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Is the GSEs’ Status Quo Sustainable?

Handshake One BHThe Federal Housing Finance Agency (FHFA)’s conservatorship of Fannie Mae and Freddie Mac, which will reach its eight-year anniversary in September, was only meant to be temporary.

The Obama Administration does not believe that GSE reform is an urgent issue. Last year, key officials such as Treasury Secretary Jack Lew and Treasury Counselor Antonio Weiss publicly stated [1] that the GSEs will not be recapitalized and released from conservatorship while Obama is president.

The financial results for Q1 2016 released by both Freddie Mac and Fannie Mae this week, particularly for Freddie Mac, have resulted in even more questions as to whether or not the current GSE model is sustainable—whether the GSEs can continue to be profitable under the conservatorship or whether taxpayers will be forced to fund another bailout. Freddie Mac reported a $354 million loss [2] for Q1, its second quarterly loss in the last three quarters (a $475 million loss was reported for Q3 2015). Fannie Mae was profitable for Q1 [3] at $1.1 billion but it was less than half of the previous quarter’s profit.

“From a sustainability standpoint, it could be sustained as a conservative enterprise for quite some time, but I don't think it's sustainable because you're going to eventually continue to have litigation from real shareholders saying, ‘What it the world is going on? It's in conservatorship, not receivership,’” said Steve Williams, Principal with Cornerstone Advisors. “That's occurring right now. Even the money moving to Treasury is still in litigation with shareholders. But more importantly, I think it's not sustainable because having the two GSEs, essentially your mortgage market standard-bearers, in this kind of limbo could ultimately constrain the health of the economy in terms of the housing market and housing finance.”

In response to Freddie Mac’s Q1 earnings release, noted Washington Post political columnist George Will wrote a piece titled “Treasury's Fannie and Freddie Rip-Off” [4] in which he described the “misadventures” of Fannie Mae and Freddie Mac and characterized the GSEs’ current situation as a “maddeningly complex story” that “illustrates the toll the administrative state takes on the rule of law.”

“In September 2008, the government rescued them with $187.5 billion and placed them in conservatorship, which is supposed to be temporary and rehabilitative,” Will wrote. “A conserved entity should be returned to normal business in private ownership.”

“A conserved entity should be returned to normal business in private ownership.”

George Will, Political Columnist

Several industry trade groups have joined the chorus of calls this week for GSE reform. The Community Home Lenders Association (CHLA) released the following statement [5] following the news of the Freddie Mac Q1 loss: “The Community Home Lenders Association is renewing its call, made in a February letter to Director Watt, to have FHFA let the GSEs build a capital buffer, in order to avert a Treasury advance.  Today’s news that Freddie Mac is reporting a modest quarterly loss only serves to heighten the importance of FHFA taking this step as soon as possible.”

Likewise, Independent Community Bankers of America (ICBA) stated [6] after Freddie Mac’s Q1 financial results were reported, “This net loss will not trigger a draw from the U.S. Treasury as Freddie Mac’s and Fannie Mae’s capital buffer bleeds away. However, it is only a matter of time until one or both of them will need a draw, putting the housing market and taxpayers at risk. ICBA continues to call on Federal Housing Finance Agency Director Mel Watt and Treasury Secretary Jacob Lew to end this destructive sweep of the government-sponsored enterprises’ revenues. Further, they should follow the Housing and Economic Recovery Act of 2008 and require both GSEs to develop and implement a plan to rebuild their capital buffers to prevent another bailout.”

Watt first sounded the alarm in February when he expressed concern in a speech at the Bipartisan Policy Center [7] over the GSEs’ lack of a capital buffer. That buffer, which is currently $1.2 billion, is required to be reduced to zero by January 1, 2018. The Watt speech immediately fueled speculation that GSE reform was imminent, but Treasury quickly put out the fire with a public statement that a recap and release was not going to happen [8]. At that time, Treasury stated that, “Director Watt's remarks underscore the Administration’s consistent position regarding the GSEs’ conservatorship: The best long-term solution is comprehensive housing finance reform.”

“It's pretty sad how long this has taken. It's just another symptom of a very dysfunctional legislature.”

Steve Williams, Principal, Cornerstone Advisors

Not only is the capital buffer dwindling, but the GSEs are not even keeping their profits. The bailout agreement was amended in August 2012, and since then all GSE profits have been swept into Treasury—a move that has triggered several lawsuits from GSE shareholders. In the first full year after the bailout agreement was amended (and not coincidentally in the minds of GSE investors who have sued over the profit sweep), the GSEs enjoyed a historic year for profitability [9] in 2013—a combined $133 billion, largely from non-recurring tax-related items and legal settlements. By comparison, the GSEs’ combined profitability for 2015 was $17.4 billion.

Attempts have been made to reform the GSEs. Senators Bob Corker (R-Tennessee) and Mark Warner (D-Virginia) proposed a bipartisan bill in 2013 [10] to eliminate Fannie Mae and Freddie Mac and replace them with a private insurance company system with a government backstop. The bill gained little traction, however. The Urban Institute has been publishing a series of essays [11] written by economists and other housing experts about different GSE reform possibilities.

Nearly everyone on both sides of the political aisle believe that GSE reform is necessary—it’s just that no one can agree on a sustainable solution.

“The problem is that I don't see a structured idea that is gaining momentum among the financial services industry or among Congressional staffers who inform Congressional leaders,” Williams said. “Usually by this time, there is an idea that is 80 percent bait, and as far as the question whether this will be resolved soon, I don't see the crystallizing idea yet. Certainly a new president may say to folks around the beltway, ‘It's time to crystallize. Give me your best option or two in the next six months.’ It's pretty sad how long this has taken. It's just another symptom of a very dysfunctional legislature.”