WASHINGTON — If Congress can’t get a housing finance reform bill passed by the midterm elections, the Trump administration and Federal Housing Finance Agency may chart a future for Fannie Mae and Freddie Mac without lawmakers’ input.

As conservator, FHFA Director Mel Watt has substantial leeway to remake the government-sponsored enterprises.

The Housing and Economic Reform Act of 2008 gives the FHFA "almost unlimited authority over what it can do to Fannie, Freddie, creditors and shareholders in extremis,” according to a report by Federal Financial Analytics.

The report details how the FHFA could move forward on GSE reform on its own. While Treasury would have input on the future state of the enterprise, significant authority resides with Watt, whose term expires in January 2019. That gives him added incentive to act before he can be replaced by the White House.

FHFA Director Mel Watt.
FHFA Director Mel Watt's term expires in January 2019, giving him a deadline to act if he wants to do so absent legislation. Bloomberg News

Karen Shaw Petrou, managing partner at Federal Financial Analytics, said in an interview that Watt and Treasury Secretary Steven Mnuchin have clear incentives to end the conservatorship of Fannie and Freddie if Congress doesn’t act.

“Fannie and Freddie are zombies right now. They are really big, really systemic zombies and the market isn’t functioning properly for lots of different reasons,” Petrou said. “The incentives are the risks of perpetuated limbo, which are significant in terms of long-term risk to the Treasury [and] continuing reliance on two conservatorships for 80% — 90% of the U.S. mortgage finance system, which impedes any number of objectives private institutions have.”

Watt and Mnuchin have both said that they would prefer that Congress pass legislation, but the window of opportunity could be closing as key policymakers including Watt, Sen. Bob Corker, R-Tenn., and House Financial Services Committee Chairman Jeb Hensarling, R-Texas, are retiring from Congress.

The issue was top of mind for Corker during a Senate hearing with Mnuchin last week, when he asked what the administration would do if lawmakers didn’t act.

While Mnuchin didn’t go into details, he made it clear that contingency plans are being discussed.

“There are certain administrative options that we have,” he said.

Hensarling reiterated that point while Mnuchin was testifying before his panel on Tuesday.

“If we once again fail to act … isn't it true that, roughly a year from now, the president gets to appoint a new FHFA director?” Hensarling said in an attempt to coerce Democrats on the panel to move off of a hard-line position opposing housing finance reform proposals that don’t go as far as the current system to protect affordable housing. “I would hope that all within earshot have listened carefully at what might happen if we choose not to engage in GSE reform.”

Following is one way the FHFA could unwind the GSEs:

Federal Financial Analytics posits that the housing finance agency could attempt to follow the Federal Deposit Insurance Corp.’s lead in unwinding a troubled institution. The FDIC has used so-called bridge banks after a failure, which the agency runs as it finds a buyer for the bank’s operations and assets.

The 2008 HERA law gives the FHFA similar powers to create a “limited-life regulated entity,” in which the agency keeps the lights on while the operations are either unwound or sold off. The debts of the old company would be wiped out.

“Current law gives FHFA considerable discretion to redesign Fannie and Freddie into limited-life regulated entities,” said the Federal Financial Analytics report. “In a receivership, liabilities and assets that are not transferred to the [limited-life regulated entities] must go into liquidation.”

Operational assets, such as the securitization expertise at Fannie and Freddie, would likely be part of the new entities.

Petrou also said new entities that buy the companies — which would no longer be government-sponsored — would likely be required to have capital levels at least comparable to those of the biggest banks.

The process of unwinding and selling the GSEs could not go on forever, however. By statute, Fannie and Freddie have to be run through receivership in two years, though it can extend that timeline to five years under certain circumstances.

Ultimately, however, the FHFA would privatize Fannie and Freddie by the end of the process.

“The new owners would obtain the GSE’s charter — a tidy brand name — but none of the privileges associated with being a government agency.”

Perhaps the most challenging part of getting from the current state to a new state for Fannie and Freddie would be to prevent disruptions in the markets.

“It is really critical that that aspect of the resolution be handled as seamlessly as possible,” Petrou said.

Not only do Fannie and Freddie back trillions of dollars in mortgages, but they are also amongst the largest counterparties in the interest rate swaps market.

“One of the great concerns … is that the day you shoot the company and put it into liquidation, investors, counterparties and swaps run for the hills unless they are convinced there would be an orderly closeout of their exposure,” Petrou said.

A limited-life company could theoretically prevent market panic, giving investors time to adjust to a new future for Fannie and Freddie.

As for the GSEs’ shareholders, the report suggested that they would likely be liquidated with the receivership.

“The only clear losers are current GSE shareholders (Treasury not necessarily included), as their claims would go into the receivership, not the [limited-life regulated entity],” said the report.

Another drawback would be the absence of the 30-year fixed-rate mortgage. Without government backing of some kind, few lenders outside of those supported by the Federal Housing Administration would offer such loans.

Whether Watt and Mnuchin want to go so far is uncertain. Mnuchin has emphasized the importance of the product to the overall market.

“I don’t think the private markets on their own would support it,” Mnuchin said last week. “As we talk about GSE reform, we need to make sure we don’t do something that would put that at risk.”

The only way to preserve that product absent legislation would be to offer an implicit guarantee to the GSEs, the same as what they enjoyed before the financial crisis. But conservatives hated that at the time, and it allowed Fannie and Freddie to publicly claim they were not backed by the government while suggesting to buyers of their debt that they were, essentially putting taxpayers at risk.

Still, unless the FHFA cuts off the possibility of support, any surviving entities may enjoy an implicit guarantee by default.

“Their implicit guarantee would convey to the [limited-life regulated entities] even though the ‘effective’ one now applicable to the conservatorship would end,” said the report.

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