The Guru Is In

GSEs: Sentence Commuted, Eligible For Parole

By David A. Smith
October 1, 2019 5 min read

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With the mid-September release of Treasury’s Housing Reform Plan, the administration has presented its exit strategy for GSE conservatorship, which may be summarized as ‘death sentence commuted, eligible for parole in a few years,’ and mapped out a strategy to do exactly that without legislation.

Eleven years ago, consciously manipulated and self-enriching financial shenanigans by Fannie Mae (and to a lesser extent by Freddie Mac) nearly broke the global financial system, which was rescued only by fast, decisive and bare-knuckled action by the Federal Reserve and Treasury. In the span of a few days and weeks, they effectively nationalized the two principal GSEs via conservatorship, confiscated private shareholders’ equity, explicitly guaranteed their multi-trillion-dollar loan portfolios, injected critical liquidity, prevented a panic-driven meltdown of global capital markets…and via emergency legislation created the Federal Housing Finance Agency (FHFA) as the GSE’s combination liege lord and prison warden.

Brutal and crude as this was, the result was mild compared with the alternative, recommended by a fair number of market-championing policy think tanks, of defrocking Fannie and Freddie as government entities, removing their federal support, and casting them out to the private markets. Clemency was shown only because the vast body of informed opinion judged (correctly, in my view) that, as the GSEs were and are the beating heart of the U.S. residential mortgage finance system, any shutdown would be economically cataclysmic for the country and the world.

Since then the entities, perhaps chastened by their near-death experience (not to mention being financially bound hand and foot), have been on their best behavior. Their businesses, both single-family and multifamily, are profitable and growing, with over $5.5 trillion in assets between them. Treasury has long since recovered its capital injection and is now reaping significant dividend repayments under the GSEs’ Preferred Stock Purchase Agreements (PSPAs).

Against this backdrop, the Treasury report’s 44 pages offer a condensed and educational history and summary of the GSEs’ situation, together with the reasoning behind the administration’s proposed policy reforms – but those interested only in the likely outcomes will speedily jump to the appendix, where Treasury lists its recommendations, conveniently classified as:

Legislative, for which read, Not until after the 2020 election, if then.

Administrative, for which read, Get done before the 2020 votes are counted.

Within its wide administrative latitude as conservator, Treasury evidently intends to implement strategic restructuring based on six main principles:

1. Prevent another runaway train. One global near-death experience is enough, thank you very much.

• Curtail, or if possible eliminate, the GSEs’ historical freedom to grow their balance sheets by securitizing their loan book instead of packaging and selling MBS.

2. De-risk the government in anticipation of conservatorship exit to create an option for a future president.

• Limit each GSE’s multifamily business to “its underlying affordability mission” as part of an overall strategy to reduce their again-growing market share and to diversify national liquidity options. Smart observers think this will tighten mortgage access for lower-income and lower-asset homebuyers and likely push up their borrowing costs.
• Prevent the GSEs from launching any new single-family program, activity, or product by first obtaining FHFA approval, including a public comment process that can probably be slow-walked to retard such expansion approval.
• Recapitalize both GSEs, mainly through retention of profits above the current de minimis baseline, to build up their capital and liquidity to commercial levels that are enough “to remain viable as a growing concern after a severe economic downturn and ensure that shareholders and unsecured creditors, rather than taxpayers, bear losses.”

3. Focus on providing secondary market counter-cyclical liquidity as the core mission and business model, because that was the original charter mission and is the critical activity on which all else depends.

• Support both single-family and multifamily mortgage backed securities (MBS), long the GSE’s core business.

4. Define clear boundaries with existing governmental agencies to separate commercial/technical business (for the GSEs) from inherently governmental decisions about regulation, subsidy and legal consumer protection (not for the GSEs).

• Trim the GSEs’ future products so that high loan-to-value, high debt-to-income, and other pro-affordability higher-risk lending moves to FHA (or VA) as part of an overall strategy to put socially motivated lending onto the federal balance sheet and into Congressional Budget Office’s credit scoring and budgeting.
• Conform GSE lending with the Consumer Financial Protection Bureau’s ability-to-repay rule to establish “a clear bright line safe harbor.”

5. Defer parole until after the election. You never know what 2021 may bring.

• Continue the PSPAs as the principal strong governance.

6. Mess with some people’s heads. If only for friends and fun.

• Maintain a nationwide cash window for small lenders and prohibit volume-based pricing discounts or similar incentives.
• “Revisit underwriting criteria for…multifamily loans in jurisdictions that adopt rent-control laws or other under impediments to housing development.” Take that, California and Oregon!

Never mind the legislative air castles: if Treasury and FHFA achieve all the administrative changes they have said they intend to pursue—and there’s no evident legal or legislative obstacle to doing so—then whoever’s sworn in next will find GSEs that are trimmed, shorn and ready to be paroled.