Is GSE Reform Dead?
The two government-sponsored enterprises (GSEs) of Freddie Mac and Fannie Mae are in their fourteenth year of conservatorship, a legal status which puts their regulator, the Federal Housing Finance Agency (FHFA), in full operational control of the two companies. When they entered conservatorship in September 2008, at the height of the financial crisis, Treasury Secretary Paulson famously called it a “timeout,” reflecting that it was meant to be a temporary status, with something more permanent to follow in the not-so-distant future. Normally, that would involve the conserved company being quickly sold off or perhaps recapitalized, and returned to conventional private sector ownership. However, the GSEs falling into conservatorship was widely regarded as the result of fundamental flaws in their operations and structure. As such, actors across the entire policy and political spectrum considered a simple recapitalization and return to private sector ownership to be unwise. This situation inaugurated what became known as GSE reform, the process of determining how to revise America’s housing finance system so that the GSEs, or their successors, would never endanger the country’s financial stability again. This made an exit from conservatorship just one component of a path for reform. However, as no such GSE reform path has yet been chosen in Washington, conservatorship continues with no end in sight.
While there was a major focus on GSE reform starting in 2009, it largely became a back-burner issue in 2017–18. It became somewhat active again during the tenure of FHFA Director Mark Calabria (2019–2021), but he departed the FHFA in mid-2021 and the subject then went quiet once more. Currently, the Biden administration shows no obvious interest in the topic. Nonetheless, GSE reform is not dead, as two key activities are very much underway now, even while many others appear to be in suspended animation.
What happened to all the big, bold proposals for GSE reform?
From 2009–2016, individuals and groups from a variety of backgrounds—including industry associations, policy advocates on both the political left and right, academics and, of course, government officials—made proposals that eschewed incrementalism and looked to replace the GSEs with “something different.” The ideas ranged widely, including but not limited to: (i) a single, government-owned monopoly, (ii) many smaller, competing mini-GSEs, (iii) one or two cooperatives owned by the primary mortgage lending industry, and (iv) a full wind-down of the two companies (with the private market left to replace the volume of mortgages previously financed by the two GSEs as best as it could). As these proposals called for the GSEs to be replaced, they were often referred to as “comprehensive GSE reform.”
Not surprisingly, the proposals typically reflected the political philosophy of the proposer (liberals and progressives looking for more government involvement and control; conservatives looking for less, if any). The bipartisan 2014 Corker-Warner Bill, which called for competing mini-GSEs and represented the middle of the political spectrum, got the furthest in Congress, but still never truly came close to becoming law. Unfortunately, despite the claims made for each proposal by its sponsor(s), public examination revealed serious concerns about each, ranging from quickly-recognized fatal flaws to, after more detailed analysis, a verdict of being unworkable in practice. In other words, they all flunked out sooner or later.
By 2018, both the housing finance policy community and the mortgage industry had shifted, to borrow a phrase, away from revolution and towards evolution. This recognized, as a start, that it was necessary to keep the GSEs operating much as they had for years in order to avoid undue disruption to America’s complex mortgage markets. Thus, comprehensive GSE reform, which had called for the companies to be replaced, evolved to become simply “GSE reform”, as the focus shifted to reforming the two existing companies. This change also reflected a political rehabilitation based upon the companies performing unexpectedly well during their decade of conservatorship (and since during the pandemic).
Importantly, that unexpectedly good GSE performance reflected the many reforms implemented during the decade they had spent in conservatorship. These included such things as (i) strict investment portfolio size limits, down massively from their pre-conservatorship peak, (ii) routinely shedding risk via credit risk transfer transactions, which also included public transparency into GSE mortgage portfolio credit performance, and (iii) the FHFA promulgating a robust, and much higher than pre-conservatorship, capital requirement.
This evolutionary approach to GSE reform thus called for keeping all the changes made during conservatorship. It also called for regulation akin to how states regulate electric and other utilities (which includes setting prices charged to the public). Today, this utility-style GSE reform is the only major idea still around with broad support. Interestingly though, it did not emanate from any of the sources of earlier big and bold proposals, but out of the careful, years-long work of reforming the GSEs inside conservatorship by the FHFA, with Treasury also playing an important role.
Legislative vs. administrative paths to GSE reform: Where do they stand?
Ideas for comprehensive GSE reform, unsurprisingly, require legislation, as the changes would be fundamental. But when there was a shift in 2018 toward reforming, rather than replacing, the two existing GSEs, it became clear that an alternative was available, which became known as the administrative path. Under this approach, the changes for the GSEs to exit conservatorship could be made by (i) the FHFA through regulation, plus (ii) the FHFA and Treasury jointly modifying the existing contract by which the GSEs get financial support from Treasury. Thus, no congressional action would be required.
