How to Evaluate the Likelihood of GSE Reform in the Next Presidential Administration: Six Questions to Ask

Introduction

Freddie Mac and Fannie Mae (F&F), the two large government-sponsored enterprises (GSEs), were placed into conservatorship in September 2008 at the height of the Great Financial Crisis, when the markets lost confidence in them.  Initially, there were hopes that their time in conservatorship might be brief,¹ but sixteen years later, they are still under conservatorship with no real end in sight. 

The root cause of this unexpectedly long conservatorship period started with the bipartisan policy consensus that the two companies should not be returned to private ownership “as is,” i.e., without first addressing their flawed business model.² For many years, this was considered the responsibility of Congress, which had established the GSEs by legislation – but Congress has never come close to agreeing on what changes would be needed.  In fact, it hasn’t seriously tried to enact such changes since about 2015.  Subsequently, the focus turned to identifying certain “administrative”³ reforms that Treasury and the Federal Housing Finance Agency (FHFA), the regulator and conservator of F&F, could undertake instead.  While two of the many significant administrative reforms needed to implement comprehensive GSE reform were undertaken in 2019-20,⁴ there has been no progress since.  

With the upcoming presidential election in November, there is speculation about whether a new administration – regardless of whether it is Democratic or Republican, although the focus is mainly on the latter – might prioritize completing the remaining administrative measures needed to implement comprehensive GSE reform, allowing the two companies to exit conservatorship within the next several years.  

After reviewing the history of GSE reform policy through the presidential administrations of the past sixteen years, this paper describes six key questions where the answers will show whether, and if so, by how much, the next administration will seriously pursue comprehensive GSE reform by administrative means, which would include the two GSEs exiting conservatorship as a major legal step along the way. 

The volatile history of GSE reform policy

Before the build-up of the mortgage bubble starting in the first half of the 2000s, F&F were generally considered to have a capable business model that successfully delivered the complex “American mortgage”⁵ to homeowners on a very large scale.⁶ That business model was, of course, built upon government support and subsidy, although this was done in an indirect manner that was not transparent to the general public.⁷ The result was that F&F usually financed 40 percent or more of all first-lien single-family mortgages for some years prior to the bubble, easily the largest source of American mortgage financing.  But with their falling into conservatorship while generating roughly one-quarter of a trillion dollars of net income losses from 2007 through 2011, faith in that business model understandably evaporated among policymakers. 

The Obama administration 

Throughout the eight years of the Obama administration, the official policy was to “wind down” the two existing GSEs while looking to Congress to pass legislation that would replace them with something different.⁸ In fact, at that time, the phrase “GSE reform” meant developing an alternative to having F&F be the primary sources of mortgage funding. 

Suggestions for potential replacement systems included options like a government-owned monopoly, one or more industry-owned cooperatives, numerous smaller GSEs instead of just two large ones, allowing them to phase out completely with the private market taking their place, and other alternatives.  

Unfortunately, none of these proposals⁹ proved after further analysis to be operationally workable, nor did any garner the needed support in Congress.¹⁰ From about 2015 to the end of the Obama administration in January 2017, the notion of a congressional solution implemented via legislation went almost totally quiet. 

Meanwhile, under the direction of the FHFA in conservatorship, F&F focused on fixing their major problems, making them better commercially competitive companies that properly served their congressionally mandated mission.  As the Obama administration left office, industry figures were noticing that F&F were serving the housing markets better than they had prior to conservatorship, a very unexpected result. 

The Trump administration 

Secretary of the Treasury Steve Mnuchin, even before his confirmation, indicated one of his top ten priorities would be GSE reform.¹¹ However, he did not specify exactly what that meant.  He then said relatively little on the subject publicly for the next two years.

In the 2017-18 period, as F&F operations under conservatorship continued to improve, the two companies effectively rehabilitated their reputations in the industry.  Combined with the seeming inability of policy specialists and Congress to ever develop a credible proposal to replace the two firms, the concept of “GSE reform” evolved to specifically mean that F&F were no longer to be replaced, but instead to continue in operation but with significant reforms to their business model.¹²  

Thus, GSE reform, in soundbite terms, evolved from meaning “replace F&F” to “reform and release F&F”.¹³ Additionally, it began to be broadly recognized that most of the needed reforms had already been made during conservatorship and only had to be maintained afterward. 

