A Practical Fix for Fannie Mae and Freddie Mac Is Finally Within Reach
Amid the gridlock and uncertainty gripping Washington, one big item left over from the Obama era has been quietly resolving itself – the role that mortgage companies Fannie Mae and Freddie Mac will play in our economy.
Among the decisive steps Congress and the Bush Administration took while the markets and economy convulsed in 2008 was passage of legislation -- the Housing and Economic Recovery Act (HERA), which led to the government sponsored enterprises (GSEs) being placed in a conservatorship under the authority of the HERA-created Federal Housing Finance Agency (FHFA). An infusion of $187.5 billion in taxpayer funds helped stabilize Fannie and Freddie, but the battle over their fates was just beginning. Given their massive footprints in the financial landscape leading up to the 2008 crisis, many conservatives argued for revoking their charters and taking them apart. Even Fannie and Freddie’s defenders acknowledged going back to business as usual would be bad policy and even worse politics.
In the absence of either a plan from the Obama Administration or bipartisan consensus in Congress on comprehensive reform, Fannie and Freddie were directed by HERA to implement a number of reforms. After nine years, it is time for all sides to recognize the new reality: Fannie and Freddie are no longer the sprawling monsters of overleverage they once were, and a practical fix is finally within reach.
Since 2009 Fannie and Freddie have unloaded assets they never should have held in the first place. The federal government has relented in its demands that the GSEs constantly expand the volume of loans they securitize, and private-sector lenders now apply more rigorous criteria before making new home loans. In turn, the mortgages Fannie and Freddie purchase and package into securities are more transparent and less risky. Fannie and Freddie have become profitable and paid back more than the $187.5 billion advanced by the U.S. Treasury. In some ways, FHFA has created a future role for the GSEs by embracing their simple, original mission -- to make sure qualified borrowers are able to obtain home financing by adding substantial liquidity in the mortgage market.
The biggest obstacle that remains to ending government ownership of the GSEs concerns reserve capital. Even with a narrow and well-defined mission, more regulatory restrictions, and more stringent lending requirements, the GSEs are still huge. They back some $5 trillion in mortgages, a figure equal to about a quarter of the entire U.S. GDP. As such, they need ample reserve capital to tap in the next financial downturn. After bailing out Wall Street banks in the 2008 crisis, Congress insisted on tougher capital retention standards. Remarkably, the Obama Treasury Department went in the opposite direction with Fannie and Freddie. Since 2012, Fannie and Freddie have been required to send their profits to Treasury, supposedly to ensure that no additional taxpayer dollars would be needed to sustain them. The revenues to Treasury now exceed the $187.5 billion bailout by an astonishing $80 billion. If not for the conservatorship, these earnings would have been retained by the companies and their shareholders.
The idea that raiding the GSEs for capital is good for taxpayers was dubious in 2012. It is simply bizarre in 2017. Early in 2018, Fannie and Freddie will have no capital buffers at all. FHFA Director Mel Watt has warned about the risk this presents to taxpayers and wants to address it. However, if Watt were to withhold the next dividend payment to Treasury, there is concern it could kick off a nasty bureaucratic fight and unsettle capital markets.
These predictions notwithstanding, HERA, which set up the conservatorship, requires FHFA to restore the GSEs’ solvency. Capital retention is essential to GSE reform. It’s important to note that FHFA’s fulfilling its obligation in this way does not preclude later action from Congress, should it choose to update or replace HERA. However, instead of waiting for unlikely bipartisan consensus to emerge on the Hill, Watt would be doing taxpayers a great service by directing Fannie and Freddie to retain their next quarterly earnings and start building up capital as a hedge against possible market downturns and losses.
Once Watt acts, the Trump Administration could further advance meaningful GSE reform by adopting a blueprint patterned after the one assembled by the banking and financial consulting firm Moelis & Co. The plan would use the GSEs’ profits to build up capital so taxpayers would never again be forced to carry Fannie and Freddie. In the short term, the GSEs would be liberated from uncertainty and could go about their important mission of providing liquidity in the home lending market. In time, Congress and the Administration could develop new ways to spur more competition in securitizing mortgages and other changes they see fit to reduce government’s role and bring more private capital into the home finance system.
By boldly fulfilling the mandate of HERA, the Trump Administration has an opportunity to lock in useful reforms and undo ill-advised policies that have been unfolding at Fannie and Freddie for most of the last decade. This would be a major victory for taxpayers and prospective home buyers and set the stage for better home finance policy for years to come.