Editor’s note: This feature originally appeared in the April issue of DS News
Fannie Mae and Freddie Mac, the two government-sponsored entities (GSEs) that back the majority of the country’s mortgage market, went into conservatorship in September of 2008 as they faced default of their loan portfolios. The conservatorship was initially thought to be a short-term arrangement to enable the GSEs to get back on their feet, and there were some efforts in Congress to unwind the positions within five years, but now there is little chance they will exit conservatorship before the November election. In fact, the status of the GSEs may remain largely unchanged for some time beyond that, though opinions of when and how they would leave conservatorship are widely varied.
Further delaying any resolution is the COVID-19 pandemic, which by mid-March had the government focusing all efforts on trying to minimize the effects of the disease on the nation’s health and economy. The various stimulus efforts were being undertaken with health and economy as the only consideration, so after-effects on any government plans not directly related, like moving the GSEs out of conservatorship, were pushed far to the back.
Before the pandemic became an issue, even FHA Director Mark Calabria has questioned the current financial status of the GSEs, telling the Credit Union National Association Government Affairs Conference last month: “The lack of capital at Fannie and Freddie jeopardizes their important mission. That is why we are focused on strengthening Fannie and Freddie.”
The goal is to strengthen them enough to bring them out of conservatorship, according to Calabrio. That prospect remains a hot topic of discussion among everyone from the pundits to the President, questions remain: will this goal truly come to fruition? And if so, what are the obstacles that remain along the way? DS News looks at the history—and future—of the GSEs.
A Storied History
Though much of the recent attention on them has been centered on their time since the turn of the century, Fannie Mae and Freddie Mac’s story begins long before that.
A 1938 amendment to the National Housing Act initially established Fannie Mae as a government agency, according to the FHFA’s Inspector General office. Fannie Mae’s mandate was to act as a secondary mortgage market facility that could purchase, hold, and sell FHA-insured loans, creating liquidity in the mortgage market and thereby providing lenders with cash to fund new home loans. Fannie Mae started buying Veterans Administration-insured loans in 1948, leading to a rapid expansion of the business, according to The American Mortgage in Historical and International Context by Richard K. Green and Susan M. Wachter.
The Federal National Mortgage Association Charter Act of 1954 (Charter Act) transformed Fannie Mae from a government agency into a public-private, mixed ownership corporation and exempted the GSE form state and local taxes, with the exception of property taxes.
Fannie Mae was reorganized through the Housing and Urban Development Act of 1968 from a mixed ownership corporation to a for-profit, shareholder-owned company, a change that also removed the GSE from the federal budget. As a result, Fannie Mae began funding its operations through the stock and bond markets.
Freddie Mac came into existence as a result of the 1970 Emergency Home Finance Act. Freddie Mac’s initial charge was to help savings and loans manage the challenges associated with interest rate risk. Most thrifts had made low-rate, fixed-interest-rate loans during the previous period of steady rates and were ill-equipped to handle the interest rate increases that had spiked from 6-10% at the end of the decade.
The Federal Home Loan Banks initially capitalized Freddie Mac with a $100 million contribution, enabling the GSE to start buying long-term mortgages from thrifts, which, in turn, cut their interest rate risk while also enabling them to make additional mortgages.
Though they had the same basic purpose—to provide lenders with a secondary market for conventional mortgages, Fannie Mae and Freddie Mac used different business strategies during the 1970s and 1980s, according to the FHFA Inspector General.
As a result of differing strategies, Fannie Mae and Freddie Mac had different outcomes in the late 1970s and early 1980s. Fannie Mae suffered from the sharp rises in the interest rates in the late 1970s and early 1980s because the long-term, lower rate mortgages were funded by shorter-term, higher cost obligations like deposits. But since it sold off its interest rate risk, Freddie Mac was relatively unaffected by the increase in interest rates.
To help Fannie Mae, the federal government provided forbearance and tax benefits.
The government, through the 1989 Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), reorganized Freddie Mac’s corporate structure to more closely match Fannie Mae’s.
The 1992 Federal Housing Enterprises Financial Safety and Soundness Act amended the GSE charters, requiring more of a dedication to supporting financing of low-income housing, resulting in aggressive in purchasing Alt-A mortgages, and private-label MBS collateralized by subprime mortgages, as foreclosures and losses increased, GSE borrowing costs went up and equity declined, resulting in the FHFA placing the GSEs into conservatorship.
The Cause of Conservatorship
Though their problems escalated sharply from 2006 until they went into conservatorship, the reasons for the government takeover go back far before the event actually happened, said Edward Pinto, Resident Fellow and the Director of the AEI Housing Center at the American Enterprise Institute (AEI).
In 1992, Congress started pushing for increased homeownership, and for several years there was a loosening of credit and lending standards, resulting in a lending boom that extended through 2005. The more relaxed mortgage underwriting rules for Alt-A and subprime mortgages heightened the liability for the GSEs just as the mortgage market was softening, said Stephen Ornstein, Co-Leader of Alston & Bird's consumer financial services team.
