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The Math About the GSEs' Future

Robert Bostrom

Trapped between conflicting requirements that indicate collapse and abolition prospects, the debate over the future status of Fannie Mae and Freddie Mac is emerging as one of the year’s biggest concerns for insiders and academics.

Future uncertainty and the temporary nature of the conservatorship “are building up pressure” to resolve Fannie and Freddie, said Robert Bostrom, who served as general counsel for Freddie Mac for five years before he joined SNR Denton US LLP in New York in late 2011.

Initially Fannie and Freddie were placed under the conservatorship of the Federal Housing Finance Agency for three years. That deadline has already passed. In Bostrom’s view, the challenge is “an inherent conflict” between the conservatorship and GSEs’ mission. Fannie and Freddie operate under a senior preferred stock purchase agreement that requires return to profitability and minimal use of taxpayer dollars. If under the terms of the conservator’s statute the FHFA is expected to preserve these assets, under the terms of their charter the GSEs need to provide affordable financing, help generate liquidity for the banks and maintain stability in the secondary housing market.

Uncertainty over the future status of Fannie and Freddie given their mandate to facilitate very costly solutions to the housing crisis “has created employee angst and management turnover,” indicating something needs to be done, Bostrom says.

Since Fannie, Freddie, Ginnie and the FHA now insure or purchase 90% of all mortgages originated, their survival problem is so huge “nobody knows what to think anymore.” Some observers see the abolition of Fannie and Freddie as a solution, but he argues, “from a market’s perspective it’s nearly impossible to do that right now.”

The uncertainty around the future leads to the continuing paralysis among the GSE executives that makes it even more difficult to make meaningful decisions. Hence, current issues “do not have an easy resolution,” or any time soon.

It makes “better financial sense” to continue the conservatorship for a period of time, because it could significantly lessen taxpayer losses in a number of ways, Bostrom says. Politics aside, “if you just do the math” data may point to a different conclusion.

The GSEs are producing probably $15 billion of annual revenue that is diverted into their loan loss reserves that are calculated based on changes in the housing prices. So if in three to five years the housing market starts to recover then loan loss reserve needs would also decline. For instance, if currently prices have bottomed down 27% to 28% and in a couple of years bounce 10% or 15%, the difference helps make a significant correction. In other words, Bostrom explained, if the home prices start to come back the mark-to-market price losses get reduced and that capital comes back to income. (If the market gets worse all these considerations are off the table.)

“No matter how much people want to get rid of the GSEs,” he says, it does not make financial sense to do so “until the private market comes back.” But as long as there are risk-retention rules and the QRM requirements to abide to, private investors are not eager to jump in. He argues that even in 2007 when the GSEs total mortgage debt outstanding was about 44%, the FHA and Ginnie Mae had in their portfolios approximately 5% to 10% of the mortgage-backed securities so private investors hold about 30% of the MBS market share. If that was the case before the crisis, it is impossible for the private markets to absorb the remaining 70%. “The government has to stay in even if they may not want to,” he says.

Another impediment to resolution is debt. Nobody wants to see close to $6 trillion of the GSE debt go into the government balance sheet, he argues, between the two of them Fannie and Freddie “wrote off an average of bout $50 billion” in deferred tax income because they had no income. If and when they become profitable and earned income, the DTI would go back up by another $50 billion.

In the end, however, it is not a simple matter of accounting gains and losses. “Someone has to be thinking holistically about it and really try to look at it without the ideological filter.”

As of now politics is overriding the math and most shy away from the GSEs’ past history, except academics who are pointing to its lessons to be learned.

In a paper published in mid-January, “How Fannie, Freddie and Politicians Caused the Crisis,” resident fellow with the American Enterprise Institute, Edward Pinto, notes how by mid-2008 Fannie and Freddie were holding a combined $5.4 trillion in securities outstanding “backed by the GSEs' full faith and credit,” which had financed 45% of all the residential mortgage debt in the U.S. These securities were aggressively marketed worldwide to investors who were led to believe that the vast majority of the loans backing these GSE securities were low risk because they were guaranteed by the U.S. government.

Presently, Pinto argues, thanks to a SEC investigation, “the GSEs have, for the first time, acknowledged the magnitude of their efforts to mislead investors” about their exposure to subprime and alt-A loans. The GSEs’ credit guaranty portfolios contained $1.6 trillion, not $600 billion in subprime and alt-A loans, he writes, as approximately $1 trillion in subprime and alt-A loans were misclassified as due to the GSEs’ high leverage—each dollar of capital supported about $80 in debt—their insolvency was inevitable.”

Pinto recalls how in 1991 Fannie’s CEO Jim Johnson sized the opportunity “to solidify political support for Fannie and fight efforts to limit or eliminate its charter benefits,” in joining community groups’ efforts to liberalize loan underwriting standards and successfully support legislation that in the mid-1990s imposed affordable housing goals on the GSEs.

“A default would have created panic,” he wrote, given the unknown value and corporate guarantees worthless of the collateral backing the GSEs’ securities “uncertainty as to the magnitude of losses would have contaminated the entire $5.4 trillion in outstanding GSE securities.”

In his calculations market values would likely have plummeted by 20% or more,  creating losses of $1 trillion or more. “The impact on the FDIC alone would have been catastrophic since depository institutions held about $1 trillion in GSE securities,” along with other investors lured by policymakers to invest in GSE securities “by way of low capital requirements.”

Furthermore, the federal government “would now be forced to acknowledge full responsibility for the GSEs’ liabilities,” which the government had established as off-balance-sheet structured investment vehicles, creating “a classic case of moral hazard” that infected the $11 trillion residential debt market.

Apparently, even Treasury secretary Timothy Geithner once noted in a private interview with the chairman of the Financial Crisis Inquiry Commission, “The GSEs were entirely moral hazard.”