Over time, the most commonly discussed version of the reforms needed for F&F to exit conservatorship also included giving the FHFA authority to set guarantee fees, similar to how a state’s public service commission traditionally sets electric utility rates, which the FHFA was already doing in conservatorship.  This was to avoid the two firms somehow colluding to keep such fees unduly high.  This became known as the “utility model.”

In March 2019, a little more than halfway through its four years, the Trump administration put GSE reform on the front burner of its policy agenda via a presidential memorandum.¹⁴ This was timed to coincide with the end of the term of FHFA Director Mel Watt, who had been appointed by President Obama, and the beginning of the term of the Trump administration’s choice to replace him, Mark Calabria, to work alongside Mnuchin on GSE reform.¹⁵ The main outcome of this work was a report issued by Treasury (the Treasury Report) in September 2019 on GSE reform and several other housing finance issues.¹⁶ With respect to legislative GSE reform, it recommended generally the “many smaller GSEs” model with some additional recommendations intended to shrink the size and role of F&F.¹⁷ But recognizing the low likelihood of Congress taking action, it also made recommendations to implement administrative reforms generally consistent with almost all aspects of the utility model that was then widely discussed and significantly supported within the industry.¹⁸ 

However, despite the report’s many administrative reform recommendations, actions actually taken to reform the GSEs were very limited:  just two key building blocks for conservatorship exit were undertaken during the remaining 16 months of the Trump administration.  The first was that F&F were allowed to retain their earnings to build capital,¹⁹ a major revision to the Obama administration’s wind-down policy that had left them with almost zero net worth.  The second was that the FHFA, in 2020, completed a new regulatory minimum capital rule that would be needed after they returned to private sector ownership.²⁰ 

This left unaddressed many other major building blocks that had to be put in place for GSE “reform and release,” several of which are discussed below. Moreover, the new capital rule also somewhat muddied up a potential conservatorship exit because it was a surprisingly high number due to the inclusion of large discretionary buffers and other non-risk-based features.²¹ The proposed level of capital jeopardized F&F’s business model, as it would require much higher guarantee fees to earn an appropriate return. This might not be feasible in the marketplace,²² and could also potentially delay by years the time needed to achieve full capitalization.

The Biden administration 

Since the Biden administration took office in January 2021, almost all GSE reform activities stopped.  The new Secretary of the Treasury, Janet Yellen, has shown a lack of interest in GSE reform by taking no action and staying silent on the topic.  With the FHFA losing its independence in June 2021,²³ the Biden administration gained direct control of both entities –Treasury and the FHFA – whose approvals would be needed to implement administrative GSE reform. But instead of using this direct control to move forward with GSE reform, the administration has made it clear it sees F&F as a means to implement, through the authority of the FHFA as regulator and conservator, various programs to expand or subsidize mortgage credit access without the necessity of obtaining approval from Congress.  Its GSE-related policy has thus been revealed to be letting conservatorship continue for the foreseeable future.

Six questions to ask

How, then, to recognize whether the next administration, whether Republican or Democratic, is indeed interested in pursuing comprehensive GSE reform that includes a conservatorship exit, either partially or wholly?  Given that at least a dozen major workstreams are needed to implement comprehensive reform, I have selected a subset of six that will likely be publicly visible and thus can reveal what is truly going on. 

