Analysts Call for Salvaging GSEs, Advocate Small Tweaks not Massive Reform


Bank of America Merrill Lynch has
jumped full on into the debate over the future of Fannie Mae and
Freddie Mac
(the GSEs). With a recent article from its rates
research staff titled “GSE profitability changes the reform
landscape” the company joins a very small contingent advocating for
a less precipitous approach to determining the fate of the GSEs.

Freddie Mac and Fannie Mae have been in
federal conservatorship since August 2008 during which time they have
drawn a combined total of $187 billion in government support.
Dividends to the Treasury total $146 billion to date, none of which
has counted against the debt. Recent changes to the agreement
between the GSEs and the Treasury Department guarantee that the GSEs
cannot build cash reserves but instead must return all but a small
buffer of their net worth each quarter to the Treasury. In the
meantime the two companies have returned to profitability, posting
several record and near record quarterly earnings and requiring no
Treasury draws for over a year. During the conservatorships they
have provided the bulk of the country’s mortgage liquidity and
completed several million foreclosure interventions.

Merrill Lynch Rates Strategists Ralph
Axel and Priya Misra say that these results provide two key

  1. the GSEs function well as government-run entities, and
  2. the infrastructure of mortgage finance is not in need of major

While the current debate among
stakeholders over housing finance reform presents arguments for and
against government guarantees of mortgages, the ownership,
management, and structure of a new securitization platform, and the
role and regulation of the private sector there is one nearly
universal area of agreement, the GSEs must go.

Most bills awaiting Congressional
action contain this provision, as did the President’s recent Phoenix
speech on housing; most other stakeholders seem to assume it as the
starting point for their own proposals. The debate is not if, only
when; whether they should be wound down over a five-year time frame
or placed in more or less immediate receivership.

But Merrill Lynch says it is “time to
separate useful reform from unnecessary reform
.” Designing and
implementing reform is not without cost or risk and there are already
huge resources being devoted to it while the risk involves the
possibility of a significant pullback in both home prices and credit
availability. Yet, the paper says, the benefits are questionable.

Senate Majority Leader Harry Reid
recently “fired the first shot” against major change but the
President’s recent speech, while basically restating the
administration’s position from a 2011 White Paper, seemed “heavier”
because his call for winding down of the GSEs comes as Congress is
actually considering it. In calling for an end to the dual
government/non-government role of the companies the President said
“For too long, (they) were allowed to make huge profits buying
mortgages, knowing that if their bets went bad, taxpayers would be
left holding the bag.”

As the two continue to produce strong
earnings, Merrill Lynch says, “the bag taxpayers are holding is
quickly filling up with cash,” and that could eventually persuade
taxpayers to change their outlook on the fate of the GSEs.

Looking back at the housing crisis, the
authors say they see what needs to be done:

  • Price credit risk fairly to
    account for long-term losses;

  • Manage risk carefully, especially
    when home prices are rising;

  • Hold appropriate capital to manage
    economic downturns smoothly;

  • Recognize that a government
    guarantee must be explicit and that, even without such a guarantee,
    government will be the ultimate backstop.

The failures of the GSEs in the above
areas were not theirs alone and the private sector did not prove any
more able to handle the risk nor did they have the capital to do so.
“The implicit government backing had some benefits and some
drawbacks, but in our view it is a relatively easy fix that does not
require an entirely new model of mortgage finance
.” The first two
items on its list have already been essentially accomplished the
paper says, it only remains to capitalize the agencies and recognize
the explicit government backing.

According to the authors, GSE earnings
are strong, their business model looks sound, and return on the
taxpayers investment is around the corner. Over the course of 2014
payments to the government will likely exceed the taxpayers
investment and over the following few years taxpayers could benefit
not just from the credit channel but from increased net government
revenues. This comes at the cost of increased credit risk, something
the taxpayers would probably face anyway, even if the model were

One of the problems of the old GSE
model was their funding of rapidly growing portfolios funded by thin
capital levels. This posed a large liquidity risk and required
access to rolling over maturing debt, not possible in the summer of
2008. Because of the implicit guarantee the GSEs had enjoyed
favorable debt funding giving them a strong incentive to focus on
this non-mission critical but highly profitable business. By
contrast the insurance side of the business generated the bulk of the
losses ($173 billion from 2008 through 2013) and contributed least to
revenues over the years.

As GSE portfolios wind down the GSEs
are becoming monoline insurance companies. They have tightened
credit risk standards while mitigating losses on the rapidly
shrinking pre-2008 book of business. While profits will taper,
capital requirements will not be as intense and government backing
likely will not be applied to non-core functions. “This is very
important reform that is already underway and will take about five
more years to complete.”

The authors ask if large-scale reform
is in the best interests of taxpayers and answer that as the GSEs
produce strong results and provide the backdrop for industry recovery
“a complete overhaul of the mortgage finance model becomes
increasingly difficult to justify
” Completely eliminating the GSEs
and replacing them is complex and risky. The infrastructure
currently in place is substantial while the size and efficiency of
the agency credit market is unparalleled and may be difficult to
improve upon. With “the required principles in place for
successful mortgage securitization…small improvements may prove
more beneficial than large changes.’

The questions that remain in the view
of the authors are the issues of the government guarantee and
ownership/capitalization. The first as they see it is not an option;
private markets cannot be asked to provide crisis backstops and the
value of the nation’s housing stock cannot be allowed to go into free
fall. The government can own the enterprise or sell part or all to
private investors while maintaining oversight and receiving
compensation for the backstop. The taxpayers’ investment should be
recouped within a year and then a portion of future earnings can be
used to develop and maintain a backstop fund. New machinery and
infrastructure is not required for this. Private capital, junior to
taxpayer capital, can be layered in because the enterprises are
profitable and well run. The government footprint can continue to be
debated as credit standards and fees an be adjusted to modify it as

The authors conclude that, in
retrospect the recent crises provided an extreme test of the system,
and while some obvious changes are needed the key reforms are already
underway. Reid’s comments may lead to growing support for small
tweaks rather than a full overhaul of the existing system.

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