Love Me Do
September 08, 2013
There has recently been a spate of articles with headlines like “More Evidence Ending Fannie Mae and Freddie Mac is a Mistake,” and “Don’t Kill Fannie Mae.” It seems the closer Congress actually gets to taking on the mortgage finance system, the more reasons people find for loving Fannie and Freddie. This reminds me of my daily struggle to walk the mile home from the Metro, rather than take the bus. They both get me home, but walking is healthier. But when I get to the bus stop, the doubts rise up - it’s hot. It’s hard. I’ll do it tomorrow. Likewise, changing the mortgage finance system is hard. There are a lot of unknowns. Congress has an iffy track record trying to legislate new, complicated financial systems. The old system worked well. The companies are making money. The crisis is over and we should just go back to the comfortable way we did things and it’ll all be good.
Fannie and Freddie did produce lots of value for the US housing economy and homebuyers in general. They standardized the mortgage process and helped lower costs. They attracted trillions of dollars in capital into the housing system, keeping it liquid and robust. They provided stability for housing finance when other financial markets suffered liquidity crises. Fannie and Freddie achieved these objectives through charters that mixed a series of benefits with a series of obligations. After Fannie was privatized in 1968, and Freddie in 1989, both companies were forced to balance the demands of shareholders with the public benefit obligations their charters required. Even after they were taken into conservatorship and funded with billions of public money to shore up their capital, their structures, brand and expertise have kept mortgage funds flowing through the worst financial crisis in generations.
What troubles me about these articles is that conflating the companies with the important outcomes we need in the mortgage system muddies the water and makes an already difficult public policy challenge even moreso. Once, affordable consumer access to mortgage credit and the companies themselves were inextricably intertwined. But their collapse in 2008 offers a rare and important opportunity to address some of the uncomfortable problems that really were too hard to deal with before, when there was no compelling reason to do so and the companies’ combined political muscle made it impractical.
The outcomes Fannie and Freddie were charged with assuring - liquidity in the mortgage market, standardization and stability through business cycles, and the broadest possible access for both consumers and lenders - remain critically important. These must be the touchstones for whatever path Congress takes.
The rest of this blog looks at some of concerns about the companies that predate this crisis, and reviews and comments on the arguments that are appearing in support of returning to them as the system’s anchors.
The Old System Was Not Perfect
• The companies enjoyed the benefits of a federal guarantee but didn’t pay for it. They did operate under corresponding constraints—they were restricted to the mortgage business, limited to the US, and they were expected to operate everywhere in the US at all times, for instance. But the heart of their business model was leveraging this implicit guarantee. Fannie engaged in multiple deep dives to explore the benefits of a fully private alternative, and each time concluded that the charter’s benefits far outweighed its costs. I assume Freddie did similar research.
• Benefits to shareholders were obvious, but not as much to borrowers. The companies did standardize the system, kept mortgages liquid and brought capital into the system through the full range of business cycles. Their dominance and standardization shrank margins that otherwise could have been inflated by other market players. In fact, some of the rush to invest in private label securities (PLS) that fueled the housing boom and bust was driven by the higher margins lenders and securitizers could command for these bonds where Fannie and Freddie were not active. But disputes over just where their charter benefits ended up were long-standing and promoted not just by banks hoping to cut into their markets and margins, but also by economists and government regulators concerned about private enrichment through the public benefits.
• Until Congress insisted in 1992, neither company had a very robust or convincing commitment to using their market position to extend homeownership opportunities or to experiment with new products and services that would do so. When they were good -through the Opening Doors Campaign and the Trillion Dollar Commitment at Fannie Mae, for instance - they were very good. But even more than a decade after Congress rebalanced their mission vs. shareholder obligations, there was constant pressure at both companies to minimize investments in the former and maximize the latter.
• They weren’t immune to failure, and when the country needed them most, they failed the test. Fannie and Freddie didn’t cause the mortgage crisis. But when the chips were down and they had to choose between satisfying shareholders clamoring for growth when PLS was booming and eroding their market share vs. standing by their chartered purpose to provide a stable anchor for the mortgage finance system, they picked the shareholders, tried to recapture market share by moving into riskier market segments, and ended up requiring billions in taxpayer support. And Fannie had nearly failed once before in the 1980’s, when it was a portfolio lender and got caught in a severe squeeze between low-yielding assets and high cost liabilities.
What Are the Arguments?
