The Heavy Lift to Implement GSE Reform-Recap-Release: Market-Improving Reforms (Part 4 of 4)

Author(s)

Donald Layton

Introduction

Whether and when the second Trump administration (Trump II) might end the 16-year conservatorships of Fannie Mae and Freddie Mac (F&F), the two large government-sponsored enterprises (GSEs), has been one of the most discussed topics in housing finance policy over the past six months.[1] This four-part series addresses the specific steps needed to actually implement such a conservatorship exit, a process informally known as “reform-recap-release.”

Part 4 completes the series by addressing a category of reforms that are not well known: those enacted by the Federal Housing Finance Agency (FHFA) to improve the operations of F&F and, through them, positively impact the broader American housing finance market, which I dub “market-improving reforms.” Originally, in 2008, there was no expectation that the conservatorships would produce such changes, which were only initially announced in early 2012. This quickly evolved into the FHFA creating a comprehensive program of dozens of such reforms that have since become well embedded in the operating processes, computer systems, and even product offerings of primary market lenders, mortgage servicers, mortgage-backed securities dealers and investors, and others involved in the housing finance system.

Previously, Part 1 of this series introduced the idea that there were fundamentally two different types of reforms to address. Part 2 discussed the first and more well-known of those two types: reforms needed to correct significant defects in the charters of F&F, some of which many policymakers believe contributed to their falling into conservatorship. Part 3 addressed what it will take to recapitalize the companies so they can exit conservatorship, and also how to dispose of the large ownership stake held by Treasury in the two GSEs.

Market-improving reforms rely entirely on FHFA’s authority as conservator to tell F&F what to do and how to do it, a legal status that will of course end upon exit from conservatorship. This, in turn, means that the reforms are likely to be partially or wholly lost, either quickly or slowly, post-exit because F&F’s boards and management, once again in control of their affairs, will inevitably make changes that they believe serve their interests best.[2] However, because the reforms are, in my view, mostly well-regarded, it would be bad public policy to leave them all at risk of being partially or wholly lost. And because they are also heavily embedded in how America’s mortgage markets operate today, their wholesale loss could also cause years of disruption as the housing finance system works through the resulting changes.

Thus, Trump II can and should seek to retain government control over some of those reforms as part of a comprehensive master plan to orchestrate conservatorship exit. That control can be retained via either a regulation (if the issue is related to safety and soundness) or a clause in the PSPA that F&F each has with Treasury. However, there are two large caveats associated with such continuing government control. First, government control of the reforms will expose them to the inevitable politics and lobbying associated with such control, which may or may not go well. Second, interventions to retain the dozens of market-improving reforms must be used judiciously because, if the government exerts too much continuing control over F&F’s revenues, expenses, and risk profile, the marketplace will likely view the exit as not genuine but a sham, essentially “conservatorship by other means.” This would likely lead to significant problems, such as making it almost impossible for the companies to issue stock, as the shareholders would have very significantly diminished authority to actually be in charge of the company’s affairs.

As part of a master plan to exit conservatorship, Trump II must address these market-improving reforms, which require workstreams to do two things:

1. Catalog all market-improving reforms mandated by the FHFA and create a comprehensive master list, which does not currently exist.

2. For each reform on the master list, undertake an organized policy process to decide whether the government should or should not seek to retain continued decision-making control over it, and if so, spell out how to implement that retention.

The heart of this post will discuss four examples of such reforms to demonstrate what that process might look like, highlighting the complex policy, political, and technical tradeoff decisions Trump II must consider for each of the dozens of market-improving reforms established over the past 16 years of conservatorship.

