Trump’s Fannie/Freddie Privatization Giveaway: Why GSE Reform Is Hard

Here we are, more than eleven years after the September Saturday when Hank Paulson announced that the government was putting Fannie, Freddie and the Federal Home Loan Banks in conservatorship, shoring them up financially by giving them a positive net worth guarantee. The intent has always been that the conservatorship would be temporary, and that the two mortgage giants, also called GSEs, for government sponsored enterprises, would win up being privately owned. The Obama Administration had a go at it, with plans proposed in 2011 that we criticized at the time for being a giveaway to banks as well as insanely taking two giants with complex operations and proposing to build new entities performing the same functions from scratch.

The Trump Administration is trying to take advantage of the enrichment opportunity that Fannie/Freddie “reform” represents and proposed its own privatization scheme earlier this month. In a sign of the times, an issue that was hotly debated back when memories of the Fannie/Freddie implosion were still fresh got barely any press mention. But as we’ll discuss, it would be another official giveaway, with different winners than the Obama version.

One reason for the lack of interest is that the Trump Treasury’s plan is likely to go nowhere. It calls for Congress to give the newly privatized GSEs a full faith and credit guarantee. Fannie and Freddie in their pre-crisis incarnations didn’t have one, and the cover pages of their prospectuses disavowed that they did, but enough investors believed otherwise that they were able to make it so. There is no reason for the Democratic-Party-controlled House to do the Trump Administration any favors by approving this scheme, which would give him a 2020 talking point and curry favor with hedge funds.

Rather than discuss the Trump plans in detail, since they are only in the early draft form and there’s good reason to think they won’t get done, we thought it might be better to take a step back and look into whether privatization makes sense. But first, let’s dispatch of the Trump plan, such as it is.

The Trump Fannie/Freddie Gimmie

Even Bloomberg hates the Trump GSE scheme. Its editorial board roused itself to give it a big thumbs down. While the Obama “reform” had lots of moving parts, the Trump one is simpler: make the GSEs private again, but with an explicit backstop. Even so, it took Treasury three years to come up with this scheme, which is even more of a “heads I win, tails you lose” deal than the pre-crisis Fannie and Freddie.

There are handwaves in the Treasury outline about capitalizing them better and having vigilant oversight. If you believe the Trump administration would do anything remotely like the latter, I have a bridge I’d like to sell you, particularly since the hedge funds investors in GSE stocks are having some success in weakening their regulator. The Administration also wants private securitizations to play a bigger role. That simply is not going to happen. The FDIC under Sheila Bair got extensive input from mortgage investors and devised an elegant, four-point reform program that would have gotten them back into the pool. It was rejected by the sell side.

A Bloomberg story recapping the Treasury proposal noted:

“We remain skeptical that much progress will be made in making it a reality, even with respect to the proposed unilateral actions, before next year’s elections,” analysts at Beacon Policy Advisors said of Treasury’s plan before its public release. If Trump loses, the “blueprint will likely fall out of favor as quickly as Trump leaves.”

While the Trump Administration argues it can take the GSEs private without Congressional approval, it does need their blessing for the government guarantee, so what the Administration can do on its own isn’t very sexy.

The Bloomberg editorial argued that doing nothing was preferable to the Trump GSE plan:

….then, as wards of the state, Fannie Mae and Freddie Mac have actually
done quite well. They have supported lending throughout the recession and recovery, boosted fees to better cover their risks, and paid more than $300 billion in dividends to the Treasury. Yet a rump of private shareholders, including hedge funds that have bought in since the crash, keeps clamoring for a piece of the profits….

The resulting structure would be much the same as before the crisis: Shareholders would reap profits until the next housing bust, when taxpayers would again be on the hook — only more firmly than last time — to cover losses.

Granted, the Treasury plan does call for shareholders to take on more risk in the form of added equity capital. It also requires the government to charge a fee large enough, supposedly, to compensate taxpayers for providing a backstop. This was how the old system was meant to work, and it failed. Such a setup gives the private shareholders every incentive to press for low fees and light capital requirements. Experience suggests they’re very
likely to get their way.

