Housing finance needs fixing, but it doesn’t need Fannie or Freddie

The financial crisis that spurred the Great Recession hit nearly a decade ago. But to date, nothing has been done to meaningfully reform some of the main drivers of the crisis. That may change next year, as key members in both the House and Senate begin to discuss what to do with government-sponsored enterprises Fannie Mae and Freddie Mac. GSE reform proposals run the gamut from comprehensive reform of the entire housing finance system to restoring the original status of the GSEs. With this backdrop, what are the sensible options for the future of the GSEs?

The status quo is not an option. Since entering conservatorship in 2008, Fannie and Freddie have become de facto agencies of the federal government used to implement policies for mortgage relief and other objectives. (Indeed, the Congressional Budget Office has consolidated the financial activities of the GSEs into the federal budget.) Through this process, however, they have retained an enormous share of the housing finance market. Along with the Federal Housing Administration, the federal government now backs the origination of around 70 percent of all new mortgages.

This state of affairs is a ticking time bomb for the U.S. taxpayer. Fannie and Freddie are the epitome of systemically important financial institutions, and they should be regarded as such. When the next disaster befalls the GSEs, the taxpayers will be on the hook to cover their losses — again. This is an imprudent strategy that should be replaced by greater deployment of private capital in housing finance.

It is true that Federal Housing Finance Authority touts the transfer of $49 billion of credit risk to private investors. But that represents only 1.2% of the GSEs’ overall portfolios. Even more disappointing, the credit risk that is actually transferred is the least risky in the GSEs’ portfolio of credit risks.

FHFA Director Mel Watt explained that the agency experimented with selling the first 100 basis points of credit risk to investors and learned that selling the first 50 bps was expensive and difficult. As a result, the GSEs end up retaining the first 50 bps of expected losses in most transactions. In other words, private investors hold the safest investments in the GSEs, while taxpayers continue to hold the bulk of the risk in the GSEs’ portfolios — a recipe for another disaster.

Moreover, keeping the GSEs on the books raises the stakes for promoting best practices within FHFA. Just two years ago — seven years into the GSEs’ conservatorship — FHFA reported that the GSEs were continuing to engage in risky behavior. And between 1994 and 2004, the Office of Federal Housing Enterprise Oversight — the then-regulator of the GSEs — found that Enron-style accounting at Fannie Mae had resulted in $10.6 billion in losses. More recently, FHFA reported that Fannie Mae had hired an unqualified candidate to serve as its chief auditor. And at the same time, FHFA was directing the GSEs to back more low downpayment mortgages while filling the coffers of the affordable housing trust fund — further increasing the risks on taxpayers.

Yet turning back the clock is even more dangerous. One of the most seductive claims is that one could simply rebuild the capital base of the GSEs and safely release them from conservatorship. That is simply a return to exactly where we were before the crisis. Fannie and Freddie are SIFIs with fundamental flaws in their business models. Restoring their status as private enterprises will not resolve the problems that existed before the crisis nor those that have arisen since they’ve been in conservatorship. If there were a genuine opportunity to create a profitable business enterprise from a monoline housing hedge fund, the private sector would have been able to take over for the GSEs at any time in their history. That they haven’t shows the GSEs’ need for government intervention – not just the explicit bailouts and guarantees, but, for example, the implicit charters, presidential appointments, exemptions from taxation and securities registration, among others.

Ultimately, the future role of the federal government in housing finance does not require Fannie or Freddie. The recent remarks of House Financial Services Committee Chairman Jeb Hensarling signify that the political equilibrium will be a government backstop against catastrophic risks in mortgage lending, particularly with regard to 30-year, fixed-rate mortgages. There is nothing about providing that guarantee that requires the public-private hybrid GSE with its charter and capital market privileges. It is true that in some plans Fannie and Freddie are reconstituted as genuinely private entities, but that may be more politics than policy.

It may be optimistic to believe that 2018 will be the year that the status of the GSEs is addressed, despite that the GSEs’ capital reserves will, as statutorily required, fall to $0 by the beginning of 2018, thereby increasing the risk of another taxpayer funded bailout. However, if reform does take place, the least important priority should be preserving the current functioning of Fannie Mae and Freddie Mac. While the names may survive, their business model and history of contributing to housing finance crises should not.