Tag Archives: duopoly

Time Is Ripe For GSE Reform

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photo by Valerie Everett

Banker and Tradesman quoted me in Time Is Ripe For GSE Reform (behind a paywall). It opens,

Federal Housing Finance Agency (FHFA) Director Melvin L. Watt told the U.S. Senate Committee on Banking, Housing and Urban Affairs last month that “Congress urgently needs to act on housing finance reform” and bring Fannie Mae and Freddie Mac out of conservatorship after almost nine years.

Conservatorship is temporary by its very nature. There is universal agreement that it can’t go on forever, but there is widespread disagreement about what the government-sponsored entities (GSEs) should look like after coming out of conservatorship – and how to get there.

“Only a legislative solution can provide political legitimacy and long term market certainty for the housing finance system,” according to a recent Mortgage Bankers Association (MBA) white paper on GSE reform. MBA President and CEO Dave Stevens said now is the time for Congress to tackle the changes that will maintain liquidity, but protect taxpayers and homebuyers.

“The last recession destroyed many communities throughout the country,” he said. “The GSEs played a large role in that. They fueled a lot of the capital that allowed all varieties of lenders to make risky loans and then received the single-largest bailout in the history of this nation. They are not innocent.”

Connecticut Mortgage Bankers Association President Kevin Moran said his organization supports the positions of the MBA.

“There’s going to be change no matter what,” Stevens said. “We’re stuck with this problem. It’s technical and complicated and needs to be done. They can’t stay in conservatorship forever.”

Taxpayers Need Protection

Professor David Reiss at Brooklyn Law School said that future delays are not out of the question.

“Change is coming, but the Treasury and FHFA can amend the PSPA [agreement] again,” Reiss said. “It’s been amended three times already. There’s a little bit of political theatre going on here. It’s incredibly important for the economy. You really hope that the broad middle of the government can come to a compromise. If there isn’t the political will to move forward, they can simply kick the can down the road.”

Reiss said the fact that Fannie Mae and Freddie Mac are both going to run out of money by January 2018 is a factor in why reform is needed soon, but the GSEs aren’t in danger of imminent collapse.

“They are literally going to run out of money,” Reiss said. “But keep in mind they will continue to have a $2.5 billion line of credit. It’s partially political. They’re trying to get the public conscious of this. I don’t think anyone in the broad middle of the political establishment thinks it’s good that they’ve been in limbo for nine years.”
The MBA’s proposal to reform Fannie Mae and Freddie Mac aims to ensure that crashes like the one in 2007-2008 never happen again, in part by raising the minimum capital balance GSEs have to maintain to a level at least as high as banks and other lenders.

“They have a capital standard that is absurd,” Stevens said. “Pre-conservatorship they had to have less than 0.5 percent capital. Banks are required to maintain 4 percent of their loan value against mortgages. That’s a regulated standard. Fannie and Freddie are not as diversified as banks are. Our view is to make sure they are sustainable; they should at least a 4 to 5 percent buffer to protect them against failure.”

To put that into context, a 3.5 percent buffer would have been just large enough for the GSEs to weather the last housing crash without the need for a taxpayer-funded bailout. Stevens said the MBA would go even further.

“They should also pay a fee for every loan that goes into an insurance fund in the event all else fails,” he said. “In the event of a catastrophic failure, that would be the last barrier before having to rely on taxpayers. Keep in mind: for years, shareholders made billions and when they failed taxpayers took 100 percent of the losses.”

Stevens said the MBA would like to see more competition in the secondary market, and that the current duopoly isn’t much better than a monopoly.

“There should be more competitors,” he said. “If either one [Fannie or Freddie] fails, you almost have to bail them out. Our goal is to have a highly regulated industry to support the American finance system without using the portfolio to make bets on the marketplace.”

A Bipartisan Issue

While some conservatives like Chairman of the House Financial Services Committee Rep. Jeb Hensarling (R-Texas) have called for getting the government out of the mortgage business altogether, Stevens said that would likely mean the end of the 30-year, fixed-rate mortgage.

Furthermore, GSEs are required to serve underserved communities. Private companies would be more likely to back the most profitable loans.

“The GSEs play a really important role in counter-cyclical markets,” Stevens said. “When credit conditions shift, private money disappears. We saw that in 2007. It put extraordinary demands on Fannie Mae, Freddie Mac and Ginnie Mae. You need a continuous flow of capital. You can put controls in place so it can expand and contract when needed.”

Reiss said getting the government out of the mortgage business would certainly mean some big changes.

