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GSE reform faces coin-toss odds

With President-elect Donald Trump’s victory and a Republican-dominated Congress, there’s been much speculation about the future of the government-sponsored enterprises Fannie Mae and Freddie Mac. Trump’s Treasury Secretary-designate Steven Mnuchin has already said the GSEs could be privatized quickly, but policymakers say that process would be complicated and contentious. Michael Bright, director of the Milken Institute’s Center for Financial Markets, spoke with Scotsman Guide News about the prospects for reform within the next two years. Bright, a former aide to  U.S. Sen. Bob Corker, R-Tennessee, was the principal author of Senate Bill 1217, the “Corker-Warner” GSE-reform bill that passed the Senate Banking Committee in 2014. 

Do you believe that the GSEs could quickly be privatized and released?

Michael BrightNo, not as they are. Not as large as they are and certainly not without the taxpayers providing a guarantee for free, which is just not going to happen. And more importantly, they can’t be quickly privatized — whatever that means for a GSE — and then released without a lot of downstream consequences. 

Look, if we take a step back and look at this realistically, we can see that there were three stool legs that made Fannie and Freddie what they were prior to the financial crisis — their congressional charters, an implied government backstop, and a belief that home prices would never go down nationally.  Collectively these things led people to believe that buying Fannie or Freddie [mortgage-backed securities] had no credit risk. It’s what made the [to-be-announced market] function and it is how the securitization markets still operate today, with credit investors and rate investors being largely separate.

Today, though, the three stool legs that allow the GSEs to function are their charters, HERA [the Housing and Economic Recovery Act], and the PSPAs [the Senior Preferred Stock Purchase Agreement]. These institutions are why Fannie and Freddie exist today. The PSPA’s commit to backstopping the GSEs via an additional injection of capital any time the GSEs need it, and it’s why the world views their [mortgage-backed securities] as sovereign-backed bonds.

Simply removing the PSPAs administratively — which is what the privatization of the GSEs argument rests on — changes the whole game and would be highly disruptive to the markets if done absent legislative reform. It’s like pulling out a stool leg without replacing it.

Why do say it will take 10 years, absent other reforms, to adequately rebuild the GSEs' buffers so they could safely be released from government control?

These are $5 trillion enterprises, and true privatization would take Congress altering their charters. It would require working with the Fed to sell their MBS [mortgage-backed securities] and explaining to foreign investors what is going on. These are not at all simple changes.

Then there’s the math. There are a lot of ways to look at the math, but they all show that, to do it fairly to the taxpayer, takes a long, long time. 

The math of recap gets pretty hard. For example, assuming even that they would need 4 or 5 percent capital — this is a pretty standard leverage ratio for a large financial firm and amounts to between $200 billion and $250 billion on a $5 trillion base. To raise this via retained earnings would take them decades.  

Realistically speaking, they can operate with government support or they can be wound down and replaced with a new system. Recap and release, though, is not really economically viable. Plans that argue otherwise tend to rely on the taxpayers forgiving a lot, which I do not think passes muster here. I just don’t think I’ve seen one yet that works.

The policy matters, too, and I will also say that there is a big difference between bringing private capital back into the mortgage market, which is a laudable goal, and “privatizing” the government-sponsored enterprises.  Absent some pretty material change, the latter, in our post financial crisis world, we know is really an oxymoron. I also do not think that is politically tenable.

Do you think that suspending the profit sweeps at this time and allowing the GSEs to rebuild capital is counterproductive?

It certainly could be. It could lead MBS investors to question the strength of the PSPAs. At a minimum, it would certainly be confusing.

Fannie and Freddie can go around the world today and tell foreign investors that their MBS and their debt is backed by a line of credit to the Treasury Department. That is the source of their capital. No one doubts this right now. If the source of their capital were retained earnings — which for a long time will be quite low relative to the overall size of their books — then investors might question whether the Treasury really does backstop them. 

Of course we know in a crisis the political pressure to bail them out would, once again, be enormous. But in the meantime, what we’d likely get is an increase in interest rates, which would be nothing other than a risk premium [to account for the chance] that a future Congress or Treasury Department would let the economy collapse in the event of a future GSE insolvency. Maybe this is a far-flung concern, but maybe it isn’t.

Spreads between GSE MBS and Ginnie Mae MBS — which have a very clear guarantee — have widened since speculation about letting them [GSEs] retain earnings has increased. This, “privatization” talk could be a driver and would likely only get worse if the talk became real.

If the GSEs have to take a series of Treasury draws over the next few years, could there be a public backlash that could hasten calls to eliminate them and potentially undermine the confidence in their securities?

No, I do not think this is a legitimate worry. It would really need to be a series of large draws that are directly linked to some sort of malfeasance or incompetence on the GSEs’ part before draconian legislation were passed, and I don’t think that’s likely. If anything, a few draws could hasten the calls to do sound, structural reform. It could be the push needed to get something done that works. But I don’t see knee-jerk or hot-headed irresponsible reform ever happening. Too much of our economy rests on housing for that to take place, in my view. 

What do you think about a proposal that would allow the GSEs to retain their earnings to rebuild a smaller buffer — enough to weather the quarterly volatility but not enough to release them — so that the GSEs could avoid taking draws while Congress embarks on reform?

If it’s part of a broader legislative effort — reform that allows for an end to the duopoly and the elimination of the special [advantage] the enterprises enjoy — then that’s one thing. But if noise is the concern — meaning if what you are worried about is political risk — then it might make more sense to just let them report earnings annually, sort of how the [Federal Housing Department] does it. This way small and temporary changes in the yield curve or the level of rates or implied volatility won’t be the primary driver of what they report. What they report could be a better reflection of the condition of the housing market, which is what the taxpayers should worry about, not the accounting value of their firms at each quarter.

Do you see any common ground emerging on what a new system of housing finance should look like?

I do. I’ve seen it for a long time. It involves a limited and clearly defined role for the government, it involves a broader role for private capital and competition among entities that have a commitment and the capacity to serve all markets through the economic cycle. And it relies on enterprises that can go insolvent — and into bankruptcy — if they make mistakes. Ideally it involves a mortgage ecosystem where lenders also have a stake in the performance of the loans they originate as well. That is a more honest private-mortgage credit market. Those are the tenets of reform that I think eventually make it into law.

There are a lot of details, but once the impetus for structural reform gets going, the desire to work out these details is powerful and gets a lot of momentum. Right now everything is set. It just takes a push.

Do you think comprehensive housing reforms will happen within the next two years while Republicans control Congress?

I think the odds are exactly 50-50. I think there is a real chance that Congress takes this on in a responsible way. I know that's a challenge sometimes in Washington, but it's pretty important. I think that we might be in a place where that can happen.


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