The Argument: We Shouldn’t Kill Fannie and Freddie. They are the best way to deliver the needed results. They worked for decades. Plenty of large financial institutions failed in the Great Recession. That crisis is over and we can take our finger off the “pause” button and get back to the way things were.
There certainly are proposals that wind down Fannie and Freddie and do not replace them with any system of government support for the broad market. But while this is a catchy headline, the current debate is not the all or nothing proposition it suggests. Most of the proposals that have emerged post-2009 have focused on disaggregating and reorganizing the functions that Fannie and Freddie grew to include over more than 70 years. They focus on what the government must do to preserve public benefits and outcomes, not preserving structures or specific companies.
This is the path emerging in the Senate Banking Committee through the legislation introduced by Sens. Corker and Warner and other co-sponsors. It was repeatedly invoked by House Financial Services Committee members arguing against Chairman Jeb Hensarling’s PATH Act, which would kill Fannie and Freddie and not replace it them with another form of government support. It was the heart of the Bipartisan Policy Center’s housing commission recommendations in February, 2013. And it was sort of endorsed by President Obama in his August 7, 2013 speech on housing policy.
The Argument: Fannie and Freddie Can Efficiently Provide Market Stability and Liquidity: Fannie and Freddie have continued to provide liquidity to the markets under conservatorship, and did so before they failed. Like other bailed-out financial institutions, they should be allowed to pay back what they borrowed and move on.
There’s no doubt that they’ve continued to provide liquidity. But this is because conservatorship has preserved the key feature of the companies’ charters—a government guarantee-and kept them running in a form of managed bankruptcy.
There’s broad agreement that attracting the capital needed for the country’s housing finance needs will require securitization to tap capital markets. There’s also broad agreement that some form of government guarantee to rate investors will be necessary to do this, especially for long term, fixed rate mortgages. Pre-conservatorship, Fannie and Freddie provided this guarantee on their securities. As their boosters point out, this system worked great. Housing finance boomed. Homeownership rates climbed. Access increased. Why try to fix something that’s not broken?
But the model worked because of the implied guarantee that led investors to assume that the companies’ mortgage backed securities (MBS) were “as good as” government securities. When the companies failed in 2008, it turned out the investors were right, getting everything the companies promised them through billions of dollars in new capital provided by taxpayers.
Since the crisis broad consensus has emerged that any government guarantee going forward should be explicit and paid for, and apply only to the securities themselves, not private companies that issue or insure them. The fees charged for the guarantee would underwrite the government’s insurance to protect taxpayers from all but the most calamitous financial donnybrooks.
But if Fannie and Freddie have to give up their most important feature - the free, implicit support of the US Government - then they have nothing to offer that any other very large financial institution could. If the government is going to provide a guarantee to investors and charge for it, why should just two companies have access to it? Ginnie Mae offers a federal guarantee of mortgage securities, for which lenders pay, and many entities issue securities through their execution.
(Of course, other financial institutions, insurance companies or automobile manufacturers that required government support during the financial crisis didn’t pay for that guarantee, either. Two wrongs, though, don’t make a right. The Dodd Frank Act attempted to deal with the larger problem through its too big to fail provisions and the so-called Volcker Rule. Whether those are effective or not is a topic for someone else. One lesson of the crisis is that no matter what, the government always will bear the tail risk of any deep and sustained financial crisis or real estate asset bubble. The challenge is to minimize the likelihood of it happening again and not be unprepared when it does.)
The Argument: It’s Not Possible to Build a Better Mousetrap. What Fannie and Freddie did is too complicated to do any other way. It would add too much uncertainty to the market. It might not work. It’s fixing something that isn’t broken.
But the crisis did break the model. As government chartered entities with special privileges and public mission responsibilities, the GSEs should have been an unbreachable safe harbor from the reckless lending by private investors and lenders that overran the financial system. Report after report has documented that they did not start the boom. But their eroding market share and fears of growing irrelevance led them to move into riskier loans to claw back share from private label executions and to remain a favored partner of some of their largest customers. The inherent conflict between having a franchise from the government and responsibilities to shareholders in an asset bubble like the housing boom proved a major contributor to their undoing.
Again, the functions that Fannie and Freddie provided must be preserved in any new system. But doing that does not require using the same entities or the same organizational model.
Some have suggested that rather than try to totally reengineer the system, the government should preserve them by simply exercising its current rights to 79.9 percent of the companies’ shares and operate them as a government-owned enterprise. (I described and explored this and other options in a white paper published by CFA in 2010.) This would rewind the tape back to before 1968, at least organizationally, when Fannie was part of the government and Freddie hadn’t been created yet. They’d have a full guarantee. The billions in profits they are now making would benefit the government. It would justify the scores of billions of dollars already lent them. There would be no future conflict between shareholders and the taxpayer. Management could be paid fairly, but not exorbitantly.
