Reports that Fannie Mae and Freddie Mac are down to fumes and
could need another infusion of taxpayer dollars to stay capitalized have revived an ongoing debate on what, if any, role the government should have in the multi-trillion dollar mortgage finance market. It is debate worth having, but we need to put the horse before the cart. The two government sponsored enterprises first need to be restored to a safe and solvent condition.
In the most perilous moment of the 2008 global financial crisis, the Treasury Department provided Fannie and Freddie with financial assistance needed to preserve liquidity and stability in the housing market, and the two were put into conservatorship under the newly-created Federal Housing Finance Agency. Six and half years later, Fannie Mae and Freddie Mac have paid back the Treasury Department, but are now being run with virtually no capital between the taxpayer and potential losses on $5 trillion worth of mortgages on their balance sheets.
Some hope to maintain this state of affairs until Congress gets up the political nerve to put them out of business in one fell swoop of legislation. But to quote the old joke about the farmer giving directions to a stranger, you can’t get there from here. FHFA needs to restore the enterprises to a safe and sound condition before they can be safely replaced with other sources of mortgage capital.
Right now, there are only three sources of capital in the U.S. to bear mortgage credit risk: government capital, capital inside Fannie and Freddie, and truly private capital, whether from banks, mortgage insurers or capital market investors.
If policymakers want to limit the use of capital in Fannie and Freddie and not have that credit risk flow back to taxpayers, then they need to encourage truly private capital to enter the mortgage space. They would have to improve the risk-return profile of doing so – increasing expected returns to investors, lowering perceived risks to those returns (whether from borrower distress or government response) or lowering the substantial post-crisis regulatory burdens imposed on the mortgage space.
Remarkably, eight years after the subprime mortgage market shut down in 2007 and almost seven years since the meltdown of 2008, we are nowhere in terms of getting real private capital back into mortgages. Instead, we continue to debate whether this is because the government wants to keep mortgage rates (i.e. returns to private capital) low to prop up the real estate and financial markets, the explosion of regulation on the financial institutions at the heart of the crisis, or the ongoing stand-off between banks securitizing mortgages and the investors who won’t bear mortgage credit risk without the government in the middle.
But it is fiscal insanity to hold a financial gun to the taxpayers’ head by allowing Fannie Mae and Freddie Mac to bear their $5 trillion of credit risk with no capital while we wait for Congress to act and for investors to return to mortgages. The threat of another financial disaster caused by suspending the safety and soundness of major financial institutions should not be what forces Congress to act or to fix a broken market.
The transition to a successor arrangement for Fannie and Freddie needs to be measured and protect taxpayers. As Fannie Mae and Freddie Mac try to rebuild capital, Treasury should be getting out – reducing its present limited commitments – not staying still (as Treasury continues to seize the profits of Fannie and Freddie following a 2012 policy shift) or getting further entrenched (as recently proposed legislation would unwisely have done).
But for government to step back, Fannie and Freddie need to build up capital to the standards required by regulators. Every dollar of capital their balance sheets should permanently replace a dollar of Treasury backstop. Taxpayers should not be on the hook for any financial obligations the next time the housing market stalls out, but they will be unless we have the enterprises build reserves and raise external capital.
The proper way to transition away from Fannie Mae and Freddie Mac is to have them raise guarantee fees and price themselves out of the mortgage market as other sources of capital are able to take over. We should open the securitization system to other issuers and guarantors to increase competition and reduce systemic financial risk. We should impose standards and increase data in the mortgage markets so banks, insurers and capital market investors can bear credit risk on a sustainable basis.
This will be a long process. While it plays out we need to remember and respect the most fundamental lesson of the 2008 crisis: Every financial institution, and especially systemically important ones, has to have enough capital to cover unexpected losses at times of financial stress or taxpayers will be at risk. Restore Fannie and Freddie to a safe and solvent condition so we can create a better mortgage finance system.