deposits, whose costs are far lower than market-rate funding.

There is no mystery as to why the banks are advocating so strongly for the MBA or Milken legislative plans; they literally are crafted to give banks maximum profit benefit. But they do it by raising costs for homebuyers, reducing the availability of mortgage credit for low-and moderate income borrowers, and increasing the interest rate risk in the mortgage finance system with no governing regulatory mechanism to slow or compensate for it through higher required capital.

 It doesn’t have to be this way, and shouldn’t be. The U.S. economy has the enviable advantage of access to dual systems of financing: a strong deposit-based lending system alongside a robust capital markets-based securitization capability. The two complement each other, but they also compete. And if not properly monitored and regulated, that competition can become destructive.

There is useful history on this from the mortgage market. In the mid-1970s, nearly three-quarters of all single-family mortgages were made and held by depository institutions—thrifts or commercial banks. Two successive thrift crises, the first in the late 1970s and the second in the late 1980s, caused that system to collapse, with thrifts’ share of single-family mortgages financed plunging from 57 percent in 1975 to 17 percent in 1995. Fannie and Freddie’s ability to tap the international capital markets for prodigious amounts of fixed-rate funding allowed us to undergo a rapid and successful transition to a more balanced financing system. At the end of the 1990s, Fannie and Freddie either owned or guaranteed more than 40 percent of all single-family mortgages, up from less than 5 percent 25 years earlier.

Homebuyers benefitted from this development and were happy with it, but the large commercial banks were not. Fannie and Freddie’s standards in the secondary market placed limits on banks’ product offerings and pricing in the primary market. Banks did not wish to cede that control to Fannie and Freddie, and what I refer to as the “mortgage wars” began. In 1999 three large banks, one subprime lender and two private mortgage insurers (owned by GE and AIG) created a lobbying group called FM Watch, whose purposes were to put out misinformation depicting Fannie and Freddie in as negative a light as possible, and to lobby Congress for changes to the companies’ charters to raise the cost and restrict the scope of their business.

The deceptions about Fannie and Freddie that began with FM Watch have continued unabated since then. In fact, the insistence that Congress either replace or greatly restructure the companies through legislation has its origins in the earliest days of the reform dialogue, when their opponents succeeded in falsely blaming them for the 2008 mortgage and financial crises. Today, of course, we know this not to be true. Fannie and Freddie were not the worst sources of mortgage credit leading up to the crisis; they were by far the best. And they were not “rescued and bailed out;” they were “seized and decapitalized”—that is, taken over at the initiative of Treasury against the companies’ will and without statutory authority, then stripped of their capital by accounting entries booked by FHFA that temporarily or artificially ballooned their expenses and forced them to take huge amounts of unneeded but non-repayable senior preferred stock from Treasury.

While the appropriate response to a rescue and bailout might indeed be legislation to remedy the defects and weaknesses of the previous system, the correct remedy for the “seize and decap” of Fannie and Freddie that actually took place—and whose negative effects now constrict the provision of single-family mortgage credit—is the reverse, that is, “recap and release.” Bank supporters have turned recap and release into a taboo phrase, claiming it’s “not enough reform,” but the Moelis plan includes both actions, along with detailed steps to ensure the plan’s success.

In contrast, legislative reform as proposed by the MBA and the Milken Institute is an inequitable solution to an invented problem, and would exacerbate the weaknesses that have developed in our mortgage finance system over the last nine and a half years. With the Fed about to begin running off its mortgage holdings, we don’t need to drive more business onto bank balance sheets, where it will be leveraged, short-funded and not capitalized for interest rate risk. Instead we need to re-invigorate the conventional secondary market credit guaranty function to better enable it to attract low-cost capital from the international credit markets, whose investors can manage fixed mortgage interest rate risk far more safely than banks. The Moelis plan does that, and for that reason the Trump administration should embrace it.


208 thoughts on “The Economics of Reform

    1. ROLG,
      I believe I read somewhere that the Supreme Court will make a decision to hear the case at the conference and the decision will be announced on the following Monday ( Feb. 19th ) as to whether they will hear the case. That would mean we would hear fairly quickly whether or not they will hear the case. Can you confirm?


        1. ROLG,
          Thanks for the calendar info. I forgot about the holiday. In any event it sounds like we should know if the Supreme Court will hear the case in the next month or so. I feel less confident in the ROPS / Bhatti cases with the latest en banc decision with the PHH case which makes for me the Supreme Court hearing the case that much more critical. I really had promise for the ROP / Bhatti cases before the decision yesterday.


          1. @jerry

            the DC circuit is majority Obama administration appointees, and likely to uphold an administration agency’s argument, especially when the case goes to actual validity of the agency as structured. SCOTUS is far less skewed to favor an administrative agency agenda. interestingly, scalia was far more supportive of agency action than is his replacement gorsuch.

            in any event, jerry is right and the PHH case needs a client willing to pay the legal bill to petition for cert. we should hear about that soon, and if i were a betting man, i would wager that the PHH cert petition is forthcoming as is SCOTUS acceptance of the case.