It sounds appealing. But advocates for this approach need to explain how to get Congress to agree to nationalize the American mortgage system and raise the government’s debt ceiling by more than $5 trillion to cover their combined outstanding debt and guarantees. And the result would not be Fannie and Freddie as we know them today.
A twist on this is to restore them as some kind of utility, devoted only to providing insurance on securities, presumably with an explicit government guarantee. This would mean regulating their returns and business practices and hoping that they wouldn’t gain the upper hand over their regulator over time. This also could be a path to maintaining the functions necessary to support affordable mortgage credit. Utilities typically work when there’s a monopoly provider of a service and preserving that monopoly is the most efficient way to provide the service, like electric power. Whether mortgage finance fits the model is a good question. But a mortgage utility would not be Fannie and Freddie.
Some others have suggested avoiding the uncertainty of changing the system by keeping the current conservatorship going indefinitely. The companies are making billions. FHFA has its foot on their necks. Consumers are getting mortgages. There’s an effective government guarantee. Through a kind of “see no evil, speak no evil” agreement with Congress, their debt isn’t yet on the government’s balance sheet. But the recent swarm of lawsuits from the remaining junior preferred and common stockholders suggests that this is not a tenable option. The longer this goes on, the more credible these claims are likely to seem.
Finally, some have suggested leaving them intact but making them pay for their government guarantees, hold higher levels of capital, and reorganize in some fashion, perhaps as a mutual company owned by lenders, subject to much closer regulation. This is a kind of “utility light” concept. The companies may have a future in a system with these features in some reorganized form. Unwinding them in their current form wouldn’t foreclose this. But if the government shifts to charging for a guarantee of securities, what is the compelling argument that only two, specially chartered entities or two reorganized into one should be entitled to take advantage of it? And the resulting companies wouldn’t be the Fannie and Freddie that we know today.
The recent calls to keep the companies don’t offer any concrete suggestions other than noting that their current structure could be “tweaked.” But the “tweaks” are the heart of the matter. That’s not at all the same thing as “Save Fannie and Freddie,” which only adds distraction to an already complicated policy debate.
The Argument: Fannie and Freddie Have Expertise that No One Else Can Replicate
Fannie and Freddie certainly dominated the mortgage securitization market, and still do today. But the ability to aggregate mortgages, secure credit enhancements and issue securities is not a magic trick only a few hundred people at Fannie and Freddie can perform. Lots of issuers do these functions on their own today through the Ginnie Mae execution, for instance, and others are doing it, albeit on a very limited scale, in the so-called jumbo market for loans greater than the GSEs’ loan limits. We certainly learned that Wall Street can do it with a vengeance, as they did in the run up to the 2008 crisis. A government guarantee, or a government chartered guarantor, is not needed to manufacture the securities. It is needed to attract a sufficiently deep and stable market of investors for them and to support other important outcomes for US consumers.
Fannie and Freddie definitely represent a source of deep intellectual capital and experience that should not be squandered in a reorganized system. But putting that talent to work doesn’t require it to be employed by the same companies or in the same structure.
For instance, there are functions at Fannie and Freddie that can and should be conveyed to government to enable it to provide a safe and sound guarantee to investors, like a common securitization platform that could standardize terms and conditions for MBS going forward. There are a lot of other talents that will be of high value to any number of new entrants in a properly structured system. The companies themselves might be able to reorganize around a reduced set of responsibilities and compete with others in a new system. But they won’t be Fannie Mae and Freddie Mac in that case.
That’s a really good reason to move forward expeditiously so the leakage of that talent that’s been going on for the last five years doesn’t reach a critical point of no return. And it argues for a careful approach that consolidates the valuable functions that are best managed in one place, like issuing government guarantees, managing counterparties, assuring that market participants serve the entire market in return for access to the guarantee, and standardizing securities, their pooling and serving standards, for instance, in a government entity devoted to these utility functions.
The Argument: Only Big Banks and the Creators of the Mortgage Crisis will Benefit From Unwinding Fannie and Freddie. The GSE’s didn’t cause the crisis (although there remain strong advocates on the fringe of the debate who still maintain they did). Big banks were gunning for them for years because they squeezed profit margins on mortgages through their dominance and advantaged pricing. Eliminating these specially chartered institutions will throw mortgage consumers to the wolves.
