Can Fannie and Freddie Escape Political Gridlock and Exit Conservatorship?
In February of 2011, the Obama Administration presented the policy plan that began the process of shrinking the U.S. government’s role in housing finance. Completing the Government Sponsored Entities (GSE) reform process has been challenging because in the years following the 2007 collapse of the subprime industry, Fannie Mae, Freddie Mac and Ginnie Mae have dominated the housing finance system. Since 2008, these three entities have accounted for more than 95 percent of all mortgage-backed security issuance that supports U.S. mortgage lending.
It has been very difficult for the Obama Administration and the Congress in Washington to cooperate and formulate a “grand plan” to bring replacement private capital back to support the mortgage market. The relevant political, economic and regulatory interests need to get to work and ensure that a stable housing finance system is established. The reformers must establish a system that provides strong liquidity and supports home affordability. They need to act as soon as possible so that positive momentum in the fragile housing recovery is restored.
Extensive studies of the cause of the 2008 financial crisis have been conducted; and, in hindsight, we know that numerous entities made mistakes that contributed to the meltdown. In a nutshell, the U.S. government encouraged higher levels of home ownership with regulatory guidelines that directed mortgage providers to loosen their credit standards. These market conditions brought on an explosion of subprime lending; and across the globe, large financial institutions loaded up on these higher yielding subprime assets (including the GSE’s, Fannie Mae and Freddie Mac). In early 2007, the U.S. housing bubble burst and large percentages of poorly underwritten mortgages began to default. As the year progressed, the subprime mortgage industry imploded. By December, the U.S. had entered the great recession … a sharp and prolonged downturn that lasted 18 months.
In August 2008, western central banks coordinated aid to ease a bank liquidity crisis; and in early September, the Federal Housing Finance Agency (FHFA) placed Fannie and Freddie in conservancy to save them. To stabilize the GSE’s, the U.S. Treasury became a preferred shareholder and committed to providing a line of funding. The FHFA and the Treasury have subsequently modified the conservator agreements to accelerate the wind down of the GSE’s retained loan portfolios and to improve their risk management planning. The agreement remains an open-ended arrangement, and this condition makes it uncertain as to whether or when the GSE’s will emerge from conservatorship.
Completing the restructuring of the mortgage financing system remains as the largest unfinished task from the financial crisis, and the executive and legislative branches of government have yet to offer a politically palatable vision for the future structures and roles to be played by Fannie and Freddie. The government remains divided in the 2014 election year; however, bipartisan (and Administration-supported) GSE reform legislation has proceeded gingerly through the Senate. The Johnson-Crapo Senate bill passed a banking committee vote in mid-May but did not receive sufficient Democratic support to move it forward for a full Senate vote. The Senate reform bill in its current form would also be unlikely to pass in the transitioning Republican-dominated House of Representatives.
So gridlock prevails in Washington amid concerns that the current GSE reform solutions do not correct the faults that triggered the financial crisis or that an untested mortgage platform may not be better than the well tested current one. Concerns that reforming the current system could further raise mortgage costs and hamper affordability have also been expressed, as well as mention of the level playing field angle that is perceived to favor the largest banks. Ensuring tax payer protection from financial loss is also an issue expressed by conservative legislators on the right.
Progress on passing and executing reform legislation before the November elections is highly unlikely. The good news is that the conservatorships have succeeded in stabilizing Fannie and Freddie as they have returned to profitability over the last two years. The reform of the mortgage giants is a huge undertaking and Washington seems to have saved the toughest financial reform challenge for last. Hopefully, their inability to form compromises and remove the uncertainty present in the current system will not be a headwind to the economic recovery.
Dale Pfeifer is the vice president of consulting services at Central States Capital Markets, LLC – Member FINRA, SIPC. The fixed-income experts at Central States Capital Markets, LLC regularly monitor financial developments that impact the GSE’s and are available to discuss these issues with you.
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Central States Capital Markets (Member FINRA & SIPC; Registered with MSRB) is an investment management and consulting firm comprised of individuals with an average level of experience of over 30 years. The investment group offers portfolio analysis and fixed income management; corporate cash management; in-house fixed income trading; and a wide array of fixed income and equity products. CSCM also offers financial advisory services to local communities and is a top underwriter of regional municipal debt. Our consulting group offers strategic asset-liability management, ALM model validations and analytical treasury support for depository institutions.
