The Heavy Lift to Implement GSE Reform-Recap-Release: The Necessary Background (Part 1 of 4)

Introduction

Since the election of Donald Trump to his second term (Trump II) last November, the most debated topic in housing finance is whether and when his administration might take Fannie Mae and Freddie Mac (F&F) out of conservatorship.[1] The two government-sponsored entities (GSEs) have been in conservatorship for over 16 years, and the last significant action aimed at their exit occurred in 2019, during the first Trump administration (Trump I), when they were authorized to start retaining profits in order to build capital.

This paper addresses not whether or when Trump II might embark on conservatorship exit, but how this administration, or future ones, could actually accomplish it. The exit process is sometimes shorthanded as “recap and release,” but this is misleading, as conservatorship exit is about much more than simply recapitalizing F&F.  Instead, “reform-recap-release,” a slightly longer phrase, does a better job of describing what needs to occur, as it indicates that there are reforms in addition to recapitalization[2] – and major ones at that – which need to be concluded before F&F become independent. 

An exit from conservatorship can occur through legislation or administrative means.  Since Congress has not focused on conservatorship exit or any type of GSE reform for many years –the last real push was circa 2014– almost all of today’s speculation assumes, correctly in my view, that Trump II would have no choice but to proceed via administrative means.  This is a key assumption in addressing the “how” of conservatorship exit.

This paper is divided into four parts. 

• Part 1 reviews the necessary history and background that got us to where we are today, and describes how there are really two different types of reforms that need to be addressed before an exit is undertaken.
• Part 2 describes the limited number of reforms needed to remedy what have been long believed by many policymakers to be critical defects in F&F’s charters,[3] as described further below.
• Part 3 covers the issues related to the recapitalization of F&F, including the large and controversial topic of how Treasury will dispose of its ownership interest in F&F.
• Part 4 covers the many issues where policymakers need to address dozens of significant and generally well-regarded market-changing reforms made by the FHFA starting in 2012.[4] This aspect of reform-recap-release is not well understood but will be the source of much of the effort needed to have F&F exit conservatorship while avoiding major market disruptions.

Altogether, the long list of issues identified in parts 2 to 4 of this series, along with the necessary steps to address them, presents a formidable and complex process that will likely take years to complete.[5]

To state the obvious, the reason the implementation of reform-recap-release needs to be well thought out and executed is that F&F are together the backbone of the country’s mortgage system, accounting for roughly half of the nearly $13 trillion first-lien mortgage market in America.  They play a crucial role in allowing most borrowers to access the very consumer-friendly 30-year, fixed-rate “American” mortgage[6] at relatively attractive rates. Additionally, GSE mortgage-backed securities (MBS) comprise the clear majority of the “agency MBS market,[7]” the second most liquid U.S.-dollar fixed-income market. This liquidity helps keep mortgage rates relatively low.

In other words, if significant mistakes are made in the reform-recap-release process, the result, such as a long-term structural increase in mortgage rates or disruption in the ready availability of borrower-friendly, fixed-rate mortgages, will likely produce very major impacts on current and future homeowners, leading to damaging political consequences.

How we got to GSE reform by administrative means

The concept of GSE reform through administrative means only emerged around 2016, a full eight years after F&F were placed in conservatorship.  The history of how this came about is necessary to understand the nature of what needs to go into reform-recap-release, especially the “reform” component.  In very condensed form, the relevant history is as follows:

• From the beginning of conservatorship to about 2016, the focus of “GSE reform” – and the official policy position of the Obama administration – was that F&F would be wound down (i.e., go into run off and be liquidated in some fashion) and replaced by “something else.”  As Congress had created F&F, the Obama administration looked to Congress to enact legislation to do just that.  However, despite many ideas proposed from various sources on what could replace F&F, none gathered the necessary political support in Congress.  In part, this was because policy specialists almost always concluded that the ideas proposed were simply not workable.
• In response, through 2016 and 2017, smaller primary market lenders – and later most of the housing finance policy community – adopted a different GSE reform strategy:  keep F&F in place as opposed to winding them up, but only release them from conservatorship after the “five or six big things wrong with their business model”[8] were fixed.  This also reflected how much the FHFA and the new post-2008 boards and management at F&F had improved their operations during conservatorship, generally regaining the industry’s confidence that had been lost in 2008.
• Recognizing that getting Congress to pass any type of GSE reform bill was remote, “GSE reform by administrative means” was developed within the conservatorship.  This approach outlined how F&F would be released from conservatorship after addressing those five or six significant issues, relying not on legislation amending their charters but instead via new FHFA regulations or amendments to the existing Preferred Stock Purchase Agreement[9] (PSPA), which was assumed to continue post-exit.  Treasury Secretary Mnuchin was the first to publicly disclose the administrative means alternative, although he indicated he hoped it would be a temporary solution, eventually replaced by legislation that would replicate its features more permanently.[10] 

The rise of market-changing reforms during conservatorship

When GSE reform by administrative means was developed, there was naturally also a focus on identifying the specific “five or six big things” that had been wrong with the pre-conservatorship business model of F&F, i.e., the defects in their charters.  The two most talked about such defects, in my recollection, were the extraordinarily low capital requirement and the ability to use implied-guaranteed (and thus subsidized) unsecured borrowing to fund a discretionary investment portfolio subject to no limit or cap.  Part 2 will identify and then discuss how to fix those “five or six big things” that were the problematic parts of F&F’s operations, which in turn stemmed from defects in their charters. 

Then, beginning in 2012, something unexpected and unanticipated occurred, which has since become a hallmark of the conservatorships.  That’s when the FHFA issued its first “conservatorship scorecard” outlining directions to F&F to pursue all sorts of market-changing reforms that the FHFA’s director at the time, Ed DeMarco, believed would improve the housing finance system and the GSEs themselves.  Between that first scorecard and the subsequent ones released each year by him and succeeding FHFA directors, numerous significant reforms were implemented, including:

• that F&F have the exact same terms (called “aligned” by the FHFA) for many activities and policies, promoting greater market standardization and cost efficiency.  Examples include (1) specific terms of loan modifications, (2) procedures for addressing representation and warranty defects on purchased loans, (3) eligibility criteria for private mortgage insurers so that their insurance policies would be acceptable to F&F, (4) adjustments to guarantee fees (G-fees) to reflect the riskiness of the underlying mortgages, and (5) many servicing policies and practices;
• that F&F have a joint venture called Common Securitization Solutions to operationalize a single joint-venture securitization platform working under governance rules set by the FHFA and, in close relation, F&F both taking actions to support the “single security,” currently known as the Uniform Mortgage-Backed Security (UMBS);
• that F&F be subject to specific requirements and limitations regarding their operations, such as (1) being required to execute certain amounts of single-family and multifamily credit risk transfer transactions; (2) having a limit on the amount of multifamily loans purchased in a year, (3) being required to offer a 3 percent down-payment program in addition to the legislatively-required affordable housing goals program, and more.  

Again, numerous market-changing reforms have been implemented in this manner.  In my view, they are generally well-regarded, and it is obvious that all were believed by the FHFA director at the time to be improvements in the market, although some may disagree about individual ones.  Regardless, more than a decade later, these market-changing reforms have become deeply embedded in the operations of primary market lenders, mortgage servicers, agency MBS traders and investors, and others. 

However, upon exit from conservatorship, all the directives behind those practices become null and void, no longer binding upon F&F. Instead, F&F’s boards and management teams would, upon exit, once again have the customary managerial discretion to do as they wish (subject, of course, to FHFA’s safety and soundness regulations), which might mean they continue the practice in question, but they might also not.  Each such practice might continue for the foreseeable future, some might be slowly modified, and others might be abandoned immediately.[11] Thus, Part 4 will describe the process of going through all the relevant directives – and there are dozens of them – to determine which of the identified market-changing reforms should not be left subject to such an uncertain future but instead be kept as is going forward.  As already stated, because each such reform selected to be kept as is could no longer be legally based on a conservatorship directive, it would have to be based either on a new FHFA regulation (if there is a necessary nexus to safety and soundness) or on a new clause in the post-conservatorship PSPA.  

