The world has changed in the decade since the US mortgage market sparked a global financial crisis. Banks have recapitalized, home prices have recovered, existing home sales are back to healthy levels, and the US economy is enjoying its tenth uninterrupted year of expansion. But in one important area of the US financial system, reform remains unfinished. We refer to the Government Sponsored Enterprises (GSEs), their conservatorship status, and their outsized roles in US housing finance.
Successive Administrations have rightfully lamented this ‘unfinished business’. Even after ten years, Fannie Mae and Freddie Mac are still wards of the US government. There is a reason for this inertia. GSE reform is difficult to pull off successfully. Do it right and you reduce the US homebuyer’s dependence on the GSE duopoly, manage to get private capital back in, and protect the US taxpayer against a repeat of 2008. Do it wrong, and you risk up-ending the world’s largest housing market.
In partnership with Annaly, we have jointly produced a report, titled, GSE reform: Unfinished business (PDF, 1.9MB) outlining a series of steps that the US Administration, as well as Congress, could take when addressing GSE reform. Most policymakers, on either side of the political aisle, seem to agree on three goals related to GSE reform, summarized below.
We see the first two goals as two sides of the same coin and consider steps that the Administration could take unilaterally to achieve them. The third goal would require the intervention of Congress. Proponents of reform also agree on a broader principle: any steps taken to accomplish these goals must minimize any disruption to the housing market.
The development of the Credit Risk Transfer (CRT) market allows Fannie Mae and Freddie Mac to offload a substantial amount of their credit risk to capital markets. While this is an important stepping point, more can be done to reform the GSEs. In order to protect the US taxpayer, Fannie Mae and Freddie Mac could continue to shed mortgage credit risk using the CRT market.
But what happens if the housing market deteriorates, making it hard to offload credit risk? We suggest a new alternative – a revolving CRT structure. This allows the GSEs to shed credit risk on most future production, thereby avoiding execution risk while protecting the taxpayer.
To attract private capital, the GSEs could shrink their footprint in areas that are not part of their core mandate, such as second homes, investor and jumbo mortgages. The implicit government guarantee that Fannie and Freddie enjoy allows them to offer lower rates than the private sector. We recommend that the GSEs reduce their presence in non-core areas, by pricing these loans without factoring in the advantages of the government backstop1, thus allowing the private sector to compete.
Policymakers could also urge industry group and rating agencies to encourage standardization in Private Label Securitization (PLS) cash flow structures, representations, warranties and repurchase triggers as well as in servicing practices. Standardization would increase liquidity, which should help financing of PLS.
If the goal of GSE reform is to foster competition and materially decrease “too big to fail” risk, Congress has to pass legislation that replaces the GSE duopoly with multiple smaller guarantors. This is a complicated undertaking. In the report, we focus on a few particularly important parts, including enforcing a prudent capital framework as well as creating a transition path.
Critically, GSE reform legislation must provide a smooth transition path from the current system to an alternative world with more private capital and less governmental involvement. The GSEs start with enormous advantages over new entrants: on infrastructure, market share, and the implied government backstop.
If Congress wants to get more entrants into housing finance, an overriding goal of GSE reform legislation must be to level the playing field to the extent possible. If not, GSE reform is likely to lead to a housing finance system similar to pre-2008 – with two giant entities guaranteeing the majority of mortgages in the US.
1 The government backstop allows GSE bonds to trade with little to no credit risk. This materially improves the pricing of the highest rates tranches (i.e AAA) which are typically over 90% of the entire capital structure.
This report outlines a series of steps that the US Administration, as well as Congress, could take when addressing GSE reform.