If It’s Not Broken – Oh Wait, It Is Broken

When Fannie Mae and Freddie Mac reported their earnings for the third quarter, both reported strong returns, but this was not greeted as particularly good news among mortgage industry observers.

Although Fannie Mae reported a net income of $3.2 billion, it also reported it would pay the U.S. Treasury $3.0 billion in dividends in December. Freddie Mac reported a net income of $2.3 billion and that it would pay $2.3 billion in dividends in December. The two government-sponsored enterprises (GSEs) were placed under conservatorship in September 2008, and in 2013, the U.S. Treasury began the “net worth sweep,” in which the two GSEs sent all profits to the Treasury.

Industry experts say the GSEs are under-capitalized, take on too much risk and are not helping underserved populations buy homes. Many think the two GSEs need to be repaired or revamped, but they acknowledge that there are some hurdles to any GSE reform right now.

“Ultimately, the only path we see out of conservatorship is for Congress to take some kind of action,” says Joseph Pigg, senior vice president and senior counsel for mortgage finance for the American Bankers Association (ABA) in Washington, D.C. “The terms of the conservatorship are that Fannie Mae and Freddie Mac are under conservatorship until Congress says they are not.”

Both GSEs pointed out that business fundamentals are strong and that they are working to reduce risk to taxpayers through credit risk transfer programs. Pigg says the development of the risk transfer programs has been among the most important reforms for the GSEs in recent years. In a letter to the Federal Housing Finance Agency (FHFA) in October – a response to the FHFA’s request for input regarding front- and back-end risk transfer programs – he noted that any program must not add complexity or costs to the borrower or loan originator. (The letter is here.)

“FHFA has begun encouraging Fannie and Freddie to engage in risk transfer,” Pigg says. “Within the framework of what’s doable outside of Congress acting, that’s a positive that FHFA and GSEs are engaged in ways of moving risk off their books and, thus, off the taxpayers. We view that as a positive step.”

Pigg adds that although some industry groups have made proposals about dismantling Fannie Mae and Freddie Mac and replacing them with new entities, the ABA has been agnostic about what reform should look like. Still, there are some factors that are important in GSE reform. “It needs to have appropriate capital, appropriate compensation for the level of risk it takes on, and it needs to be transparent in the risk it’s putting in the market,” he says. “That’s sort of become a recent concern.”

The recent concern, he explains, comes from the push to expand the credit box, with new products related to buying loans with low down payments. “We are not opposing that, but we want to be clear that low down payment loans’ history has shown a tendency to be riskier,” Pigg says. “If Fannie and Freddie put those in the marketplace, they need to be transparent about the risk.” He points out that the ABA has members of all sizes, and the goal is for them all to have access to secondary market financing.

Glen S. Corso, executive director of Community Mortgage Lenders of America, agrees that GSE reform should help smaller lenders. Before the financial crisis, Fannie and Freddie were giving favorable pricing to the largest lenders. “Obviously, some changes are needed to Fannie and Freddie to prevent a repeat of what happened in 2008,” he says. “There is no dispute there at all.”

The dispute, Corso says, is over what form the reformed GSEs should take. He favors the utility model, which means the GSEs would have public shareholders and be regulated by a board that would monitor soundness and pricing. “Why don’t we just keep Fannie and Freddie instead of the elaborate plans to do away with them?” he says.

A less elaborate plan would enable the GSEs to help expand the mortgage market. “Whatever needs to be done, as long as it’s done responsibly and creates more business for my members, great – it’s a win-win for everybody,” Corso says. The barrier, he says, is Fannie and Freddie have very little capital and are supposed to have zero capital in January 2018. “That makes you conservative and hesitant to do new things because the slightest misstep means you go back to the Treasury and get another draw on credit.” The solution, he says, would be to allow the GSEs to retain some of that income and build up that capital.

That option is also outlined in a paper by the Congressional Budget Office – “The Effects of Increasing Fannie Mae’s and Freddie Mac’s Capital.” Among the conclusions is the following: Retaining a portion of their net income would increase the government’s investment in the GSEs, which would help them cover potential losses and also increase the stability of mortgage markets, but providing those additional resources would expose the federal government to increased risk of losses.

Any GSE reform will need to prioritize access and affordability for all creditworthy borrowers, says Nikitra Bailey, executive vice president of the Center for Responsible Lending. “People of color and lower-wealth families have been successful in homeownership when they receive safe and responsible loan products,” she says. “However, they are being locked out of the marketplace.”

Bailey points out that reforms including the Dodd-Frank Wall Street Reform and Consumer Protection Act have already worked to rid the marketplace of risky loan products. “Now, what we’re really concerned about is pricing,” she says. “Specifically, how mortgage loans are going to be priced going forward. Some of the changes that already have been implemented have made mortgage loans more expensive because they are overly reliant on risk-based pricing.”

The FHFA should focus also on average pricing and pooling loan risks, Bailey says. That would allow small lenders to compete on the same level as large lenders and ensure geographic opportunities, too.

She says she cannot predict what will happen with GSE reform or when, but in general, a healthy and well-functioning mortgage market will enable growth among communities that have been left out of the recovery. “Seventy percent of future first-time homeowners will be borrowers of color,” she says. “We need to ensure we’re not locking out this important market segment.”

The Mortgage Bankers Association (MBA) has a task force that will offer strategies for GSE reform, says Bill Killmer, senior vice president for legislative and political affairs. “We want a sustainable secondary mortgage market model that can endure the next 100-year flood, whenever that might take place,” he says. “The tricky part is how to build adequate architecture and infrastructure for that, keep the best of what has been working with Freddie and Fannie, and improve on the regulatory apparatus.”

Absent any crisis, he says, it is unlikely the new administration will look at the topic in the first 100 days. Also, it’s hard to tell whether Congress will take action, especially after it did not pass the Housing Finance Reform and Taxpayer Protection Act or the Johnson Crapo bill, a Senate attempt at GSE reform in 2014.

The MBA will reveal some task force findings in 2017. “We’re trying to be very thoughtful in our approach,” Killmer says. “There is a lot at stake here.”

Meanwhile, others are not very optimistic about a timeline. “Well, no real chance this Congress; I give it maybe 25 percent chance next Congress,” says Mark A. Calabria, director of financial regulation studies at the Cato Institute. “I doubt reform will happen until one or both of the GSEs starts losing a lot of money and takes a big draw from Treasury, which is possible whenever housing market next turns down. So maybe within [the] next five or six years.”