1. Is a reformed but still viable F&F business model being specifically articulated?  Exiting conservatorship is all well and good, but without knowing what comes after – i.e., what business model is being implemented – is analogous to one hand clapping, i.e., obviously incomplete.  It is simply necessary for that business model, along with the steps needed to implement it, to be as fully articulated upfront as possible.  The Treasury Report from 2019 made a good first pass at doing this but stopped well short of a full and detailed plan. 
2. Is the existing regulatory minimum capital requirement being revised downward?  As described above, the current regulatory minimum capital requirement is objectively too high, leading to uncertainty as to whether the F&F business model would work going forward.  This means it is necessary for the capital requirement to be revised to be more consistent with the results of the legally mandated stress tests that are supervised by the FHFA, which, in this case, means considerably lower.  Of course, the capital requirement will still be well above what it was pre-conservatorship.  It is up to the FHFA to do this.  It will require a public notice and comment period and is likely to be accompanied by a lot of predictable politics.²⁴ 
3. Is there a declared “commitment fee”²⁵ to be paid to Treasury?  Most of both the political left and right have long desired for GSE reform to include a requirement that F&F pay an explicit fee to Treasury to fairly compensate the taxpayer for providing the credit support that allows F&F’s liabilities – especially the mortgage-backed securities it issues – to trade at such low interest rates.  Strangely, though, in 16 years of conservatorship, such a fee has never been established. There has been no declaration of its level or even just how it would be structured (e.g., would it be a percent of assets?).  For GSE reform to be seriously implemented, this has to be decided and declared.²⁶
4. Is the planned conservatorship exit real or not (Part 1)? One path for conservatorship exit is for F&F, while still being undercapitalized, to be released but subject to a regulatory consent decree with the FHFA.  Regulators imposing a consent decree on undercapitalized financial institutions are a standard practice.²⁷ On the other hand, if the consent decree includes terms that grant the FHFA extensive authority to approve management decisions similar to what it currently enjoys as conservator, then the exit is more nominal than substantive. As a result, the consent decree terms must be carefully examined to tell whether the exit is substantive or just an exercise in political optics. 
5. Is the planned conservatorship exit real or not (Part 2)? Conservatorship exit, even if only upon full capitalization of F&F so that there is no consent decree involved, will result in Treasury becoming the controlling stockholder of both GSEs due to the legal agreements established when F&F were put into conservatorship in 2008.²⁸ This means that the presidential administration will still be calling all the shots at F&F, just via Treasury rather than via the FHFA.  For true and comprehensive GSE reform, there needs to be a concrete plan for Treasury to sell off its shares and fully return F&F to private ownership. In the meantime, in order to attract equity investors to buy its shares, Treasury must restrict its ability to influence the affairs of the company.²⁹ If there are no such plans or restrictions, then it makes sense to question whether the GSE exit from conservatorship is meaningful or mainly for show. 
6. Is there an integrated primary and secondary capital raising plan? Perhaps the most intricate and complex part of comprehensive GSE reform is how to raise capital – both primary (for funds to increase the net worth of F&F) and secondary (for Treasury to sell off its shares post-conservatorship).  Three examples of the many key issues to be addressed are:
   • Establish what Treasury will do with its approximately $320 billion senior preferred shares:  will it write them off, convert them to common shares for eventual sale, or something else? 
   • Determine how much primary equity needs to be raised and establish a strategy for doing so, considering that the amount needed is unprecedented compared to even the largest IPOs ever conducted.
   • Coordinate the two separate capital raising requirements – one each for Freddie Mac and Fannie Mae, which presents a truly unique challenge:  will they be done pro rata together, or will one company go first – running the risk that there will not be enough market appetite for the second?³⁰

And this is only a small sample of the issues.  Any attempt to raise capital will break new records in terms of both size and complexity every step of the way.  But without a comprehensive capital raising plan, the government – now through the FHFA, later through Treasury – will remain the de facto owner of the two companies well into the foreseeable future.

Conclusion

Comprehensive GSE reform has not happened, nor is there any evidence it will happen soon, even though conservatorship has lasted sixteen years.  The reason for this is that the task is amazingly big and highly complex, requiring expertise in many different domains, and calling for politically-contentious decisions at every stage.  Perhaps most importantly, mortgage markets are working very well without such reform, so why would a presidential administration go through this trouble when it would have many more pressing issues to address?

The most thoughtful official effort by a presidential administration is reflected in the previously referenced Housing Reform Plan published by Treasury in September 2019. However, only a modest portion of the required planning work called for in that document³¹ has been completed, with just two building blocks of a comprehensive plan implemented since.

Thus, even if the next presidential administration aims to make progress on GSE reform, it is likely that only several more building blocks will be implemented during its four years.  Of course, while these steps may not lead to full and comprehensive GSE reform, they could move the ball down the court in a very meaningful way. It’s possible that these efforts might even include a conservatorship exit – a very visible action – while leaving for the future other remaining building blocks needed to complete comprehensive reform.

Amazingly, after sixteen years, interest in comprehensive GSE reform is still strong.  By watching to see how well a new presidential administration answers the six questions listed above, we can determine whether the completion of comprehensive GSE reform will be possible in just a few years or rather extend even further into the future. 

Footnotes