Conflict of visions in GSE reform
Watching the progress of the discussion around the Trump administration's plans for ending the conservatorship of Fannie Mae and Freddie Mac, it is possible to discern two distinct narratives — descriptions of future policy goals that are largely at odds with the other. Whether Congress and/or the mortgage industry is able to untangle these two opposed threads is anyone's guess. Have no doubt, however, that the future of the mortgage market is at stake.
One the one hand, we have the narrative that says that Fannie Mae and Freddie Mac will be allowed to accumulate capital after the punitive payments to the Treasury known as the "sweep" are ended. The GSEs instead will pay a fee to compensate the taxpayer for the use of the sovereign credit support that these entities enjoy under conservatorship. Once these entities have retained or raised sufficient new capital, they will be "released" from government ownership. At least that is the stated plan from Trump White House today.
On the other hand, the Trump administration seems determined to scale back the operations of the GSEs, ending the purchase of loans for second homes, cash-out refinancing and even multifamily commercial mortgages. These reductions in the footprint of the GSEs will have the effect of reducing volumes and profitability, making it more difficult to either retain capital or raise new funds from private investors.
To add to this conflicted situation, Treasury Secretary Steve Mnuchin has essentially decided to play chicken with Congress in order to force legislative action on housing reform. Under the Treasury's road map, Treasury and the Federal Housing Finance Agency will commence "reform" under existing law if Congress fails to act by the end of the year. On the eve of what promises to be a highly contentious general election cycle in 2020, the odds of congressional action on housing are remote, possibly even negative.
FHFA Director Mark Calabria testified in front of Congress last week that that administrative action to reform the housing finance system should come even before the end of the year. The first step will involve the end of the sweep and the negotiation of a new fee to be paid to the Treasury. If we take the GSE risk sharing deals done to date as a price benchmark (15-20 basis points), insuring the $5 trillion in total GSE debt should be worth $5 billion to $10 billion annually to Treasury so long as Fannie and Freddie remain in conservatorship.
Next comes a more problematic exercise of setting new "risk based" capital rules for the GSEs and deciding whether these large mortgage insurers are "systemically significant." The trouble with the discussion over "capital" is that it largely ignores the fact that the GSEs now operate under the credit of the United States. As we focus the attention of investors and credit markets on private capital and away from the support of the U.S. Treasury, the credit standing of the GSEs is going to degrade. We may even see Moody's, S&P and the other rating agencies put the GSEs on watch for a credit downgrade in anticipation of eventual "release" from conservatorship.
After the end of the sweep and a decision on new capital rules by the FHFA, actions that could take well into 2020 to complete, then comes the fun part. As we've noted in past comments about GSE reform, there is little discussion in Washington as to how reform will affect the business models of these housing giants. Suffice to say that a nonbank mortgage insurer is unlikely to have an "AAA" credit rating, with or without a credit line from Uncle Sam. Should the FHFA start to limit the activities of the GSEs, then the reduced volumes and profits will negatively impact investor perception, credit ratings and the ability to accumulate capital.
For example, when director Calabria speculates about possibly raising new money from investors to speed the release from conservatorship, he avoids any specifics about just what that offering document would tell prospective investors about the future business of the GSEs. As Calabria takes steps to protect taxpayers, he must necessarily diminish the attractiveness of the GSEs to private investors.
Indeed, it is debatable whether investors would purchase new equity shares in the GSEs without an explicit guarantee from the Treasury going forward. The prospective end of the GSE "patch" for qualified mortgages, for example, could reduce loan purchase volumes through the GSEs by 10% or more, according to a report by Kroll Bond Ratings.
Most executives who operate mortgage companies view the Washington conversation about GSE reform with a combination of bemusement and dread. On the one hand, the childlike naivete displayed by policy makers regarding the business implications to the GSEs of ending the conservatorship elicit chuckles and outright incredulity. But the prospect of Secretary Mnuchin and Director Calabria handing the residential mortgage market to the big banks on a silver platter as part of "leveling the playing field" is a most unwelcome, even disastrous development.
The table below shows the relative market share of the GSEs, the banking industry, Ginnie Mae and the private label market. Of the $1.6 trillion in new originations this year, most will be originated by independent mortgage bankers. A few very large banks will then purchase and sell about 90% of these new loans into the secondary market as RMBS. Nonbanks, however, are rapidly becoming issuers in their own right, especially in the Ginnie Mae market.
JPMorgan, Wells Fargo, Bank America and the other large "too big to fail" banks are GSEs, just like Fannie Mae and Freddie Mac. The housing GSEs, including the Federal Home Loan Banks, have historically served as a counterweight to the monopoly power of the large money center banks in the secondary mortgage market. In 1994, the Securities and Exchange Commission amended Rule 2(a)7 and effectively prohibited nonbanks from issuing mortgage pass through securities to money market funds. Since that time, independent mortgage bankers have been subordinated to the whim of the largest banks as providers of short-term liquidity.
Once the GSEs are no longer wards of the state, they too will be subject to the ebb and flow of the credit markets and the credit preferences of the big banks and bond investors. The real question to ask about GSE reform is not about protecting the taxpayer or releasing Fannie Mae and Freddie Mac back into pseudo private ownership. Rather, we ought to ask whether the real agenda of President Trump, Secretary Mnuchin and Director Calabria is to limit or cripple the business activities of the GSEs and thereby expand the market share of the biggest banks in the prime half of the mortgage market.
How much of a discount from book is Director Calabria willing to accept in an offering of GSE shares? Does he or anyone at Treasury even understand that question? Policymakers need to recognize that the change from government to private ownership for the GSEs is not a positive credit development. Most private players in the industry trade a steep discount to book value and are sub-investment grade credits on an unsecured basis.
Even a modest change in the credit standing and funding costs of the GSEs would prove disastrous for both enterprises, perhaps even forcing them back into government ownership shortly after "release" into private control. The conflict between protecting the taxpayer and returning the GSEs to private hands is fraught with practical difficulties that Mnuchin, Calabria and their colleagues have yet to address.