The Treasury's plan to accelerate the wind-down of Fannie Mae and Freddie Mac by replacing the 10% dividend payment established as part of the conservatorship with a quarterly sweep of their profits signals the beginning of the end of the GSEs as we have known them.
The logical next step toward revitalizing the housing finance system is to combine both agencies, with the goals of the Federal Housing Finance Agency's strategic plan released earlier this year as the guide for such realignment.
Merging the agencies would once and for all announce the final chapter for the companies and end a variety of business practices that are inefficient and illogical in light of their conservatorship status. One of these is the pretense that the agencies are really engaged in a competitive business. The companies continue to maintain separate agreements with lenders over the pricing and terms of business offered in exchange for their loans, introducing unnecessary frictions in the market.
One such friction is related to the growing pricing wedge between Fannie and Freddie mortgage-backed securities. Although Freddie Mac securities have historically traded behind Fannie's in the market for a variety of technical reasons, the gap has widened considerably over time. In earlier years, the perception that Freddie Mac's securities may prepay faster than Fannie's created part of the pricing drag, which itself may have been partially self-inflicted due to the inherent competing risks of default and prepayment within a mortgage contract. For mortgages, higher credit quality reduces the probability of default, but raises incentives for mortgage refinancing when such opportunities are available to the borrower. Years before the crisis then, Freddie's credit discipline may have played a role in the securities pricing gap. In response to the securities pricing differential, Freddie has had to make side payments to lenders in the form of refunds to induce lenders to do business with it.
Continuing this practice by maintaining separate securities perpetuates the myth that any real competition remains between the GSEs in their current state. Calls from various constituencies in the mortgage business to establish a single security are sensible. But why stop there?
Treasury should convene a blue ribbon bipartisan commission comprised of industry experts and practitioners to form a detailed plan for what comes next in resolving the agencies and replacing them. Admittedly, we only have to look to tax policy to see how such commissions have fared over time. However, there is some common ground by which both parties could empower such a commission to recharge efforts to restructure the secondary mortgage market.
Placing one of the agencies into receivership may literally take an act of Congress given their charters. Nonetheless, the housing recovery that both parties and homeowners long for can't get off the ground with the existing business-as-usual approach to handling the GSE issue.
Combining the agencies would bring a number of benefits. First, via a single security, any remaining differences in credit standards would be eliminated, creating greater clarity for mortgage underwriting. Second, combining the agencies would achieve certain efficiencies that would allow the merged entity to better allocate resources for activities that support the FHFA's strategic plan. This would provide further cost savings to taxpayers. For example, why should there be two automated underwriting systems maintained by separate staff on separate systems at this point, four years into the conservatorship?
Right now the taxpayer owns two of every process and system used to source loans, securitize, and manage legacy portfolio and mortgage modification activities. This creates confusion among lenders, perpetuates a dying business model where resource duplication results in extra costs to taxpayers, and prevents more focus on needed improvements. By reallocating resources between the agencies, efforts toward realizing a common securitization platform could be redoubled, and portfolio reduction activities and distressed homeowner remedies accelerated.
Some argue that before we can fully proceed with a true wind-down of Fannie and Freddie, the future structure of the secondary market has to be established. While it is critical that the contours of the future housing finance system should be vigorously pursued, given the time it will take to implement the new process, taking the next step with the GSEs to restructure them as a legacy business model directly telegraphs to the market that meaningful change lies ahead.
When Cortes arrived in the New World, to motivate his troops he burned his ships. Combining the GSEs serves this same purpose while offering so many tangible benefits.
Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.