We put it more bluntly in 2011, over similar handwaves in the Obama plan:

Despite the Treasury’s claims that the new GSEs would not fall into the same bad habits as the old GSEs, there is nothing convincing in place to prevent that from happening. The new GSEs are likely to become riskier over time. They will in aggregate have a huge amount of lobbying power just like the old GSEs. Think they aren’t gonna lobby together? Think they aren’t gonna seek variances so they can lever themselves up more? If you think otherwise, you need to revisit the history of the financial services industry since 1980.

Fannie/Freddie: Their Outsized Financial and Political Roles

One can concede that there’s a lot not to like about the GSEs. Laundering housing subsidies through the mortgage market is inefficient, makes it difficult to assess program effectiveness and establish accountability, and often has produced overinvestment in housing. If we want to encourage the development of rental housing, or find ways to promote greater homeownership among lower income borrowers, the policy mix whenever possible should favor budgetary allocations and tax breaks (including tax credit rather than mere tax deductions) over financial services industry enriching and often difficult to target mortgage market gimmicks.

The Republicans particularly hate the GSEs because Fannie was central to the Democratic Party affordable housing coalition. Reckless Endangerment, by Gretchen Morgenson and Josh Rosner, described how Fannie chairman and CEO Jim Johnson worked to cement various interest groups into a force to be reckoned with. A good recap from the 2011 review of the book in Fortune:

Front and center in the authors’ hall of shame is a figure who has largely escaped scrutiny: Former Fannie Mae CEO James A. Johnson, power broker, friend to presidents, Kennedy Center chair. From 1991 to 1998 — before he was succeeded by Franklin Raines — Johnson transformed Fannie Mae into the engine behind Clinton-era “homeownership for all” policies — enthusiastically backed by the President, Treasury Secretary Robert Rubin, housing secretaries Henry Cisneros and Andrew Cuomo, and House Banking Committee Chair Barney Frank, among others. “Flexible” lending standards designed to get more people in homes became the Fannie Mae template that led to a rash of subprime mortgages-and a housing crash.

Along the way, the authors write, Johnson and his mostly Democratic cohorts at Fannie Mae threatened enemies and regulators who questioned the behemoth’s “affordable housing” initiatives, while rewarding supporters (spending $100 million on lobbying and campaign contributions between 1989 and 2009). Johnson courted Countrywide Financial CEO Angelo Mozilo, “founder of the mortgage lender that became synonymous with subprime” and instituted a fabulously rich bonus system at Fannie Mae (the authors estimated he earned $21 million in 1998 alone, and the agency later came under investigation for accounting fraud).

But we have to deal with existing conditions. The GSEs plus Ginnie Mae now provide over 90% of residential mortgage financing. The so-called private label securities market is pretty certain never to resume its pre-crisis levels because the origination side rejected reforms that investors required. Moreover, it is widely accepted that the 30 year fixed rate prepayable mortgage, the backbone of the residential mortgage market, would not exist without a government guarantee. The reason to think that’s so is that no other market has such a product. As we wrote in 2011 in our critique of the Obama GSE reform plan:

Every advanced economy in the world has a mortgage market that provides affordable loans to the middle class without GSEs or other large scale government guaranteed mortgage product. However, the Treasury uses their failure to provide a “pre-payable, 30-year fixed-rate mortgage” as the justification for creating a new variant on the Fannie and Freddie theme.

There’s no good reason to distort policy and refuse to learn from the experience of other markets to preserve a particular product, especially when there is good reason to think it isn’t as pro consumer as its advocates would have you believe. The big difference between the US and other markets is lenders here bear all the interest rate risk; for the most part, consumers have the option to repay with no or low penalties and can avail themselves of a fixed interest rate. That means when interest rates drop and the lender would enjoy the benefit of having a relatively high yield bond, investors can take it away from them by repaying. That also creates uncertainty for lenders as to how long the maturity of their bond is likely to be (repayments due to home sales are more predictable than prepayments due to refis).

