It has been 14 years since Freddie Mac and Fannie Mae were put under full operational control of the Federal Housing Finance Agency (FHFA) at the height of the financial crisis in September 2008. At the time, then-Treasury Secretary Henry Paulson called the move a “timeout” reflecting the temporary nature of the move.
According to Don Layton the Senior Industry Fellow for the Joint Center for Housing Studies at Harvard University, also the former CEO of Freddie Mac, believes that the Government Sponsored Enterprises (GSEs) falling into conservatorship was widely regarded as the result of fundamental flaws in their operations and structure. As such, scores of people on all sides of the of the ordeal believed that a simple recapitalization and being returned to the private sector as a bad move.
This situation created what came to be known as GSE reform, or the process of determining how to revise the country’s housing finance system so that the GSEs could never endanger the country’s financial stability again.
Currently, there are no plans in Washington on GSE reform meaning conservatorship will continue for the foreseeable future.
The Biden administration has not shown a major interest in the topic of GSE reform. While there was a major focus on reform in 2009, the topic became a “back-burner” issue by 2017. Interest in reform picked up during the tenure of FHFA’s then-Director Mark Calabria from 2019-2021, but not much discussion has happened since.
Layton states that GSE reform is not dead as two activities are underway, even though the thought of exiting conservatorship appears to be in suspended animation.
To better inform people on the subject, Layton proposed and answered four questions on the current state of GSE reform.
What happened to all the big, bold proposals for GSE reform?
The majority of big proposals for the GSEs occurred between 2009–2016 when interested parties from across the financial spectrum—including industry associations, policy advocates on both the political left and right, academics and, of course, government officials—looked to replace the entities with something different. Popular ideas included a single government-owned monopoly, breaking up the GSEs into smaller “mini-GSEs,” turn it into one or two cooperatives owned by the mortgage industry, or winding down the GSEs and letting the private sector to replace loan volume.
One GSE reform bill that got the furthest in congress was the bipartisan Corker-Warner Bill of 2014 which called for competing “mini-GSEs,” but it never came close to becoming law. Public examination of the bill brought up serious concerns about the proposal which ranged from fatal flaws to a general consensus that the bill was unworkable in practice.
Around 2018, policy experts and mortgage industry players shifted away from revolution and moved towards evolution keeping the GSEs operations as normal to avoid disruption to the complex mortgage markets. Thus “comprehensive GSE reform” has now become “GSE reform” meaning the companies will be reformed rather than replaced.
If anything, the GSEs have thrived under conservatorship. Many of the reforms instituted in the last 14 years have helped them along including: limiting investment portfolio size limits, shedding risk via credit risk transfer transactions, and the requirement of a robust and much higher capital requirement.
“This evolutionary approach to GSE reform thus called for keeping all the changes made during conservatorship,” Layton said. “It also called for regulation akin to how states regulate electric and other utilities (which includes setting prices charged to the public). Today, this utility-style GSE reform is the only major idea still around with broad support. Interestingly though, it did not emanate from any of the sources of earlier big and bold proposals, but out of the careful, years-long work of reforming the GSEs inside conservatorship by the FHFA, with Treasury also playing an important role.”
Legislative vs. administrative paths to GSE reform: Where do they stand?
Ideas for reform obviously require new legislation to be passed, but when it became clear that there was a shift from replacing to GSEs to reforming them through what became known as an “administrative path.” Layton said that this approach bypasses the need for congressional legislation because the changes necessary for the GSEs to exit this oversight could be made by the FHFA through regulation, plus the Treasury could modify the existing contract by which the enterprises gets funding through them.
“Right now, in fact, the consensus in Washington is that any legislation about GSE reform will not happen for many years at a minimum,” Layton said. “Given how well the GSEs are working in conservatorship, there is no pressure on Republicans or Democrats in Congress—who have very different ideas about what should be done with the GSEs—to force compromise on a reform plan. That means the administrative path is the only realistic option available right now.”
What two key GSE reform activities are quietly underway right now?
According to Layton, the most important GSE reform activity now underway is that the two enterprises are retaining all their earnings to build capital, an extremely important fact that many people gloss over. This makes the GSEs more financially stable, meaning they do not have to ask the treasury for additional cash injections, which are ultimately funded by taxpayers.
The second reform activity is FHFA Acting Director Sandra L. Thompson making changes to Calabria-era regulatory minimum capital requirements which called for an “unnecessarily high level” of capital. The limited scope of the revisions that have been implemented are designed to eliminate a “perverse incentive” for the GSEs to take on high risk mortgages and an equally perverse disincentive to lay off mortgage credit risk.
“Unfortunately, those are the only two important GSE reform activities underway right now,” Layton concluded.
What should we watch for to see if additional GSE reform activities get underway?
Layton sees three areas where additional government action is needed to facilitate a conservatorship exit. These changes are major undertakings which will take a lot time to implement (Layton estimates years, not months). They are:
- The existing regulatory minimum capital rule must be revised downward. This means largely adopting the underlying economics of how capital is required for risk in the banking system, but then applying it to the particulars of the GSEs, which are very much not banks, where the current capital rule treats them too much as though they are. Too high a regulatory capital requirement would directly translate into a privatized GSE having too high a cost of capital. As the largest component of guarantee fee pricing is the cost of capital, that would directly lead to inordinately high guarantee fee pricing by the two companies. Such a revised capital requirement would take at least a year, maybe even closer to two, to develop and implement. (See my earlier post which explains how the current rule’s capital requirement is demonstrably excessive versus the official stress test results released by the FHFA last year.)
- The FHFA must build the proper legal and operational infrastructure for utility-style regulation of the GSEs after they would have exited conservatorship. This is a heavy lift for the agency, assuming it duplicates the well-established state-level utility regulatory regime rather than trying to create something de novo. This would include establishing wholly new activities such as holding public hearings when the GSEs request pricing changes, examining all operating expenses to see which ones might be ineligible (e.g. unduly lavish customer entertainment), doing financial and economic studies to determine the required rate of return for investors (about which hearings would also be held), and so on. These things are second nature to state-level public utility commissions, but far afield from what financial regulators like the FHFA do.
- Ultra-complex mechanics need to be developed and implemented for each GSE to restructure the ownership of its equity. That ownership is currently distorted by Treasury holding all of the senior preferred stock (with over $200 billion outstanding) as well as warrants on 79.9% of the common stock, both of which sit beside the historic (i.e. pre-conservatorship) common and junior preferred shares, which are still owned by public market investors. (Such public market investors have few rights during conservatorship, but its ending would return those rights—such as the ability to elect the Board of Directors—to them.) A conservatorship exit requires that this equity ownership structure become undistorted and conventional, and free from conservatorship-related legal uncertainties. Treasury, more than the FHFA, is key to this happening, and the complexity, especially in such immense size and for two companies at the same time, is unprecedented. (Included in this undertaking would be establishing a fee for the GSEs to overtly pay Treasury for its support.)
Click here to view Layton’s full report.