Both GSEs had several times more in outstanding loans than their capital could support and spent the first year in conservatorship deferring the hits to their capital, Pinto said.
The conservatorship was a necessary evil that helped to stabilize an unstable mortgage infrastructure, said Rick Sharga, President and CEO of CJ Patrick Co. “It helped the market recover and ensured there was liquidity. On the downside, it increased the government footprint in the mortgage market, making it very hard for private capital to come back in.”
As the conservator, the FHFA maintained broad authority over the GSEs. But rather than managing every aspect of their operations, the FHFA reconstituted the boards and charged them with enforcing normal corporate governance and procedures.
But in the first year of the conservatorship, the delinquencies continued, further extending the GSE financial troubles, Pinto said.
Under the 2014 strategic conservatorship plan, FHFA outlined three goals:
- Maintain safe and sound operations while fostering a liquid, competitive, and resilient housing finance market
- Reducing taxpayer risk by increasing the amount of private capital in the mortgage market
- Building a new single-family securitization infrastructure for use by the GSEs and adaptable for use by other secondary market participants
“Conservatorship, and any associated cost-of-funds advantage related thereto, is also augmented by the carve-outs for QM and ATR through the safe-harbors created for the GSEs,” said Tim Rood, Head of Industry Relations at SitusAMC and the Chairman of The Collingwood Group, a SitusAMC company. “The Safe Harbor provisions have allowed the GSEs to issue loans to borrowers whose loans would not otherwise qualify as QM, at a lower price point than private capital. During this same time, lending through GNMA-backed programs has also greatly expanded. The result is a much larger subsidy to borrowers through these government programs than would otherwise exist in the private markets.”
The benefit of the conservatorship is that it froze the market and allowed the GSEs to rebuild their capital, said Steve Horne, CEO of Insight One. However, stricter underwriting guidelines also made it more difficult for many consumers to obtain mortgages. Many potential borrowers could not meet the 43% debt-to-income ratio. While lenders could still make loans that didn’t meet those guidelines, it would mean keeping loans in their own portfolio, which lenders are reticent to do.
“The politicians understand this issue which is why solving for the GSEs has been difficult to get momentum around,” Rood said. “It is also why consumer advocacy groups are pushing for an average prime offering rate (APOR) test for QM in the hopes that limiting the spread allowed for a QM loan will force lenders to keep risk premiums down for the loans that enjoy QM status today but would not under the existing non-GSE definitions (ex. 43% DTI being exceeded)”
Seller-servicer guidelines for appraisals changed immediately with the conservatorship, said Bill Garber, Director of Government and External Relations for the Appraisal Institute. Previously, the same entity could make the loan and appraise the property. Under the new rules, a separate third party had to be used or there had to be a solid separation of the appraisal and lending processes if done with the same company.
“There weren’t enough checks and balances before,” Garber said.
The End in Sight?
When they went into conservatorship, few expected them to be there nearly a dozen years later. And even those calling for conservatorship to end soon, don’t expect any changes until some time after this fall’s election.
How quickly conservatorship will end remains a matter of debate. There’s no real consensus on the best way to end the conservatorship, Ornstein said. “They’ve been shock absorbers for risk in the mortgage market. If they leave conservatorship, there’s no assurance that the private market will step in.”
Allen Price, Senior Vice President at BSI Financial, said that any plans for emergence from conservatorship are likely to be put on the back burner until some time after the current coronavirus pandemic has passed.
The pandemic is going to have such a significant impact to the economy, that preparedness in not only planning for such health issues but in all phases of government, will be given a much more through examination, even if plans were thought to be good previously, according to Price.
Even before the pandemic, government organizations seem to be going in different directions. In October of 2019, the Treasury Department and FHFA agreed to allow the GSEs to keep $45 billion in capital to exit conservatorship, but a month later, the FHFA said it would re-propose the capital requirement rules sometime this year.
The FHFA wants to ensure that the GSEs are a source of liquidity in an economic downturn and support equitable market access for small lenders, Calabrio said. So the FHFA wants to build their capital, reduce their risk profiles and strengthen the FHFA’s regulatory capabilities.
The FHFA plans to have a draft proposal for commentary around April, with a final proposal by the end of the year, meaning the soonest the GSEs could come out of conservatorship would be 2021.
Even that scenario is dependent on the outcome of the coming election, said Michael Flynn co-chair of the Mortgage Banking and Financial Services Regulatory Industry Groups at the Buchalter law firm, who previously served as Acting General Counsel of the U.S. Department of Housing and Urban Development, and as General Counsel of Flagstar Bank and PNC Mortgage.
“I’ve seen what Calabrio has said and he’s interested in pushing [conservatorship] forward, even if he can’t get the outcome during the current Administration,” Flynn said.