Having consumers share some of the interest rate risk would allow them to borrow at lower costs, yet those options (such as mortgages with prepayment restrictions, or adjustable rate mortgages with interest rate floors and ceilings) are not widely offered (the subprime/Alt-A “adjustables” were teasers with rate resets or option ARMs, which both were products that presupposed a borrower refinancing).

More fundamentally, despite the document’s brave talk of the American Dream of homeownership, a long-dated mortgage no longer fits well with job market and household instability…

Now with job tenures short and most households dependent on two incomes, neither of which is assured (plus divorce rates are high), people who commit to 30 year mortgages really have no way of knowing what their incomes will be or where job opportunities will take them in five years, much the less fifteen or twenty five.

Another reason our 30-year fixed rate mortgage isn’t as consumer friendly as you might think is that a very high percentage of the savings achieved by refinancing at a lower rate is stripped out by the lender in the form of fees, while with an adjustable mortgage, the benefit would go to the borrow. Other ways to share risks between borrowers and lenders would be to bar refis entirely in the first five years of the mortgage.

The cost of the 30-year fixed rate mortgage isn’t simply corruption-prone guarantors. It’s also that those guarantors have to hedge the prepayment risk. Way back in 2002-2003, the scale of those hedges became so great that they started to be systemically destabilizing; the Fed got an unexpected break due to an accounting scandal at Freddie, which led to a balance sheet cap.

And contrary to popular perceptions, making bad loans was not the main reason the GSEs got into trouble. Recall that the GSEs are insurers, so they take insurance proceeds up front, invest them, and then pay on claims as they come in, which in this case would be mortgage defaults. From a 2014 post:

Remember, the ginromous losses that the GSEs took were almost entirely due to bad investments. They invested their proceeds from their insurance fees in subprime loans and bonds. But on their securitizations, losses were typically in the 2% range on issues in the period shortly before the crisis. That was still bigger than the loss levels they had anticipated and they were way too thinly capitalized, so they came up short on that side too, but the overwhelming majority of the losses were due to bad investments.

Finally, both the Obama and Trump reforms failed to deal with the festering problems in the mortgage markets, such as servicing abuses and the fact that the GSEs have been put in the conflicting position of managing credit and liquidity risk. As Raj Date pointed out in a Roosevelt Institute article:

The second source of the GSEs’ power to backstop liquidity is their portfolios. Because the GSEs are able to obtain debt financing from investors who fully expect a taxpayer bailout in a crisis, their ability to maintain, and even grow, an investment portfolio of mortgages and MBS can defy free-market gravity: their assets can climb as others sink.

This is a real benefit. But it is not additive to what the government can already accomplish, through the “official” lender of last resort, the Federal Reserve. During this financial crisis, for example, the Fed opened its funding to an unprecedented range of financial institutions, and both purchased and advanced loans against a wide range of assets — including GSE and private-label MBS. And when the Fed puts taxpayers at risk through such liquidity mechanisms, it is, ultimately, taxpayers that benefit if circumstances turn out well. With the GSEs, by contrast, considerable upside is captured by a number of private parties aside from taxpayers — GSE equity holders, GSE management, and GSE bondholders.

The Bloomberg editorial similarly made a suggestion about how to better handle the GSEs credit guarantee:

Fannie Mae and Freddie Mac could be merged into a single, fully government-owned corporation that would transfer most of its credit risk to private investors, retaining just the
catastrophic risk that only the government can bear. This would get private capital involved without letting it so easily shift risk to taxpayers. Pricing the guarantee correctly would be easier. This in turn would promote more competition from completely private lending channels. As it happens, Fannie Mae and Freddie Mac have already been moving in this direction, issuing special credit-risk-transfer securities and creating a common mortgage-securitization platform.

It would be nice if we got some bona fide mortgage reform. But with the gaping chasm between what Democrats and Republicans think that amounts to, don’t hold your breath.