“I think there is some evidence that some 30-year, fixed-rate mortgages could still exist,” Reiss said. “It would dramatically change their availability, though. Interest rates would go up somewhere between one-half and 1 percent. Some people might like that because it reflects the actual risk of a residential mortgage, but it would also make housing more expensive.”

Be Careful What You Wish For GSEs

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Jim Parrott and Mark Zandi have released a report, Privatizing Fannie and Freddie: Be Careful What You Ask For. The authors go through a very useful exercise in which they break down the cost of reprivatizing. The report opens,

Few are happy with the current housing finance system that has Fannie Mae and Freddie Mac in conservatorship and taxpayers backing most of the nation’s residential mortgage loans. Yet legislative efforts to replace the system have largely faltered, raising concern that we may not have the political will or competence to replace it any time soon.

This has created an opening for those who contend that we should not replace the system at all, but simply recapitalize the government-sponsored enterprises and release them from conservatorship. Fannie and Freddie were remarkably profitable prior to the financial crisis, after all, and have been consistently in the black recently. Why embark on the laborious, risky and now stalled process of fundamental reform when we can simply return to a model that we know can provide steady access to affordable, long-term fixed-rate lending?

While we both have serious concerns with the wisdom of releasing the duopoly back into the market, we thought it useful to set those concerns aside for the moment to explore the economics of the move. The discussion often takes for granted that this path would take us back to the world precrisis, but economic conditions and the regulatory environment have changed in ways that would significantly affect how Fannie and Freddie would function as reprivatized institutions. (2)

Parrott and Zandi conclude that

The debate over whether to recapitalize and release the GSEs into the private market is often framed as a choice of whether or not to return to a prior period in lending. For all its shortcomings, the argument goes, at least we know what to expect in the cost and availability of mortgage credit. But this is a misconception. In releasing the GSEs into the private market again, we would release them into a very different regulatory and economic environment, and they would respond, not surprisingly, by charging very different mortgage rates. (4)

I really have no argument with Parrott and Zandi’s paper, but I would note that their conclusions don’t differ so much from the pre-crisis academic papers that attempted to quantify the increase in mortgage rates that would result from privatizing the two companies — fifty basis points, give or take (see, for example, The GSE Implicit Subsidy and Value of Government Ambiguity).

I value Parrott and Zandi’s paper because it reminds us to keep pushing forward with real housing finance reform even though Congress has not yet made any progress on that front.

Risky Business Model for Homeowners?

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The Mortgage Bankers Association issued a report, Up-Front Risk Sharing: Ensuring Private Capital Delivers for Consumers, intended to increase the role of the private sector in the portion of the mortgage market currently dominated by Fannie Mae and Freddie Mac.  The MBA argues that to “entice private capital into the mortgage market, FHFA should require the GSEs to offer risk sharing options to lenders at the “point of sale.” (1) The report notes that about “60 percent of new mortgage originations today are sold to the GSEs. This dynamic means that the GSEs’ credit pricing has effectively determined the cost of and access to credit for a wide majority of all new loans.” (5) The GSEs’ credit pricing is thus not set by the market.  The report continues, the GSEs

are now charging more than twice as much in guarantee fees as they did a few years ago, at the same time their acquisition profile shows they are taking on very little credit risk, even compared to pre-bubble credit standards. For example, average credit scores for GSE mortgage purchases prior to the crisis were about 720; today they are 760. Similarly, the weighted average LTV of loans outside of the HARP program are in the high 60% range, several percentage points lower than in the early 2000s. With this combination of high fees and ultra conservative underwriting, it is not surprising that the GSEs are seeing large, indeed record, profits — their revenues are up and their costs are down, not through their execution, but through government fiat and a privileged market position. (2)

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Without quibbling with some of these characterizations, I would note that I have long taken the position that the private sector should bear more of the risk of credit loss in the residential mortgage market. As a result, I welcome proposals for them to do so.  This particular proposal also reduces the role of the GSEs which, while just a partial reduction, is another welcome development.  So, this proposal appears to be good for the mortgage industry (particularly private mortgage insurers).  It is also good for taxpayers because the private sector would be taking on credit risk from the federal government.

The question that remains is whether this is the right solution for homeowners.  The MBA says that this proposal will increase access to credit.  It would be helpful if the industry could model this claim.  The lending industry has its own cycle of credit loosening and tightening, so it would make sense to understand how such a cycle would impact homeowners if we moved toward such a system and moved away from the Fannie/Freddie duopoly.