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GSE reform could and should start now

The Milken Institute this week laid out a blueprint for the new leaders of the Federal Housing Finance Agency (FHFA) to prepare the groundwork for Congress to reform Fannie Mae and Freddie Mac and eventually end their 10-year conservatorship. Eric Kaplan, director of housing-finance policy at the Milken Institute Center for Financial Markets, discussed the recommendations with Scotsman Guide News.

The FHFA is under new leadership this month. Is that why you released the paper this week, and are they the intended audience?

erickaplanWe are thinking about government and industry stakeholders. It will speak to different audiences depending on the nature of it, but look, it is the beginning of the year; there is new leadership coming into the FHFA; new leadership taking over the CFPB [Consumer Financial Protection Bureau]. We look at the CFPB as being just as critical to the equation as the FHFA, albeit for different reasons.

Because we are focusing on administrative actions, it is directed at the new leadership, but really the question of housing-finance reform does cut across the entire ecosystem. We don’t anticipate there are going to be any actions taken completely in a vacuum. Any move that any player makes, there will be an impact that cuts across the rest of the system. In some cases, the impact will be intentional. In some cases, it will be unintended consequences. That is one of the reasons we think about the broader audience. In a perfect world, we would like to see coordinated discussion and coordinated efforts so that there is a plan that is being followed, a cohesive, coordinated, comprehensive plan.

Why do you begin the paper with the importance of getting a handle on how much capital these entities should hold?

It is more because of the business that is currently underway. There are two things that are currently underway. The capital rule has been proposed and  the new MBS [the single mortgage-backed security common securitizations platform]. One of the critical pieces of housing-finance reform — if you are going to have a government component — is making sure that the entities, whether it is a government agency, a government-sponsored enterprise [GSE] or its successor, that they are properly capitalized in order to avoid any kind of a failure or any kind of risk to the safety and soundness of the system.

There has been a tremendous amount of commentary on the capital rule as proposed, but we think that, for the most part, there is pretty universal thinking that stakeholders would like it to be more transparent. We want to dig down further. We appreciate the effort, but we would like more transparency. Pretty much all versions of a housing-finance system of the future involve some government presence. If you have any kind of a government-sponsored enterprise or a successor entity, the question of capital is critical.  

The Mortgage Bankers Association, and some others that support legislative reforms by Congress, don’t favor allowing the GSEs to resume building capital before Congress passes legislation. Why do you recommend allowing them to do so?

This is one that we really debated back and forth. At the end of the day, we see it more as operational. Rebuilding capital should not be seen as a precursor or a prelude to, or justification for, releasing them from the conservatorship without addressing the charter flaws. Rebuilding capital is not meant to lull the market into a false sense of security that everything is fine, and then be used as a justification to release the GSEs from conservatorship without fixing the flaws. It is more operational. They need capital to operate. They have a cushion now. Pretty much all end-state visions will require them to have capital in some amount. There is some very deep debate about what that number should be. The one thing we do agree on is that we think the amount of capital should be enough that they can avoid failure and avoid the need for any kind of extraordinary measures like we saw in the financial crisis.  

Although the paper is framed as a path for administrative changes, the recommended changes would, it seems, set a course for Congress to create system with multiple GSE entities. Why do you support a multi-entity system?

We touch on that, but you can just as easily get to an end state where the two of them are released and you just have two, but they are treated as utilities. You could even have one. The main thing for us here is that [the current system] is a duopoly and, given the current construction of the charters, it is the privatization of profits and socialization of losses.

Here is the thing. Ginnie Mae and other government agencies exist for the benefit of the housing-finance system. They are government entities and the actions that they take are on behalf of the housing-finance system.  

Fannie and Freddie, when they act, are private mortgage companies. They are profit-seeking enterprises. And so, the charters give them significant advantages to act with the taxpayer at risk for their actions in order to maximize their profits. I get it. If that is what they are, that is what they are, but call them what they are. If they are private companies, then you get to the point about the duopoly. If you are acting like a private company, if you are trying to maximize profit, to me, that means the market screams for competition, or the ability for others to compete. Otherwise, whether it is a monopoly or a duopoly, typically those benefit the "opolists." That is the critical issue. The way they have acted in the past, they are set up to act that way.

We saw what happened in the crisis. We saw what happens when that goes wrong, and that is what we have to avoid. That is why we didn’t get to the end-game vision here. There are many different visions that this can take, and we don’t think that any of these [proposals] preclude any number of end-state visions. We are not so much weighing in on that, but the part about the privatization of profits and the socialization of losses and what that means in the context of the GSEs and how they are currently structured under the charters, that is one of the issues that we are getting at here. That is what we mean by needing to fix the charter flaws. We should not be in a position — we know too much, we have been through too much — to ever put the housing-finance system in a position like it was in 2007-2008, and we shouldn’t be lulled into a false sense of security about that.

One thing that makes nonbank originators nervous is the real possibility that the FHFA will shrink Fannie and Freddie’s footprint. Your paper recommends that the FHFA take some steps to reduce the size of the GSEs by eliminating certain products, such as cash-out refinances. Why do you support that?

Building more diversity in financing sources into the housing-finance toolbox and doing it safely and soundly, we think will strengthen the system. We are not saying go back to the Wild West of the precrisis days. We are very clear that a lot of the measures must have the right guardrails in place to avoid the elements of the crisis. In this case, you have got the taxpayer on the hook for the vast majority of the loans in the market. And we’ve seen the issue of charter creep.

Streamlining [the GSEs, government agencies] is a way of getting the taxpayer out of the first-loss position, or reducing exposure of the taxpayer to the housing-finance system and bringing more diverse sources of financing to the housing-finance system, but again doing it safely and soundly. We don’t call for a wholesale reduction of the government footprint. We think it should be done up to a point. We are not saying what percentage it should be, but we do think there are some products that are adequately served by the private market.

The entire transition process into a new system could take a decade or more to complete, but how long would it take the FHFA to implement your recommended changes?

There are some things that we call for in the paper that would require evaluation and consideration. We point out certain things that we want the agencies to investigate. Doing the investigation and then reaching conclusions based on the investigation, and deriving action steps from them, that could take a little while. Some could be put in place right away. Some will take time, maybe a year, two-year time frame with some sort of a rollout. I think anywhere from the near-term to  all the way up to the two- to four-year range, somewhere in there. Again, it depends on how much works needs to be done to come up with solutions as opposed to taking steps right away. 


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