Right now, in fact, the consensus in Washington is that any legislation about GSE reform will not happen for many years at a minimum. Given how well the GSEs are working in conservatorship, there is no pressure on Republicans or Democrats in Congress—who have very different ideas about what should be done with the GSEs—to force compromise on a reform plan. That means the administrative path is the only realistic option available right now.
But there is one wrinkle in pursuing the administrative path. There is a legitimate fear that it is not designed well enough to last long-term. In particular, the regulations and contractual changes needed to implement it are too easily changeable by future administrations, rather than being more permanently established through legislation. Thus, for example, Treasury Secretary Mnuchin talked about the administrative path being only the start of GSE reform, with legislation to follow in order to validate and make the changes legally permanent.
I note that FHFA Director Calabria, who stated his priority was to engineer a conservatorship exit, pursued such an exit via the administrative path, even while (very much against the odds) calling for legislation as well.
What two key GSE reform activities are quietly underway right now?
The most important GSE reform activity now underway is that the two companies are retaining all their earnings to build capital. I cannot emphasize enough how important this is. First, it makes the GSEs more financially stable, meaning that during conservatorship they are less likely to call on the taxpayer, through Treasury, to make additional cash injections into the companies if losses were to be incurred. Second, it makes a conservatorship exit, whether by legislative or administrative means, much easier to implement. This capital-building represents an administrative reform path action, as it was enabled solely by the FHFA and Treasury agreeing to modify the contract by which Treasury financially supports the GSEs while they are in conservatorship. The capital accumulation began late in the Trump administration but, wisely, the Biden administration has not ended it. As of September 30, 2021 (the latest figures available), the GSEs between them have a net worth of $67.5 billion, a much-improved position over the near zero figure of just a few years earlier.
The second reform activity underway is the FHFA, under acting Director Sandra Thompson, making important if limited revisions to the Calabria-era regulatory minimum capital rule, which is widely viewed as (i) calling for an unnecessarily high level of capital, as well as (ii) being poorly structured as it creates incentives for the GSEs to make uneconomic decisions. The limited revisions now underway are designed to eliminate (i) a perverse incentive for the GSEs to take on high risk mortgages and (ii) an equally perverse disincentive to lay off mortgage credit risk.
Unfortunately, those are the only two important GSE reform activities underway right now.
What should we watch for to see if additional GSE reform activities get underway?
To get to a conservatorship exit in which the GSEs would be regulated on a utility-style basis, there are three areas where additional government actions are needed. Each is a major undertaking, and some will take considerable time (at least several years) to implement. In order from least difficult to most difficult, these are:
- The existing regulatory minimum capital rule must be revised downward. This means largely adopting the underlying economics of how capital is required for risk in the banking system, but then applying it to the particulars of the GSEs, which are very much not banks, where the current capital rule treats them too much as though they are. Too high a regulatory capital requirement would directly translate into a privatized GSE having too high a cost of capital. As the largest component of guarantee fee pricing is the cost of capital, that would directly lead to inordinately high guarantee fee pricing by the two companies. Such a revised capital requirement would take at least a year, maybe even closer to two, to develop and implement. (See my earlier post which explains how the current rule’s capital requirement is demonstrably excessive versus the official stress test results released by the FHFA last year.)
- The FHFA must build the proper legal and operational infrastructure for utility-style regulation of the GSEs after they would have exited conservatorship. This is a heavy lift for the agency, assuming it duplicates the well-established state-level utility regulatory regime rather than trying to create something de novo. This would include establishing wholly new activities such as holding public hearings when the GSEs request pricing changes, examining all operating expenses to see which ones might be ineligible (e.g. unduly lavish customer entertainment), doing financial and economic studies to determine the required rate of return for investors (about which hearings would also be held), and so on. These things are second nature to state-level public utility commissions, but far afield from what financial regulators like the FHFA do.
- Ultra-complex mechanics need to be developed and implemented for each GSE to restructure the ownership of its equity. That ownership is currently distorted by Treasury holding all of the senior preferred stock (with over $200 billion outstanding) as well as warrants on 79.9 percent of the common stock, both of which sit beside the historic (i.e. pre-conservatorship) common and junior preferred shares, which are still owned by public market investors. (Such public market investors have few rights during conservatorship, but its ending would return those rights—such as the ability to elect the Board of Directors—to them.) A conservatorship exit requires that this equity ownership structure become undistorted and conventional, and free from conservatorship-related legal uncertainties. Treasury, more than the FHFA, is key to this happening, and the complexity, especially in such immense size and for two companies at the same time, is unprecedented. (Included in this undertaking would be establishing a fee for the GSEs to overtly pay Treasury for its support.)
To conclude, GSE reform is not dead, but aside from (i) the two companies retaining earnings to build capital, and (ii) the FHFA making limited changes to the regulatory capital requirement, it is very much in suspended animation.