If nothing is done to replace the functions that Fannie and Freddie provide, this is likely to be true. But it doesn’t necessarily follow that life without them has only one outcome or that they are the only means to prevent it.
A non-Fannie/Freddie future that maintains the essential governmental functions they provide today would require a system that set high and consistent standards for assets backing guaranteed securities. Securitizers and credit enhancers would have to demonstrate service to the entire country, and to the broadest possible range of credit-worthy borrowers. This would require good regulation and close oversight, something that will be needed regardless of how many issuers using government guarantees there are.
Another strand of this argument is that without the modifying influence of Fannie and Freddie, big banks will be able to ramp up fees without limit and all the benefit the GSEs provided to consumers will be lost. Ironically, recent rates for some jumbo loans have been lower than for Fannie and Freddie loans. A system that charges for a federal guarantee will be more costly than the old one which did not charge for it. That’s just logical. But it’s not clear to me why transparency in pricing to consumers and competition among credit enhancers battling over market share while balancing the costs of risk and capital to mitigate it wouldn’t keep costs under control. Fannie and Freddie competed aggressively for market share in securities guarantees, one reason guarantee fees remained low. But they also were able to subsidize that business with their highly profitable portfolios, and without guaranteed portfolios it stands to reason that the fees will rise no matter what.
The Argument: Fannie and Freddie Operate a Portfolio, and This Provided Significant Systemic Benefits That Cannot Be Replaced. The GSEs can buy whole loans directly from originators because they have portfolios, funded by debt they issue, which carries the same implicit guarantee as their mortgage securities. Small lenders love the GSEs’ cash window because it is a competitive alternative to selling loans to large aggregators, and the GSEs don’t require the originator to surrender the servicing rights, with their ongoing communication with the consumer. The cash bid also sets a reference price that limits what large aggregators can charge originators who either can’t or won’t securitize the loans on their own.
Preserving access by small lenders to secondary market capital must be a high priority for reform. But if the GSEs are stood up again without a guarantee, they won’t have any particular advantage over any other large lender willing to buy loans. And if Congress were willing to extend a guarantee to the portfolios and charge a fee for it in order to advantage a cash execution for small lenders, how could this benefit remain restricted to only one or two companies?
The 12 Federal Home Loan Banks are owned by these very same smaller banks and still have implicitly guaranteed borrowing authority. Maybe they could be directed to provide this service, since liquidity for home lending is supposed to be their main purpose, they have no interest in taking the servicing rights, and there seems no appetite in Congress for eliminating their implicit guarantee. Or, as is proposed in the Corker-Warner bill, a cooperative owned by smaller lenders could do the same thing.
Finally, many small lenders in today’s market successfully use the Ginnie Mae guarantee directly to get liquidity. A system with a government guarantee on securities, but not on entities issuing them, ought to offer the same opportunity.
Less Smoke, More Fire
Some of the recent essays with the headline “save Fannie and Freddie,” seem to really be making the point that radical proposals to simply eliminate the companies without replacing them with something that sustains the good outcomes they helped provide would be disastrous. I agree with that point of view. But in that case it would be much more helpful to focus on what’s needed in the future system and how to best organize it, rather than stirring things up with headlines about the entities themselves.
Some others do go further and argue that simply hitting the “reset” button and restoring the companies themselves is the right path. Some of these are opportunistic and cynical hedge fund investors in the companies’ stock who would gain mightily if this happened. Some think the companies have been unfairly blamed for the system’s failure and ought to be allowed the same opportunity to pay back what the government lent them and move on as other mega-finance companies. Others believe that it is too hard to rebuild a new system, and that some decades of successful performance should count for something, even after the crisis and the firms’ collapse.
These boosters have yet to answer the tough questions of how to actually make the mousetrap better, focus it more clearly on public benefit, effectively balance the underlying tensions between private ownership and public purpose and minimize exposure by the taxpayers except in extraordinary crises. And now that we’ve had one, this is more important. The more clamor there is for preserving the companies without addressing these problems, the more focused the discussion will become on the companies and their conflicts and controversial structures, rather than their functions, and the less productive it will be.
The collapse of Fannie and Freddie is really too good a crisis to waste, as Rahm Emmanuel might put it. Creating a durable system that will support reasonable access to sustainable mortgage credit for rental and ownership housing is critical for the nation’s economic and social health.
It’s easier to take the bus, but I hope we’ll get out and walk this time.
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