Clearing the Road for GSE Reform

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With conservatorship of Fannie Mae and Freddie Mac well into its seventh year, the government has now had control of the housing agencies longer than 47 members of the Senate have been in office. This delay speaks volumes about the complexity and magnitude of the issue and the competing interests involved.

The new Republican-controlled Congress will be tempted to abolish Fannie and Freddie altogether. However, they would encounter staunch opposition from various liberal housing groups and a likely veto from the White House. Lawmakers' best chance of breaking the impasse of the last seven years is to pass three measures that would shrink the problem of government-sponsored entities down to a size that will be easier to solve in the future.

First, Congress should mandate deeper mortgage insurance coverage or credit risk retention for loans sold to the GSEs. Fannie and Freddie are currently the world's most expensive insurance agents. Taxpayers put up all of the capital supporting their credit guarantees. Regulators set their credit, pricing, collection and enforcement policies. After covering their very sizable operating costs, the agencies funnel any remaining profits to the U.S. Treasury. All these agencies do is market taxpayer-provided insurance.

Therefore the most important step Congress can take right now is to begin shifting the credit risk away from the taxpayers. Instead, give the risk to private, investor-owned mortgage insurance companies and banks that are prepared to hold and price it.

The GSEs are required by law to have MI coverage or other credit support for mortgages with loan-to-value ratios greater than 80%. It would be a simple step for Congress to lower this LTV threshold until essentially all of the credit risk on a mortgage is in private hands. While the GSEs have engaged in some back-end risk-sharing arrangements, these deals have been inadequate in dealing with the problem because they keep the GSEs and their regulator at the center of the credit decision and credit risk.

By moving credit risk into the hands of private investors at the front end, Congress could reduce the GSEs' market footprint without delving into a political fight over abolishing them. If the agencies serve primarily as government-sponsored counterparty risk guarantors, they become a much easier problem for a future Congress and president to solve.

Second, Congress should repeal the law that the GSEs must be rebuilt if they are placed into receivership, as required under the Housing and Economic Recovery Act of 2008. HERA requires the regulator to reestablish the GSEs and sell their equity to private holders within five years of their being placed into receivership. Given that GSE reform has moved at a pace somewhere between glacial and plate tectonic, the Federal Housing Finance Agency has been justifiably hesitant to start this five-year clock.

Removing this requirement would accomplish two things. First, taxpayers would enjoy a massive reduction in the GSEs' operating costs if the agencies were placed into receivership. The agencies' unnecessary divisions and redundancies could be eliminated without negatively impacting the current operations of the mortgage market. For example, much of the external and Securities and Exchange Commission-required financial reporting would go away, as well as any other expenses related to corporate governance. In addition, departments such as problem loan resolution and property disposal could be unified into a single group. Second, repealing the requirement would make a clear public statement the failure of the GSEs was also an indictment of the entire GSE model.

Moreover, putting the GSEs into receivership would effectively end the lawsuits by the various Fannie and Freddie private-equity investors seeking to lay claim to the profits generated under the current conservatorship arrangement. Under conservatorship, investors argue that they have legal claim to the corporate entities' cash flows-even if those profits are based on government guarantees. But under receivership, the corporate entities would effectively cease to exist. While shareholders might challenge the receivership action, it would explicitly ensure that as long as risk is borne by the taxpayers, earnings on that risk also belong to them.

Lastly, Congress should establish regulatory oversight of the Securities Industry and Financial Markets Association committee that sets eligibility rules for trading mortgage-backed securities in the "to be announced" market.

SIFMA's rules are usually market-neutral. Its decisions typically center on questions like what time the markets will close on New Year's Eve. For mortgage-backed securities, however, the group's TBA rules have the effect of picking winners and losers.

Fannie and Freddie securities have been traded on separate TBA markets for years, but the bulk of trades take place in Fannie's. Higher liquidity has given Fannie securities roughly a half-point price advantage over Freddie's.

The securities are now essentially identical in terms of guarantee and prepayment speeds. The only real difference is that Freddie investors get their cash 10 days earlier. But SIFMA's TBA committee has refused to allow Freddie securities to be delivered into Fannie TBA contracts and thus close the pricing gap between the two. In order to keep Freddie in business, taxpayers have had to subsidize the price of Freddie securities at a current cost of about $400 million per year.

Acting without outside oversight or accountability, some members of SIFMA's TBA committee have blocked any change to the rules. In various public and private meetings over the years, they have stated their belief that they have a fiduciary responsibility to their investors. Investors in Freddie securities are the ones benefiting from the large subsidy. Without reform, the SIFMA committee will be able to pick the winners and losers in any new secondary market structure.

Congress should bring SIFMA under existing Office of Management and Budget rules as to how trade associations set industry standards. The SIFMA committee would then be required to operate in a way that is representative, transparent and responsive, and in which all parties would be guaranteed adequate consideration of their views and objections.

Congress should also simply prohibit the subsidy payments on Freddie securities. Without the ability to make the subsidy payments, Freddie could not compete with Fannie and would not be able to stay in business unless SIFMA made the necessary changes. Either way, the taxpayers begin saving roughly $400 million per year.

These three steps will not solve the problem of the GSEs. Taken together, however, they will set us on the path to reform -- and make the ultimate problem a much smaller one for future lawmakers to tackle.

Jay Brinkmann retired as the chief economist of the Mortgage Bankers Association in 2014 and now resides in New Orleans.


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