The GSEs and the Economic Cycle: Realistic Expectations
“The GSEs should be fully buying mortgages at all times, regardless of the state of the economy or mortgage markets.”
“The GSEs should be countercyclical, buying a small percentage of new loans in good times and a large percentage in bad.”
I have encountered such sentiments about the GSEs (the government-sponsored enterprises of Freddie Mac and Fannie Mae) over the years – in think tank publications, industry association white papers, proposed legislation, and elsewhere – especially when the plan for them to exit conservatorship is being addressed. It was and still is quite common to hear and read.
It’s also quite wrong.
The GSEs, post-conservatorship, will not be able to ignore market conditions or be countercyclical if they are to be stockholder-owned. It’s fundamentally inconsistent. The countercyclical role belongs to others.
Mortgages – specifically, single-family first mortgages – are originated by thousands of banks (a shorthand meant to include all types of depository institutions) and non-bank lenders, but they end up being permanently financed mostly (i.e. about 95 percent) from just four sources. These are (in order of being impacted by the economic cycle, starting with the most sensitive):
- The private label securitization (PLS) market, where mortgage loans are packaged together and sold as securities to investors, but also where there is no government-affiliated entity guaranteeing the credit to those investors. PLS has under 5 percent market share of outstanding mortgages. Despite efforts by both the financial community and the government to increase this market share, it has been stubbornly stuck at low levels ever since the financial bubble burst. Free-market advocates regard it highly as they consider it “true private capital.” Unfortunately, it is also viewed in the markets as the most volatile, procyclical source of mortgage capital; in a downturn, whatever new flow market share it has at the time is expected to quickly decline.
- Banks, which currently own about 25 percent of all outstanding residential first mortgages. In an economic downturn, with increased loan loss provisions and their assets becoming riskier, banks will tend to slow new lending of all types, including mortgages, as they seek to bolster deteriorating capital ratios, both on their own initiative and acting under regulatory pressure. This means their lending will not be countercyclical or even neutral – their history is to be somewhat procyclical.
- The GSEs of Freddie Mac and Fannie Mae, which currently own about 45 percent of America’s outstanding single-family first mortgages. Prior to conservatorship, they were the beneficiaries of major subsidies to support their profits. Also, their Congressional charters and political considerations required them to be a continual source of support to the primary mortgage markets (i.e. where lenders deal directly with borrowers). Combined, this resulted in them operating since the 1989 thrift crisis almost without regard to the economic cycle, at least until the Financial Crisis of 2008 occurred. At that point, the ability of the GSEs to not be procyclical was shown to be unsustainable, given their private sector capital ownership. After all, how could they not be procyclical when facing massive losses and rapidly deteriorating capital ratios? They were able to maintain their desired neutral-to-countercyclical lending role after 2008 only because the government took them over and directly provided the capital support they needed to do so. Going forward, in the reformed, post-conservatorship state that seems to be emerging… well, that is going to be a different story, as discussed below.
- Federal Housing Administration (FHA)/Veterans Administration (VA), the two government agencies which are insurers of residential mortgages (which are then securitized through another part of government). They currently account for about 18 percent of residential first mortgages outstanding. As direct units of the US government, they have no pressure on them during a downturn that is comparable to what the other three sources feel. Their funding is directly on the books of the government, their securitization guarantees carry the full faith and credit of the government, and they have no equity holders or stock price to worry about. (Partially mimicking the private market, they are supposed to adhere to a calculation akin to a capital ratio, but there are no market consequences of not doing so.) In the 2008 Financial Crisis the FHA and VA were therefore able to be a major countercyclical source of mortgage credit, growing their market share of new purchases from under 5 percent (which was lower than their historic level of usually being between 5 and 10 percent) to over 20 percent. (Interestingly, they have maintained a high market share of new mortgage flow ever since; it’s near 20 percent still, despite the mortgage cycle doing quite well in the last 7 years. This is a topic for another day as it seems to indicate that, in practical terms, their countercyclicality is one-way only.)
This quick summary is a reminder of an economic fundamental: if a source of mortgage credit has private sector capital supporting it, it cannot truly be countercyclical. It probably can’t even be neutral except in the mildest downturns. Only the government – as the owner of the money printing press – can ignore market conditions. Therefore, the countercyclical role can only fall to the FHA and VA, as direct government units.
The two GSEs, assuming they come out of conservatorship according to the current plans of Treasury and their regulator, the Federal Housing Finance Agency (FHFA), will no longer have their historically large subsidies and will be subject to rigorous capital requirements (akin to what the largest banks have). Therefore, when it comes to growing or shrinking their balance sheets in a downturn, they cannot be heavily countercyclical and grow them. They probably cannot even be mildly countercyclical. At best, perhaps, they can be neutral. Simply put, and despite the obligation they have under the Congressional charters that created them, no one is going to invest equity in them that will sit idle for months, years, maybe even decades, earning no return, until needed to support a big surge in the size of their mortgage guarantee books when the economic cycle turns down. It’s just incompatible with being owned by private sector shareholders. That incompatibility was hidden during the pre-conservatorship years by their large subsidies, combined with strong mortgage markets, but moved to the front burner for all to see in 2008. Going forward, it’s obvious they should not be expected to fulfill a countercyclical or even neutral role.
So we have a conundrum: congressional charters which necessitate the GSEs fully supporting lending in all market conditions are undermined by the financial return the GSEs need to produce to attract the private sector capital also required by those same charters. The only possible solution so that the GSEs can be countercyclical in times of great financial stress in the future is therefore for the government to either temporarily release them from those rigorous capital requirements or provide the capital itself in some fashion in the interest of maintaining the national economy. In essence, that’s what placing them in conservatorship did in 2008. But do we really want to go through that again? Perhaps it’s time to be realistic: countercyclicality is for FHA and VA, as direct government entities. Freddie Mac and Fannie Mae should be assumed neutral, at best, and more likely somewhat procyclical, just like the banks.