Background on the conservatorships’ market-improving reforms

There has never been anything quite like the conservatorships of F&F.[3] There was therefore no track record or playbook to use as guidance for the series of FHFA directors in office since conservatorship began.[4] From 2008 to about 2011, the first years of conservatorship, the focus of the FHFA’s control over F&F was unsurprisingly addressing the delinquencies and foreclosures that overwhelmed the mortgage system, including at F&F, during the great financial crisis. By 2012, delinquencies had peaked, and Ed DeMarco, then the agency’s long-term acting director,[5] announced that, as Congress was not making any substantive progress on legislatively replacing or modifying F&F,[6] he would begin to move the two companies forward by implementing key reforms. As a result, in early 2012, a new “strategic plan” for the conservatorships,[7] and the very first “conservatorship scorecard,”[8] which listed specific tasks F&F had to complete as part of that strategic plan, were issued. This creative and unprecedented approach to conservatorship was fully embraced by the next FHFA director, Mel Watt, who took office in early 2014 and served a full five-year term. It thus became fully embedded in how the FHFA has pursued its role as conservator, with annual scorecards implemented ever since.

With the benefit of hindsight, it is clear that the FHFA was using its conservatorship-derived legal authority to implement reforms designed to improve how F&F delivered on their mission to provide broad access to mortgage credit, including being more cost-efficient and reducing their risk to the taxpayer. Given how large and important F&F are as a source of mortgages, the hope was that these improvements would also benefit the entire housing finance system. Of course, different FHFA directors have had different views of what exactly a “better” housing finance system should look like, and that shows up in the nature of the reforms they oversaw, leading to some inconsistencies.

Nevertheless, over time, four main themes have emerged from the dozens of market-improving reforms implemented:

“Aligning[9]” of practices. The goal here was to standardize the operations of both GSEs so that primary market lenders, mortgage servicers, and others could use a “one size fits all” approach in dealing with them. This alignment thus offered an opportunity to directly reduce operating costs in the mortgage system and provided standards that other sources[10] of mortgage credit might also adopt for even greater savings.
Updating policies. Many F&F policies and the resulting market practices have been revised to reflect lessons learned from the mortgage bubble collapse and its aftermath,[11] with the objective of benefiting the collective mortgage system as a whole rather than narrowly just F&F. This type of updating was also naturally reflected in the aligned practices described above.
Expanding access to credit, while maintaining safety and soundness. This primarily reflected lower guarantee fee (G-fee) pricing for targeted groups of homebuyers and, at other times, modernized methods to determine borrower creditworthiness.
Reducing risk to F&F. Reduce both the taxpayer’s and the broad financial system’s exposure to the risks of F&F through a variety of methods and actions.[12]

Workstream #7: Catalog all market-improving reforms mandated by the FHFA and create a comprehensive master list.

I would estimate that there are at least several dozen such reforms, and they have become quite pervasive in housing finance. Determining a full list will require reviewing every annual conservatorship scorecard (both the public version and the more detailed internal one), every one of the many hundreds of conservatorship directives issued since 2008, and possibly even interviewing the staff of FHFA and F&F.

Workstream #8: Determine the desired post-conservatorship outcome for each market-improving reform by implementing an organized process to decide whether to allow the reform to evolve organically post-conservatorship as F&F individually see fit, or instead to take specific action to retain government control over it, either via regulation or a PSPA contract clause.

The review process would be quite complex, as it needs to address technical issues, policy tradeoffs, political impacts, and the practical realities of maintaining government control for each reform identified in Workstream #7. As previously mentioned, the government should not retain too much control of F&F’s revenues, profits, and risk profile, as that would amount to “conservatorship by other means” which would in turn make its shares extremely unattractive to investors.

This organized process might also need to include not just the FHFA, F&F, and Treasury, but possibly also input from the public, including industry representatives, consumer groups, and others.

Workstream #8 examples: Four reforms selected to demonstrate the degree of complexity involved

I have chosen four very different specific examples of market-improving reforms – including one with multiple components – from among the many available.[13] All have been in place for at least several years and thus are very embedded in the operating activities of primary market lenders, servicers, mortgage-backed securities (MBS) investors and dealers, and other industry players. This relatively brief review of each is intended to demonstrate how the decision of whether to retain a reform via regulation or PSPA contract clause will be complex, requiring considerations of technical, policy, and political impacts. Ultimately, these decisions will each be a difficult call, requiring judgment about the trade-offs involved. The resulting decisions will also undoubtedly be second-guessed – and likely lobbied against – by interest groups that would have preferred a different outcome.