          2. I scanned PHH vs CFPB. Judge HENDERSON understood laws better and the prior relevant cases more accurately than the majority. I felt he was like Judge Brown making things simpler. The majority was like a computer grading job applications. I trust SCOTUS.


  1. the briefing for SCOTUS to grant cert review of the perry dc circuit court opinion is finished.

    reasons for review are to: i) resolve a split among circuits relating to whether shareholders can maintain derivative actions where fhfa has a manifest conflict of interest (see class action plaintiffs’ reply brief:, and ii) because of the importance of the decision in terms of dollar amount at issue, the misinterpretation of “may” as improperly expanding upon any limitation on fhfa’s discretion under the statute, and the need to prevent fhfa from insulating Treasury from committing explicit violations of its duties under the statute (see fairholme reply brief: and perry reply brief:

    will SCOTUS grant cert? cant tell. when will we know of SCOTUS’s decision? dont know. if SCOTUS grants cert, however, the legislative/administrative reform timeline will have to accommodate a delay likely past 2018 elections.


    Liked by 1 person

    1. fortunately or unfortunately, today is law day.

      the dc circuit en banc held in PHH that the cfpb is constitutionally structured (in effect reversing the dc circuit merits panel decision):$file/15-1177.pdf

      fhfa is similar in many respects to cfpb. the bhatti and rop cases just starting out in federal district courts seek to invalidate the NWS based, in part, upon the argument that fhfa is unconstitutionally structured.

      i say in part because the bhatti and rop cases also seek to invalidate the NWS based upon argument that the fhfa director at time of NWS was appointed in violation of the appointments clause of US constitution.

      that appointment clause argument IS being heard at SCOTUS in Lucia and interestingly the US Solicitor General agrees with plaintiffs in that case that the SEC law judges were improperly appointed (lending support to the bhatt and rop appointment clause violation argument).

      i feel confident that SCOTUS will grant cert in PHH. this case goes right to the heart of the structuring, independence and discretion of administrative law, which is a big constitutional question that i believe SCOTUS will want to resolve.


      Liked by 3 people

        1. @anon

          either the industry will fund the appeal (as you say PHH no longer has a monetary incentive) because it has a continuing interest in the claim even though corkery is out, or the other case (name not at my fingertips) teed up before the DC circuit that is a pure constitutional claim will go on up. gibson dunn may even stay on case for reduced fee etc. ted olson is the olson in morrison v olson, a case that would likely be overturned if SCOTUS takes PHH and reverses. there is skin in the game for olson.


    2. I’ve read all three reply briefs by plaintiffs’ counsel, and–although I’m admittedly biased–found them to be persuasively argued. Now we wait to see whether the Supreme Court justices decide to hear the case. I certainly hope they do. With legislative mortgage reform efforts (again) seemingly on the verge of failure–based on how far the just-leaked Senate “staff discussion draft 29” is from anything that could possibly gain enough bipartisan support to pass–it looks as if inertia and the appeal to most parties of the status quo of conservatorship may be about to reassert themselves. We could use a victory for the plaintiffs somewhere in panoply of court cases to serve as a stir to administrative action.

      Liked by 2 people

      1. @bill and tim

        essentially there are three legal irons in the fire: i) the fairholme court of claims case which has finished discovery and the next step is an amended complaint and defendants’ motion to dismiss, arguing that even if NWS is permitted by HERA, it effected an unconstitutional taking of shareholder’s property interests in their shares–relief is money damages; ii) the perry appeal to SCOTUS, arguing that NWS violated HERA–relief is voiding NWS; and iii) the bhatti/rop cases, arguing that fhfa was unconstitutionally structured at time of NWS adoption (and still is), and that then fhfa acting director who adopted NWS was not properly appointed by president and confirmed by senate (was acting without constitutional appointment for three years at time of NWS…longest period constitutionally recognized for recess appointments, which is an analogy to an acting director, is two years).

        i could go on, but the takeaway is that if you have reached the conclusion that the senate banking committee draft #29 is just a start and a meager one at that, you need to add to that the notion that it doesnt begin to address the outstanding litigation, which no respectable piece of legislation should ignore. indeed perry, the only case that could basically go away during the legislative timeframe before 2018 elections, will itself persist post 2018 elections if SCOTUS grants cert.

        the relevance of the PHH case is that the claim that fhfa is unconstitutional structured likely wont be resolved until after SCOTUS grants cert re PHH case, which i believe it will.

        so the senate banking committee draft can ignore the litigation, but it seems to me that a comprehensive legislative “solution” to GSE/housing reform, which Mnuchin apparently wants, should address the litigation which is on track to continue well beyond the 2018 elections.


