Donald Markwardt
Senior Research Analyst, International Finance and Macroeconomics Research
Capital Flows and Systemic Risk
Donald Markwardt is a senior research analyst in international finance and macroeconomics at the Milken Institute. He studies topics relating to systemic risk, capital flows and investment. Concentrating on systemic risk assessment in the financial system, his recent work focuses on liquidity and financial stability in the asset management industry.
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Reforming housing finance: Do we have to wait for Congress?
By: Donald Markwardt
January 30, 2013

During the housing crisis, the U.S. government made good on its implicit guarantee to step in during a catastrophe, stabilizing the market at great cost to taxpayers. Since then, public-sector involvement in housing finance has reached unprecedented levels. Federal agencies and the government-sponsored enterprises (GSEs), which are under federal conservatorship, account for more than 80 percent of first-lien mortgage loans and virtually all mortgage-backed security (MBS) issuance.

Fannie Mae and Freddie Mac have proved profitable lately, nearly paying back the TreasuryaEUR(TM)s $188 billion capital injection. But as Federal Housing Finance Agency (FHFA) Deputy Director Wanda DeLeo recently said in Senate testimony, the GSEsaEUR(TM) recent progress aEURoeshould not blind us to the very real costs associated with [their] failures.aEUR? In the event of another housing collapse, taxpayers will be left holding the bag once again.

ThataEUR(TM)s why the FHFA wants to shrink the GSEsaEUR(TM) role and bring more private capital into the mix. In recent weeks it announced that Fannie and Freddie would charge more in fees on their loan guarantees and proposed reducing guaranteed loan limits by 4 percent. While encouraging, these modest changes alone probably wouldnaEUR(TM)t put a huge dent in their market share. Larger-scale efforts are needed.

Legislators are considering two plans to expand private participation: the PATH Act in the House and a proposal from Bob Corker and Mark Warner in the Senate. (A third, put forward by Sens. Tim Johnson and Mike Crapo, focuses on Federal Housing Administration finances but does not reform the GSEs.) The Protecting American Taxpayers and Homeowners Act, or PATH, would wind down Fannie and Freddie over five years and stand behind mortgages only through the FHA. The majority of the housing finance system would be private. The Corker-Warner plan would also dismantle Fannie and Freddie over five years and replace the FHFA with a newly created agency, the Federal Mortgage Insurance Corp. (FMIC). The FMIC would offer an explicit catastrophic guarantee, but it would be paid for upfront through guarantee fees on private MBS, putting private capital in a first-loss position.

The PATH Act passed out of committee in July, and there was hope that a plan combining elements of Corker-Warner and Johnson-Crapo would come out of the Senate Committee on Banking, Housing, and Urban Affairs by year-end. This target has passed. Additionally, there is talk that House Democrats will unveil their own proposal in early 2014. As the debate moves from committee hearings to the floor in each chamber, it remains uncertain whether a consensus approach will succeed. At recent gatherings in Washington, analysts have suggested that reform might have to wait until 2017 and a new president takes office. So in the absence of legislative reform, what options are available?

One approach is for GSEs to transfer some of their massive mortgage credit risk directly to the private sector through the capital markets. They can issue debt with performance tied to the underlying mortgage loans, offering attractive returns to investors in exchange for a lighter risk burden. GSEs have recently begun experimenting with this type of risk-sharing vehicle. Freddie Mac issued two series of Structured Agency Credit Risk securities (STACRs), and Fannie Mae sold similarly structured Connecticut Avenue Securities (C-deals). The issues sold for a combined $1.8 billion, offering credit protection on $65 billion of mortgages.

Only on Fannie and FreddieaEUR(TM)s multitrillion-dollar balance sheets could $65 billion be considered a drop in the bucket. The goal is to scale up these offerings, letting private capital price and assume most of the first-loss exposure. Interest has been strong among investors such as pension and hedge funds, but issues linked to rating the securities must be resolved before big players like banks and insurers can get substantially involved. They will probably be fixed over time, and the agencies are expected to continue to sell these securities in 2014.

Another recent proposal would also sidestep Congress. In early November, a group of hedge funds and private equity firms, led by Bruce Berkowitz of Fairholme Capital, made a bid to privatize large parts of the two GSEs. These investors already own $35 billion in preferred shares, with Fairholme holding the largest slice at $3.5 billion. The preferred shareholders, though, are in litigation over their share of dividends now that Fannie and Freddie are in the black.

If their bid went through, the investors would acquire the parts of GSEs needed to write MBS guarantees with the goal of creating state-regulated, monoline insurance companies. They would capitalize these MBS insurers with $52 billion, including $35 billion from their current preferred shares. As the new companies operate the guarantee business and other aEURoerun-offaEUR? companies sell assets, Fannie and Freddie would disappear. The investors have argued that their plan, with high capital ratios, can succeed with or without federal reform of housing finance or a government guarantee.

With the sting of the last bailout still fresh in Washington, the offer faced a cold reception from both Congress and the White House. aEURoeTaxpayers can do a lot better than this deal,aEUR? Warner told the Wall Street Journal, and Gene Sperling, director of the National Economic Council, said, aEURoeI want to make clear our administration believes the risks are simply too great that this would re-create the problems of the past.aEUR? Despite these reactions from policymakers, the Fairholme bid indicates an appetite among investors to reenter the mortgage market, just as the FHFA and Congress hope to see. The bid also signals that the GSEs, in their core business of purchasing mortgages and guaranteeing MBS, retain significant value. The Fairholme bid may not be the right deal at the right moment, but the government could be more open to these kinds of external proposals if they offer more agreeable terms.

From the STACR and C-deals to the Fairholme bid and the FHFAaEUR(TM)s recent announcements, all signs point to private capitalaEUR(TM)s readiness to step up its role in financing AmericaaEUR(TM)s housing. Whether that comes about through congressional reform remains to be seen, but in the meantime alternative avenues to reduce taxpayersaEUR(TM) risk do exist. Now, while the market is strong, could be an opportune time to embrace these proposals, before another contraction dampens the private sectoraEUR(TM)s enthusiasm for getting involved.