The “single security.” In June 2019, F&F introduced the “single security,” formally known as the uniform mortgage-backed security (UMBS), after many years of development. This consists of an FHFA mandate to both GSEs to (1) define all the terms of the MBS that each issue in exactly the same way, and (2) manage prepayment speeds[14] so that they are nearly equal. Together, this allows the MBS issued to be traded in certain circumstances without regard to which GSE issued it (hence the “uniform” nomenclature). The introduction of the UMBS has produced two main benefits: (1) it eliminates the extra interest rate previously required by investors in Freddie Mac’s MBS,[15] which stemmed from its lower liquidity (which was due to it being smaller than Fannie Mae), thereby fostering greater competition between the two GSEs; and (2) the interest rate required by investors on the UMBS is slightly lower than even what Fannie Mae had previously enjoyed because the combined liquidity of UMBS is greater than Fannie Mae’s standalone liquidity. This is now an embedded market feature among MBS dealers and investors, primary market lenders, and others. Rolling back these changes would seem detrimental to public policy, leading to slightly higher interest rates, reduced competition between F&F, and significant market disruption.
Annual multifamily volume cap. Since 2013, the annual conservatorship scorecard has established a cap on the dollar volume of multifamily loans purchased by F&F within a calendar year. The original reasoning behind the cap was to limit the GSE footprint, but later it also became explicitly aimed at ensuring that the taxpayer subsidy implicit in GSE financing did not unfairly advantage F&F too much in their competition with private market providers of such finance (mainly banks and insurance companies). That seemed to be a very valid policy concern when, around 2015, F&F’s combined market share was approaching 50 percent. Originally, this was done via a simple dollar cap, which quickly evolved to be equal for both F&F, set by the FHFA each year based on the estimated multifamily mortgage loan market size. The cap became considerably more complex over time as different FHFA directors imposed more nuanced policy views by having certain categories excluded from the cap calculation, or mandating that certain categories be at least a significant percentage of the volume.

Thus, if the cap is not retained in some form, the strong assumption is that F&F, competing with the advantage of government subsidies, would quickly account for at least half, and maybe considerably more, of the national multifamily lending market. Therefore, it can be reasonably argued that retaining the cap is a high priority. Doing so can be relatively easy via a PSPA clause, especially if the cap is constructed as a simple dollar amount[16] established each year by the FHFA.
Mandating a standard loss mitigation “waterfall.” With the bursting of the mortgage bubble beginning in 2007, mortgage credit providers nationwide, including F&F, soon abandoned the historic practice of addressing defaulted borrowers by almost immediately moving to foreclosure. Instead, lenders developed what is called a loss mitigation waterfall, i.e., sequential actions that provide alternatives to foreclosure that better balance helping the delinquent homeowner while simultaneously reducing expected losses to the lender. The FHFA mandates that F&F use a very specific waterfall developed under its leadership within conservatorship.[17]

If the conservatorship exit does not retain this reform under government control, it is reasonable to expect F&F to each modify the waterfall separately over time to minimize their losses, even if this results in somewhat greater losses for the borrower than is currently the case. Of course, this also means full alignment (i.e., F&F using the exact same waterfall) will undoubtedly be lost. However, if the government did retain control of the waterfall, precedent[18] suggests that, over time, the economic balance will increasingly shift towards more loss being placed on F&F and less on the distressed homeowner.

To sum up, determining whether the loss mitigation waterfall – either in whole or in part – should be retained under government authority is not an easy call to make, nor is it clear what a PSPA contract clause to achieve such an outcome would look like.
Setting guarantee fee (G-fee) pricing. F&F’s G-fees, currently averaging about 0.65 percent,[19] are among the most closely watched numbers in housing finance, despite representing only about one-tenth of today’s entire mortgage interest rate. The FHFA controls the fee through three separate mechanisms, each of which could be separately retained under government control post-conservatorship exit.

