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Risk Sharing Scrutiny Underscores Impracticality of Scrapping GSEs and the Need for Capital

Recently, calls for replacing the GSEs have turned into proposals for reforming them – which is an acknowledgement of numerical realities.  Of course, any viable reform idea for institutions that support $5 trillion of the $9-trillion U.S. mortgage market must address where capital would come from and how to distribute benefits and risks in a new regime.

A piece by former FDIC Chairman Bill Isaac in the American Banker, “Risk Sharing is no Substitute for Capital at Fannie and Freddie,” and a forum yesterday by the Bipartisan Policy Center put a spotlight on the critical question about capital in a so-called risk sharing arrangement.

As Isaac explains, more risk sharing by the GSEs would mean the companies would keep on purchasing mortgages but, instead of holding all the credit risk themselves, they would share some or all of that risk with others who would be compensated for bearing the risk. That is not a bad idea in itself but policymakers must keep in mind that Fannie and Freddie have not been able to build up capital buffers since the Treasury Department started vacuuming up 100 percent of their profits three years ago.

Isaac points out that it is hard to identify large pools of risk-bearing capital, aside from Fannie and Freddie, to duplicate their role in providing the housing finance market with liquidity. Ticking through possible options, he notes that it is unlikely that the capital will come from the banking sector, since regulators would likely reject having banks overly concentrated in mortgage risk which would set the stage for making “too big to fail” banks even bigger. The mortgage insuring sector only has about $8 billion in equity capital today so, even if it grows at stunning pace, it is inconceivable that it will approach the $5 trillion in mortgages held by Fannie and Freddie. Meanwhile, private investors have not shown much interest in credit risk, having bought up only $21 billion of what Fannie and Freddie unloaded during the last few years.

During the Bipartisan Policy Center event, Bob Ryan, acting deputy director for Federal Housing Finance Agency, revealed that the agency is looking into allowing private mortgage insurers to cover more possible losses on future Fannie Mae and Freddie Mac home loans. But, as Politico reported, there are looming questions about the adequacy of a buffer to protect taxpayers. If there is another major downturn in the housing market, which is all but inevitable, many private insurers would almost certainly face difficulties and could fail. This would mean Fannie and Freddie would have to cover losses.

This practical consideration about where capital comes from might account for why there has been a shift in the debate from replacing the GSEs to reforming them. The fact is that we need the GSEs and the critical counter-cyclical role they play in the mortgage market. As we pointed out some months ago, Mortgage Bankers Association President and CEO David H. Stevens has acknowledged that the amended conservatorship that depletes the GSE of capital is problem.  Even though he has called for changes in the GSEs’ charters, he recently acknowledged, “The role the GSEs play in supporting an affordable and sustainable housing finance system is absolutely critical to this nation.”

Some have suggested simply transferring risk away from the GSEs. Remember though, the GSEs are for-profit companies. As such, they have to earn a fair return on the capital they employ and cannot be asked to give away business.  It would be ludicrous to propose, for example, that property and casualty insurers give up profitable business to – or subsidize – competitors. Similarly, the GSEs should not have to hand over business to competing companies – even if they are in conservatorship. 

It is also audacious for anyone to argue that having the GSEs surrender their business to competitors is somehow a way to reduce systemic risk. As private companies, the GSE should evaluate the profitability of risk sharing based on the numbers. This is certainly not something Congress should decide in a politically-charged atmosphere.

Of course, that brings us back to a more fundamental issue of bringing the conservatorship to a conclusion based on the terms set out in the law. The Housing and Economic Recovery Act (HERA) requires the FHFA to “conserve and preserve assets” and “restore [them] to safe and safe and solvent condition.” While HERA has been misapplied in many ways, systematically forcing the GSEs to subsidize competitors is patently opposed to the letter and spirit of the law and is antithetical to market dynamics.

Doing away with Fannie Mae and Freddie Mac is not going to happen. What we need are reformed GSEs that are well capitalized and profitably run both for their public mission and for their shareholders, just like any other financial institution. Risk sharing transactions could have a role in reforms but they must be driven by real safety and soundness concerns. To that end, the Treasury’s sweep of the GSEs’ revenues must end so they can build up capital reserves.