        Liked by 1 person

  2. Tim,

    Finally, the Senate Hearing video w Mnuchin is finally up on the Senate’s website:

    When you have a chance, listen to Corker questioning Mnuchin on Housing Finance Reform and please share your thoughts. In particular Corker tests Mnuchin on several points, in particular he gets him to acknowledge guaranteeing MBS securities & not the entities, then unsuccessfully pushes hard on Administrative reform & possible receivership, and for the first time on camera, potentially acknowledges shareholder rights It starts at 1hr:14min:50sec…


    1. I’ve now listened to the Corker/Mnuchin session, and have a few reactions worth mentioning. First, you missed a subtlety on the “guarantee the MBS” issue. Corker phrased his question about guaranteeing MBS versus entities this way: “If we have a government guarantee in the future, would it not be your preference that it be at the actual security level and not the entity level?” To which Mnuchin responded, “That would be my preference.” That’s not the same as Mnuchin saying he thinks there SHOULD be a government guaranty on MBS. Second, when Corker asked Mnuchin if he had “thought about” receivership for Fannie and Freddie, Mnuchin declined to take the bait, responding, “We’ve thought about and considered lots of things; I don’t really want to go through in this format publicly all the different alternatives you and I have spoken [about].”

      But I think the most interesting exchange was around the topic of legislative mortgage reform. Corker asked Mnuchin what Treasury’s options would be if Congress didn’t act. When Mnuchin gave Corker the response I’m sure he thought Corker was looking for—“There are certain options we have; these entities are very complicated; I would just say my strong preference would be to work with Congress on a bipartisan basis to reach a long-term solution,” Corker paused for a moment, then said in a low, flat monotone, “Yeah.” Then he added, “But in the event this great bipartisanship doesn’t survive, and we don’t get this done—it’s a very complicated topic—what are some of the steps you might take?” Having just finished reading the “Staff discussion draft 29” of what’s been called Corker-Warner 2.0—which as I note below totally punts on all of the difficult implementation issues associated with replacing Fannie and Freddie with the proposed 5 to 6 de novo credit guarantors—I strongly suspect Corker knows this legislation isn’t going anywhere. His answer to Mnuchin’s call for bipartisan legislation certainly seemed (to me) to reflect that.

      Liked by 3 people

      1. [Edited for length and clarity.] I agree with your observations.

        Corker’s response seemed to signal that he is resigned to the fact that the path forward will proceed through Treasury / FHFA. Mnuchin confirmed his position as lead dog to me when he laid out his terms for working with congress on reform towards the end of the hearing when provided the opportunity to speak openly (no specific question asked – just killing time.)

        The relevant time stamp from C- Span hearing video is 2:10:46 – 2:11:30.

        However what concerned me was the following quote:

        “I hope we do figure out a solution to this so that we don’t leave these entities around for another 10 years.”

        Given past language used, do you think he meant to say “…another 10 years in their current state (conservatorship)”?

        Or do you think it was perhaps a rare unmeasured statement, where in fact Mnuchin is open to a multiple guarantor model with an explicit guarantee on MBS directly and without the existence of the GSE’s in the future?

        In this clip he also seems to imply that he isn’t convinced an explicit guarantee is necessary on MBS directly…..but that there should be compensation for any IMPLICIT guarantee provided.

        Essentially, could you please review the above mentioned clip and provide any insights or clarifications.


        1. It’s clear to me that Mnuchin meant to say he didn’t want to leave Fannie and Freddie around for another 10 years in conservatorship (had he meant “leave them around at all” he wouldn’t have added the 10 year period).

          In this appearance before the Senate Banking Committee Mnuchin spoke in very general terms about possible alternatives for reform–both legislative and administrative–and didn’t explicitly rule anything out, including getting rid of Fannie and Freddie. But in an interview at a Wall Street Journal CEO Council session last November, he did. An interviewer said to him, “A lot of very conservative economists have been arguing a long time [that Fannie and Freddie] are fundamentally market-distorting institutions and that they should just be done away with. Would you go that far?” Mnuchin responded, “No, I wouldn’t,”

          On the issue of an explicit government guaranty Mnuchin was noncommittal, saying, “We don’t have to do that,” but he went on to say, “If we DO [put the taxpayer at risk with a government guaranty], that the taxpayer be compensated and that there won’t be any implicit guaranty that they’re not compensated for.” I read that as Mnuchin saying that if there is some form of federal “embrace” of the new versions of Fannie and Freddie short of an explicit guaranty–that allows the range of domestic and international investors to hold the companies’ MBS as eligible investments–this arrangement would need to be paid for.

          Liked by 1 person

          1. Not sure what admin reform can do. Can it guarantee MBS issued by other than GSEs like Citi? Can it force Citi to contribute to affordability fund? I feel that authorization should be only from Congress.


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