Mechanism #1 – Setting the average G-fee. The FHFA, circa 2017, established what it calculated to be a proper market rate of return the GSEs should earn on the single-family business. This, based on a specific set of capital requirements formulae, in turn determined an average level of G-fee to be charged to produce that return. If the FHFA does not maintain this mechanism to set G-fees, there are serious concerns among some policymakers and other interest groups that F&F could implicitly collude to raise G-fees. Others are worried about the opposite impact: that it could lead to a “race to the bottom” to win market share.[20] Or it could, of course, turn out to look like normal competition, with F&F reasonably competing with each other and other providers of mortgage credit (e.g., FHA, bank balance sheets, etc.). We just don’t know ahead of time which it will be.

Many housing advocates, therefore, want the FHFA to maintain control of the G-fee via what is usually referred to as “the utility model.”[21] However, achieving this would require an extensive legal and regulatory infrastructure – akin to what exists at the state level for electric utility regulation – to ensure that F&F can provide a “fair return” to their shareholders. This is necessary to guard against political control over the FHFA translating into a G-fee that is set too low.[22] It is unclear whether such a framework could be implemented without new supporting legislation, which seems very unlikely to occur.

Mechanism #2 – Setting risk adjustments. During the early years of conservatorship, the FHFA instituted a mechanism to risk-adjust F&F’s G-fees, so the two companies would act more like private sector lenders than government agencies. The risk-adjusting is determined using a simple and publicly available two-dimensional matrix that reflects loan-to-value ratios versus credit scores. However, this command-and-control approach was later made somewhat redundant in 2017 after the establishment of a proper risk-based regulatory capital system for use during conservatorship. That’s because the new capital system clearly indicates the risk adjustments needed to maintain appropriate returns on mortgages of various risk levels.

The current system of risk-adjusting, implemented through a mechanism known as loan-level price adjustments, has long been the source of significant lobbying aimed at reducing or even eliminating it. Thus, it is easy to predict that, if risk-adjusting remains under the control of the FHFA post-conservatorship, such lobbying will simply continue. Again, as there is no current legislative requirement for F&F to earn a “fair return,” this lobbying could well be effective over time. Alternatively, if the risk-adjusting matrix is not retained under government control and F&F can do their own risk-adjusting, the post-conservatorship regulatory capital requirement should still provide an incentive for them to do so on a proper economic basis. As a result, it may make more sense for the government not to attempt to retain control over risk-adjusting.

Mechanism #3 – Imposing policy-based G-fee increments and decrements. The FHFA, strictly on a policy basis, increases the relative G-fees for various types of loans it deemed to be less worthy of taxpayer support, such as mortgages on second homes and investment properties. On the same basis, it sometimes decreases G-fees to support greater access to mortgage credit, such as cutting pricing for first-time homebuyers with low to moderate incomes. This is sometimes referred to as a program of cross-subsidies, although there is no evidence that the increases and decreases in fees offset each other. Also, these adjustments are made under conservatorship authority since they lack legislative backing, unlike other GSE mission-based programs.

The argument for the FHFA to retain authority to make such adjustments, based solely on its policy judgment rather than through a legislative mandate, is likely to be quite controversial. Nevertheless, if retained, we can expect it to be modified from time to time as presidential administrations change. On the other hand, if the FHFA does not retain this authority, it is expected that F&F will drop the increments and decrements fairly quickly, given the lack of a legislative requirement to keep them. However, perhaps a few visible ones will be retained as symbols of a corporate commitment to make mortgage credit broadly accessible, supplementing the legislatively-required affordable housing goals and duty-to-serve programs. Thus, left-leaning interest groups will argue strongly for the so-called cross-subsidy program to be maintained under government control, while right-leaning ones – pointing in particular to the lack of legislative backing – will likely oppose it.