This, of course, is the same process that the charter-defect reforms would also have to follow in order to be implemented administratively, despite their totally different historical background. 

I note that industry and media discussions about conservatorship exit have only recently begun to focus on a few market-changing reforms, with no obvious understanding of the large number of reforms involved and their potential impact going forward.  Part 4 will be perhaps the first comprehensive public discussion of the topic. 

So, to sum up, reform-recap-release needs to work through a very long list of often quite-complicated issues to address (1) the small number of needed reforms to correct for charter defects, (2) how to implement the recapitalization of F&F (along with the disposition of Treasury’s large ownership interest), and (3) how to keep dozens of generally well-regarded market-changing reforms in operation after a conservatorship exit.  This all leads to the conclusion that a properly executed F&F release from conservatorship is going to be a long, detailed, and resource-intensive process. 

Footnotes

[1] Various interest groups have been advocating for Trump II to begin the process of conservatorship exit as soon as possible. Despite that, comments by Scott Bessent, the new Secretary of the Treasury, and William Pulte, the new Director of the Federal Housing Finance Agency (FHFA), the regulator and conservator of F&F, indicate that such an exit is not being pursued at this time, although it may be pursued later.  They also add that, if and when an exit occurs, the process would be done quite carefully so as to not result in disruption to the mortgage markets, especially one that leads to an increase in mortgage rates. Somewhat unexpectedly, Mr. Bessent has more recently indicated that, when pursued, it might be linked to President Trump’s concept of the U.S. establishing a sovereign wealth fund.

[2] The reforms being discussed herein refer to those known prior to Trump II. They do not attempt to address potential changes that the current or future administrations might adopt with respect to housing finance or the GSEs.

[3] The congressional legislation that created each of F&F, which specifies their purpose, restrictions on their activities, obligations, and even their subsidies to some degree, is known as their “charter.”

[4] In 2012, the first annual “conservatorship scorecard” was issued. Those scorecards have been the primary vehicle by which the FHFA instituted market-changing reforms to improve, in the eyes of the FHFA directors, how the mortgage markets work. I do not believe anyone back in 2008, when conservatorship began, had any idea such reforms would come about, much less change so much how the mortgage markets work.

[5] For example, a change in an FHFA regulation requires following the steps specified in the Administrative Procedures Act, which includes a public comment period.  My experience with such changes at the FHFA is that major rules require most of a year or even longer to implement. 

[6] The “American” mortgage has a 30-year fixed rate, full amortization over its term, free prepayment at any time for any reason, an interest rate that can be locked up months prior to a mortgage closing on a home purchase, and is available with a loan-to-value ratio well over 80 percent – all at an interest rate that is relatively low compared to other consumer loan products. 

[7] The “agency MBS” market refers to the MBS issued by F&F as well as Ginnie Mae, which is the securitization arm of the Federal Housing Administration (FHA) and the U.S. Department of Veterans Affairs (VA).

[8] The business model of F&F refers to the obligations, restrictions, advantages, and even subsidies given to the two companies by the congressional legislation known as their charters. 

[9] The PSPA is a legal agreement, instituted simultaneously with conservatorship back in 2008. It exists between Treasury and F&F. This agreement ensures that they receive enough government-quality financial support, which helps restore market confidence in their securitization and business model.

[10] Changes in regulations and the PSPA implementing reform by administrative means could be relatively easily undone by a future administration if it so wished.  By contrast, changes implemented via legislation would require that Congress then pass even more legislation, and that is considered a very high bar and much less likely to occur absent a crisis. 

[11] Complicating this process is that “aligned” practices were developed after the FHFA used its conservatorship authority to override normal anti-trust prohibitions against F&F, as direct competitors, collaborating on many matters.  Going forward, those anti-trust prohibitions may very well prevent the development of new aligned practices or even place many existing ones in jeopardy. It will be an area of future research to determine what the anti-trust limits, post-conservatorship exit, would be on maintaining or adding to aligned practices.