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The Long, Hard Road to GSE Reform

Fannie-Freddie-logos-twoFor some time, policymakers and industry executives have thrown around the idea of reforming and recapitalizing Fannie Mae and Freddie Mac, but is it possible at this point?

With every proposal for GSE reform being shot down at every turn, the chances of change occurring remains slim but not impossible.

Alex J. Pollock, Senior Fellow at the R Street Institute and former President and CEO of the Federal Home Loan Bank of Chicago, wrote in an essay released by the Urban Institute [1]Tuesday that the American housing finance sector is "as important politically as it is financially, which makes it hard to reform."

"More than seven years later, America is still unique in the world for centering its housing finance sector on Fannie and Freddie, even though they have equity capital that rounds to zero. Now they are primarily government-owned and entirely government-controlled housing finance operations, completely dependent on the taxpayers. Nobody likes this situation, but it already outlasted numerous reform proposals," Pollock explained.

Pollock's assessment that GSE reform is unlikely is bad news for taxpayers—especially in light of a speech by FHFA Director Mel Watt [2], conservator of Fannie Mae and Freddie Mac, at the Bipartisan Center in February. Watt spoke of risks facing the GSEs that are "certain to escalate" the longer the conservatorships continue, with the chief risk being the fact that Fannie Mae and Freddie Mac are required to have zero capital by January 1, 2018.

Watt noted that a disruption in the housing market or period of economic distress could cause the need for another draw on Treasury by Fannie Mae and Freddie Mac—i.e., another taxpayer-funded bailout similar to the one the GSEs had to take in 2008 to avoid insolvency. Watt also pointed out, however, that not only would GSE reform be extremely complex, but so are the conservatorships themselves.

“We know that the stakes are high for the housing finance market and for the broader economy,” Watt said in the speech. “However, as I have indicated in my remarks today, there are substantial challenges and risks associated with the unprecedented size, complexity, and duration of the conservatorships of Fannie Mae and Freddie Mac.”

While Watt's remarks caused some to speculate that the end of the conservatorships is near, the Department of Treasury issued a statement a week after Watt's speech stating that a so-called "recap and release" (recapitalization of the GSEs and releasing them from conservatorships) was not going to happen in the near term.

“Taxpayers injected $188 billion into the GSEs to stabilize the housing market and lay the groundwork for our economic recovery,” a Treasury spokesperson said.  “Director Watt's remarks underscore the Administration’s consistent position regarding the GSEs’ conservatorship:  the best long-term solution is comprehensive housing finance reform. Until then, Fannie Mae and Freddie Mac will continue to rely on the $258 billion of taxpayer provided support to sustain market confidence.”

In his analysis, Pollock suggested seven ways to approach housing finance reform:

  1. Turn Fannie and Freddie into SIFIs at the “10 percent Moment”
  2. Enforce the law on Fannie and Freddie’s guarantee fees
  3. Encourage skin in the game from mortgage originators
  4. Form a new joint FHLB mortgage subsidiary
  5. Create countercyclical LTVs
  6. Reconsider local mutual self-help mortgage lenders
  7. Liquidate the Fed’s MBS portfolio

Yet another theory of why GSE reform may not be possible anytime soon is that Fannie Mae and Freddie Mac earnings are holding back recapitalization. Establishing enough capital with earnings would take decades, according to a recent report from the Wall Street Journal by John Carney [3].

"The question is likely to remain a theoretical one for the foreseeable future. The chances of the companies being released from conservatorship is extremely low," Carney wrote. "A far more probable outcome is that the companies eventually get wound down and replaced by a new system."

Carney continued, "This brings us full-circle, demonstrating that there is no realistic scenario under which the companies will be released from conservatorship in the foreseeable future. That leaves us with either a situation in which the conservatorships last in perpetuity or the companies get wound down and replaced with something new."