The four examples discussed above clearly demonstrate that each and every market-improving reform will likely require detailed homework before deciding whether to retain it under government control. Analyzing dozens of such reforms will be a significant and time-consuming task. Further, this process must be completed against a background in which there will likely be lobbying on both sides about every single reform, along with the concern that too much continued government control will be critically unattractive to the potential shareholders who are needed for either a new issue of common shares or for the eventual sale of shares by Treasury.

Series conclusion

This four-part series has aimed to describe the rather broad scope of what a conservatorship exit implementation should look like if handled in a comprehensive and well-considered manner. That scope has included reforms to address long-standing charter defects, how to recapitalize F&F enough for conservatorship exit, and considerations about the sale of Treasury’s significant ownership stake in the two companies. It also included a process to evaluate which of the many market-improving reforms implemented by the FHFA should remain under government control post-conservatorship. Ideally, all these issues should be integrated into a cohesive master plan for exiting conservatorship.

The extensive and intricate nature of this master plan will reflect and confirm America’s housing finance system’s longstanding reputation for complexity. The challenges involved are further compounded by the sheer size and complexity of F&F, which have only increased during conservatorship. As a result, successfully engineering a conservatorship exit that will not inadvertently cause large problems in America’s housing and mortgage markets will surely be a daunting task. After all, the fear of a conservatorship exit process making a big mistake, thereby materially harming those markets and, through them, damaging current or prospective homeowners, is one important reason conservatorship has lasted this long and, in my view, is likely to drag on for at least several more

Footnotes

[1] On May 21, President Trump shared a social media post indicating that it might be a good time for his administration to focus on conservatorship exit and that he might issue an executive order for it to be studied, which some media referred to as a “tease.” As background, Trump issued an executive order for such a study in his first term. That study took eight months and led to a report by Treasury (https://home.treasury.gov/system/136/Treasury-Housing-Finance-Reform-Plan.pdf ) that examined various issues but left many unanswered questions. The only concrete and impactful action that came from the study was the decision to retain earnings for the purpose of building capital.

[2] In addition, their ability to collaborate with each other to maintain some of the reforms will be restrained by anti-trust requirements.

[3] Conservatorship is a very obscure and rarely-used regulatory legal status. It is associated mostly with the FDIC taking over a failing small bank and then directly operating it for a short period (weeks or a few months) until a sale to a stronger bank can be arranged, as opposed to the bank going into liquidation. Thus, the frequent comment heard in the early years of F&F’s conservatorship that it was “unprecedented in size and scope” was correct.

[4] There have been only four multi-year directors (or acting directors) of the FHFA since conservatorship – Edward DeMarco, Melvin Watt, Mark Calabria, and Sandra Thompson. The most recent director, William Pulte, began his term in March of 2025.

[5] DeMarco served as acting director from September 1, 2009, to January 6, 2004.

[6] The Obama administration policy was to wind down the two GSEs and look to Congress to develop “something else” to replace them. In 2012, this process was not far advanced; by 2014, despite a significant effort in the Senate and House, it did not succeed. Eventually, the consensus among policymakers changed circa 2016-2018 to keep F&F, rather than replace them, after first fixing their key defects.

[7] See https://www.fhfa.gov/media/24806.

[8] See https://www.fhfa.gov/document/ExecComp3912F.pdf.

[9] “Aligning” was the word used by the FHFA to indicate that each F&F would perform certain functions in exactly the same way.

[10] F&F are the biggest sources of mortgage credit. Other large ones include two government agencies, the Federal Housing Administration (FHA) and the U.S. Department of Veterans Affairs (VA). Banks also hold loans on their balance sheets. A smaller source, but one regarded as having big potential by certain members of the housing finance policy community, is the private label securitization (PLS) market, where there is no government or GSE guarantee to investors in mortgage-backed securities against credit losses.

