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Finally, a Bold New Proposal to Break the Impasse on GSE Reform

There has been no shortage of proposals to end the conservatorship of Fannie Mae and Freddie Mac and create a new mortgage finance system. Most have been misnamed “reform” proposals but a framework outlined last week could be a game changer.

Moelis and Company, a banking and financial analysis firm, laid out a common-sense way for the GSEs to exit their government-run confinement, feasibly build up and maintain appropriate levels of capital so taxpayers would never again be compelled to bail the companies out in the future. As laid out in “Restoring Safety and Soundness to the GSEs,” instead of scrapping Fannie and Freddie’s infrastructure and governing structure, the proposal would allow Administration officials to use their statutory power to create single purpose insurers with a narrow mission and free the GSEs of their once-highly leveraged investment portfolios. Thus, the American Dream of homeownership would remain within reach without disruption under this plan. And last but not least, current and future shareholders will become owners of well-run and profitable companies whose value will be set by market dynamics rather than bureaucratic fiat.

Not surprisingly, self-serving special interest groups are already trying to poke holes in this blueprint. The Mortgage Bankers Association, for example, warns it would serve shareholders rather than taxpayers. This is a baffling assertion. Taxpayers are the largest beneficiary in this blueprint, which provides for substantial gains of up to $75-$100 billion to the U.S. Treasury on top of the $266 billion that has already been paid back from the 2008-9 bailouts. In contrast, the MBA’s plan would keep the government’s (i.e. taxpayers’)  guarantee behind the big banks’ mortgage backed securities.

As explained during a teleconference last week, the plan begins with some fact-based assumptions. From a shareholder perspective, among the most important of these is that the government has been paid back for the $187.5 billion taxpayers were compelled to provide to keep the GSEs from collapsing in 2008. Since Fannie and Freddie returned to profitability five years ago and were systematically plundered ever since with the implementation of the Net Worth Sweep, Treasury has taken in $266 billion. That alone is an $80 billion dollar windfall never expected under the Housing and Economic Recovery Act.  The only reason the matter of the government being paid back has even been debated in recent years was the accounting distortion adopted by the Obama Administration. This new proposal puts an end to the myth that the taxpayers can be made whole only by keeping the GSEs in conservatorship and siphoning their capital.

Another key assumption is that the government can realize additional revenues of roughly $75-$100 billion by exercising warrants in shares of stock it holds. This is a fact, not a fanciful projection.  In addition, under the proposal Moelis and Company has put together, up to $180 billion in additional core capital can be raised through retained earnings, existing shareholders and new investors. No other plan anticipates shareholders and investors underwriting a failsafe mechanism for protecting taxpayers. No other plan departs so completely from the unfair presumption that taxpayers are simply another source of capital. This blueprint will ensure Fannie and Freddie will be in safe and solvent condition, as required by HERA.

In addition, under the plan, Fannie and Freddie will be run differently in the years to come. If we learned anything from the financial crisis, it is that overleveraging and undercapitalization was a dangerous and preventable mix. This new proposal calls for the imposition of capital standards akin to those Congress has seen fit to impose on the nation’s largest banks. As we have noted, Fannie and Freddie back over $5 trillion in home loan debt so it makes no sense to let them operate with capital reserves well below what is required at too-big-to-fail banks. Taxpayers should never again be on the hook for covering possible losses at the companies.

Unlike so-called reform proposals that would simply dismantle Fannie and Freddie and divvy up their portfolios as well as their function to big banks and other private sector entities, this plan recognizes the indispensable role of Fannie and Freddie in sustaining a liquid and stable secondary mortgage marketplace. To date, no academic, politician, trade association or policy expert has come up with a way of making sure the 30-year, fixed-rate mortgage and other financing tools would exist without Fannie and Freddie or nearly identical entities. After four generations, the societal and economic benefits of home ownership are clear: stronger neighborhoods and communities, the opportunity for average Americans to create wealth that can be passed on, and economic activity generated by construction and finance.

At the same time, the proposal would enable Fannie and Freddie to build on reforms undertaken in recent years by their conservator, the Federal Housing Finance Agency, and stipulate that they be run as responsibly capitalized and regulated single-purpose insurers.  Fannie and Freddie would continue to shed their investment portfolios and get back to their role as regulated, shareholder-owned mortgage guarantors, bearing mortgage credit risk in exchange for guarantee fees. They would retain no investment portfolios beyond securitization inventory.

Another highly desirable aspect of this proposal is that it can be implemented in four years without Congressional legislation. Despite the misapplication of HERA that started under the Obama Administration, the law is actually quite clear. FHFA was charged with returning the GSEs to a sound and solvent condition so they could resume operating as shareholder-owned entities supporting home financing. It is well past the time to revert to what the statute mandates.

As we have argued strenuously, proposals by Sens. Bob Corker (R-TN), Mark Warner (D-VA) and others over the years would have been averse to the interests of taxpayers, home buyers, and certainly shareholders. Most have relied on untried approaches and wishful thinking. During the Obama years, there was never sufficient consensus in Congress on a post-conservatorship model that the Administration would embrace or had much interest in even discussing.  

Fortunately, Treasury Secretary Steve Mnuchin has expressed an earnest desire to get the government out of the home finance business. This proposal does that. It is time the Administration use its statutory authority to fulfill its responsibilities. As Mnuchin has said, Congress can and should be an active partner in refining housing policy. However, there is no need for the Administration to await legislation that will almost certainly be too flawed to clear the House and Senate. If President Trump is looking to make a tangible impact on the lives of average people, he should direct his Administration to take up this plan.

In essence, the blueprint Moelis and Company has put together would end the illegal practice of using taxpayers as a capital source. It would allow FHFA to stop making dividend payments to Treasury and protect taxpayers from a capital draw and future bailouts. It would finally bring an end to the Net Worth Sweep and restore shareholder rights. Rather than disrupting the economy by dismantling a time-tested home finance model, the proposal gets back to basics. Sufficiently capitalized GSEs would maintain stability and liquidity sufficient to sustain homeownership and access to affordable rental housing. However, the government’s role would be all but eliminated except for regulatory standards. All of this can be achieved by Administration officials who can build on reforms already implemented and it requires no legislation by Congress.     

The proposal will surely undergo rigorous scrutiny as other plans have. It is especially important that fair, level-headed, and practical people who want to address this unfinished task of the 2008 crisis – free of ideology, partisanship, and self-interest –  give it due consideration.