If there’s a second Trump administration, the plans to emerge from conservatorship are more likely to move forward after the election, said Clifford Rossi, professor of the practice in finance and executive-in-residence at the University of Maryland’s Robert H. Smith School of Business and former senior risk manager for Fannie Mae and Freddie Mac, If the Democrats win in November, they might look at it a little longer.”
Whichever party is in power after the election will want GSEs with a stronger risk governance so that neither Fannie or Freddie goes back to making the risky loans that were responsible, a least in part, for the conservatorship in the first place, Rossi added.
“The chance of the GSEs leaving conservatorship any time soon is slim,” Pinto said. “There are a lot of obstacles and not a lot of agreement of how to do it. There needs to be agreement on capital and how the GSEs can de-risk.”
Price agreed, adding that many in the industry would be skeptical of the ability to de-risk without very careful government oversight. So he expects any emergence from conservatorship to be delayed until a couple of years after the election.
The FHFA has hired Houlihan Loukey, an investment bank and financial services company to develop a plan for the privatization, but any plan is still in its earliest stages.
“Houlihan Loukey will aid the FHFA in the development of a capital restoration plan on the heels of a capital framework; you can’t build a plan until you know what the framework is,” Rood said, pointing out that as of early March, the FHFA had yet to publish a new capital standard. “The most likely outcome in a conservatorship exit is that the UST and FHFA will need to amend the PSPAs of Fannie and Freddie to settle outstanding lawsuits with investors and amend the NWS to permanently stop the sweeping of their earnings. The enterprises will continue to be allowed to build capital to the new standard set by the FHFA—consistent with the requirements of conservatorship.”
The UST white paper on GSE reform runs the gamut of administrative and legislative reforms, but the preferences and priorities of stakeholders is largely unclear, according to Rood. What is clear is that the administration wants the GSEs to take less risk, to be fairly compensated for the risks they take, and to take risks that are commensurate with their level of capital.
Rossi said another possibility to raise capital for the GSEs would be an initial public offering.
Measure Twice, Cut Once
Several in the industry point to the need for a careful, gradual, well thought out plan before conservatorship would end.
“You can’t just unplug them; a lot of things could happen. The chances of getting it wrong are too high,” Horne said.
“Will they be capitalized enough and strong enough?”, Flynn asked.
Ornstein added that, even if the end of conservatorship is some time off, the GSEs will definitely have a smaller role in the mortgage market of the future. The “qualified mortgage patch,” which exempts GSE-backed loans from meeting all aspects of QM terms, is set to expire in 2021.
However, the Mortgage Bankers Association doesn’t want the QM Patch expire without a defined plan for creditworthy borrowers who don’t reach the QM’s 43% debt-to-income ratio.
Sharga also expects the GSEs to leave conservatorship, though any changes to how the GSEs operate will need to be done gradually, with much thought and consideration, he said. “The whole trick is to move them out in a way that protects taxpayers and enhances consumer access to credit.”
Sharga added: “They will need more oversight than before. They need better controls for credit risk than they had before.”
Sharga said he also wants to see a more level playing field for community banks and credit unions with any restructured GSEs.
Regulators want to make sure GSEs “aren’t over their skis” when they leave conservatorship, added Garber, who expects the process to move forward once the capital rule is defined.
Rossi and several others said that one of the big questions that remains is whether post-conservatorship Fannie and Freddie will offer implied government guarantees.
Horne added that leaving conservatorship would likely lead to increased consolidation in the mortgage market.
In the unlikely event that there’s no path for the enterprises to build sufficient capital, statutorily they will be required to be taken into receivership, Rood added. This will force the outstanding lawsuits and investors to settle disputes or, if the lawsuits are too much for the entities to bear, face a receivership. He thinks the first scenario is much more likely.
“We believe it’s likely that the GSEs will maintain a UST backstop and access to a line-of-credit. The QM patch will likely expire in Q2 of 2021 (following an extension of the patch) and QM will likely be amended in ways that are aimed at luring private capital back into the housing market,” Rood said. “If this happens, the safe-harbor advantage the GSEs experiences today would be removed and greater competition from private players would likely arise.”
“In the new age (post-conservatorship), we will see the GSEs and private market compete more directly,” Garber said.
Whether the GSEs leave conservatorship entirely or are little changed in the next few years, their status will certainly change. But whether an implied government guarantee will still exist is still a matter of some debate. If it still does exist in a new GSE environment, private lenders are unlikely to pick up any slack the GSEs leave as they change.
As the GSE environment changes, it also remains to be seen if it will result in tighter or looser credit, which would have a direct effect on the housing market, said Rohit Gupta, President and CEO of Genworth Mortgage Insurance. He also pointed out that any changes should be made when the market is strong. “A down cycle is a bad time to do reform.”
“They need to have complete transparency across the mortgage market,” Gupta added. “It’s important to have a functioning and transparent mortgage market. Any reform needs to provide better [protections] to ensure a stable financial system.”