[11] The United States developed through the early 2000s a sub-prime mortgage bubble that turned into a broader mortgage bubble, which in turn collapsed starting in 2006-2007. When that collapse broke out to create massive stress in the broader global banking and financial system in 2007-2008, it led to the great financial crisis and a major recession. House prices peaked early in 2007 and didn’t bottom out until they had fallen almost 20 percent five years later. (See https://fred.stlouisfed.org/graph/?id=USSTHPI.) The homeownership rate grew well above its historic level to peak at 69.7 percent in Q2 2004 and then collapsed down to 63.1 percent in Q2 2016, a full twelve years later. (See https://fred.stlouisfed.org/series/RSAHORUSQ156S.)

[12] Those methods and actions include: limiting or reducing F&F’s footprint, instituting credit risk transfer requirements, increasing F&F’s required capital, etc.

[13] I note that choosing to highlight these four examples was difficult, as there were numerous high-profile cases to choose from. Some additional examples that also provide good illustrations of the types of issues that need to be considered are:

All the components of the “servicer alignment initiative” other than the loss mitigation waterfall.
The requirement for doing certain volumes of credit risk transfer transactions for single-family and separately for multifamily loan purchases.
The aligned eligibility requirements for private mortgage insurance.
What to do with Common Securitization Solutions, a joint-venture processing subsidiary owned by F&F. It is heavily linked to what will transpire with the “single security,” as discussed below.
The minimum standards required for lender title insurance.
The requirement to implement the Uniform Mortgage Data Program.

[14] A defining feature of MBS is that borrowers of the loans contained within the pool backing the MBS are free to prepay for any reason at any time. The expected rate of prepayment impacts the value of the MBS directly, as higher prepayment speeds lower its average expected maturity, and vice versa for lower prepayment speeds. For the MBS issued by Fannie Mae and Freddie Mac to trade interchangeably, which is the objective, the prepayment speeds of the underlying pools of each specific coupon must therefore be nearly equal. This, in turn, requires F&F to actively manage the characteristics (e.g., average loan-to-value ratio) of the loans in each particular type of pool to be quite similar.

[15] The extra interest rate paid by Freddie Mac varied over time as market conditions changed, but we used 0.05 percent as a reasonable estimate of its long-term average during my years at Freddie Mac.

[16] The cap could continue to be set by FHFA judgment, or the PSPA clause could specify a certain target F&F market share (e.g., 40 percent).

[17] It is important to understand that choosing the specifics of a “waterfall” involves more than just technical considerations. It requires informed judgments about the likely behavior of distressed homeowners and finding the right balance between the economic harm to F&F versus that faced by a typical distressed homeowner. This means an FHFA-determined waterfall will inevitably always reflect the policy and political views of the presidential administration in power at the time. As an example of this, the FHFA introduced a controversial change aligned with Biden administration priorities approximately two years ago. This addition created a permanent forbearance option for homeowners (which had previously existed on a temporary basis during the COVID pandemic or declared natural disasters) who self-declare a hardship, which pushed the balance of losses a bit further towards F&F and away from the homeowner.

[18] The analogy is electric utility rate regulation, which has a long history of politicians looking to keep rates low in order to curry favor with voters. However, the legal requirement for the rate-setters to ensure that investors earn a “fair return” (the language almost exclusively used in the related legislation) is specifically designed to push back against this bias. In the case of the loss mitigation waterfall, it is unclear what would push against the political pressure to favor distressed homeowners – i.e., voters – over F&F.

[19] This 0.65 percent includes a 0.10 percent tax first established in 2012 that goes directly to the general federal budget. The net G-fee, i.e., the revenue that actually goes to F&F, averages only about 0.55 percent.

[20] As a matter of history, such a race to the bottom is cited by several observers (some focused on pricing, others on credit requirements) as a major cause of F&F falling into conservatorship.

[21] This is a reference to a state public service commission regulating electric utility pricing, where legislation requires that the utility’s shareholders earn a “fair return” as a counterpoint to the normal political pressures to keep electricity rates low.

[22] There has been no known effort by the FHFA to determine what that infrastructure would exactly look like, nor have there been to my knowledge any articles from prominent think tanks addressing it in detail.