by Stijn Van Nieuwerburgh and Lawrence J. White
The financial regulatory reform bill that was recently proposed by Senate Banking Committee Christopher Dodd has a huge hole: It says nothing - absolutely nothing! - about Fannie Mae and Freddie Mac. These are the two investor-owned government-sponsored enterprises (GSEs) that currently are at the center of the residential mortgage markets in the United States. They are the two 900-pound (or $900-billion-in-assets) gorillas in the room that keep getting ignored.
Not only has the Dodd proposal ignored them, but the bill that was passed by the House of Representatives in December was wholly silent on their fates, as was President Obama's State of the Union Address in January. All of Washington seems to be in a conspiracy of denial.
This denial is so egregious because these two GSE companies are involved with more than half of all U.S. mortgages. Their financial collapse in the summer of 2008 led to government-imposed conservatorships, along with financial lifelines extended to each of them by the Treasury that are now open-ended. They have already dipped into the Treasury for over $100 billion, and all signs are that they will need substantially more. Their eventual bailouts will likely have the largest net costs of all of the government's bailout efforts.
How can the GSEs not be part of the "real reform" that the President called for in his State of the Union Address?
In order to understand what needs to be done, it will be useful to review what the GSEs currently do.
The GSEs have been performing two roles: First, they have bought, bundled, and securitized trillions of dollars of mortgages, in the form of mortgage-backed securities. Because investors in these MBS might otherwise be leery as to whether the mortgage borrowers will actually repay their mortgages, the GSEs have guaranteed the credit (default) risk on these MBS, in return for a small fee. The GSEs have held a small amount of capital (equity), as a cushion against these default losses.
Second, they have purchased hundreds of billions of dollars of their own MBS for investment, financing these purchases almost entirely with debt (i.e., with only a little equity) and thus running highly leveraged operations. Because of their special ties to the U.S. Government (and thus their GSE status), they were able to borrow all of this debt on especially favorable terms.
In both roles, the GSEs (as part of their special status) were expected to play a social role in encouraging home ownership by low- and moderate-income households.
Because both GSEs have sustained sizable losses on their portfolio mortgage investments as well as on their guarantees, their thin equity cushions have evaporated, and they are effectively insolvent.
So, what is to be done?
It is clear that the GSE model has blown up. The mixing of private incentives and public support brought out the worst possibilities, not the best. The GSE model should be abandoned. In its place we recommend the following:
First, the large MBS portfolios of the two companies should be liquidated. There is no role for a gigantic government-sponsored hedge fund that invests and trades in MBS. These assets can be corralled into a special entity, like the Resolution Trust Fund that was created during the S&L crisis, and slowly sold off to private investors.
Second, these entities' securitization functions should be spun off to the private sector. We believe that there is a future for "private label" securitization of mortgages. Given the experience of the past few years, investors will (sensibly) demand much greater levels of transparency, as well as simpler structures, and securitizers will comply. Protection for senior investors in MBS will be provided by appropriately sized junior (loss-bearing) tranches. Guarantees for junior tranches may be provided by trusted and well-capitalized insurance companies. If government guarantees are necessary for these securitization markets, those guarantees should be explicit and explicitly priced - perhaps by sharing risks with insurance companies and using their pricing as a guide (as is currently done with terrorism reinsurance).
Third, the social mission of promoting home ownership should be removed from any of the private-sector entities that survive and instead should be transparently lodged in the government (e.g., the Federal Housing Administration), where it properly belongs.
The widespread political refusal to address the GSEs' future is inexcusable. The way forward for the GSEs is clear, and should be embodied in any financial regulation reform legislation that President Obama signs. Our three-point proposal represents good finance, good economics, and good government. To use the language of hockey, this would be a political hat trick.