Route to housing finance reform runs through the FSOC

Housing finance reform has stalled. Perhaps it would be jumpstarted by being honest about Fannie Mae and Freddie Mac (FMFM): they are SIFIs.

SIFIs, for the uninitiated, are Systemically Important Financial Institutions – effectively those financial entities that are Too Big To Fail (TBTF).  SIFIs are designated by the Financial Stability Oversight Council (FSOC) and are subject to a much more stringent supervisory oversight regime characterized by greater capital and liquidity requirements.  But thus far FMFM have dodged the FSOC designation as TBTF that would make them SIFIs. That is wrong; and there is a lot more to it than Four Letter Financial Acronyms (FLFAs).

The financial cataclysm in 2008 plunged the U.S. into the Great Recession. There have been a lot of assertions that greedy bankers knowingly manipulated the financial system to take advantage of homeowners and mortgage investors alike, creating a housing bubble and jeopardizing the economy.

This is simply wrong.  The financial crisis was in part (but not wholly) the result of bad mortgage lending. Beginning in the late 1990s and accelerating in the 2000s, there was a large and sustained mortgage and housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by more rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida.

Important factors included weak disclosure standards and underwriting rules for bank and nonbank mortgage lenders alike, the way in which mortgage brokers were compensated, borrowers who bought too much house and didn’t understand or ignored the terms of their mortgages, and elected officials who over years piled on layer upon layer of government housing subsidies.

Those bad mortgages were at the heart of the business model of Fannie and Freddie.

Fannie Mae and Freddie Mac lowered the credit quality standards of the mortgages they securitized. A mortgage-backed security was therefore “worse” during the crisis than in preceding years because the underlying mortgages were generally of poorer quality. This turned a bad mortgage into a worse security. And it turned the undercapitalized Fannie Mae and Freddie Mac into dangers to the financial system.

This made it easy to understand the need to put them in conservatorship, or at least that is how it appeared at the time. Recently, however, there has been a revisionist argument that this was unnecessary that focuses on arcane aspects of cash flows and balance sheet accounting. This misses the key point. Conservatorship was never about Fannie Mae and Freddie Mac, per se. It was about the danger they posed to the larger financial system. Indeed, given the large holdings of agency debt around the globe, any hint of default or haircuts literally put the credibility of the United States on the line.

The “no bailout needed” argument is part of a larger effort to encourage Treasury to recapitalize Fannie and Freddie and release them from conservatorship. The “recap and release” idea has already been dismissed by Treasury. But even more fundamentally, it is premised on the notion that things can just go back to the way they were before the crisis.

Under Dodd-Frank, they cannot. Fannie Mae and Freddie Mac are SIFIs no matter how the FSOC looks at them. As institutions, they are very large, highly leveraged financial institutions with monoline risk exposures to the mortgage market. Size was apparently the initial criteria for designation that inappropriately swept insurance companies into the SIFI net. It should apply to the housing GSEs as well. Alternatively, history has shown clearly that their activities and products are a financial time bomb that would and should merit designation.

Fannie Mae and Freddie Mac were SIFIs in 2007. They are SIFIs right now. They would be SIFIs the moment they exited from conservatorship. Accordingly, there is simply no way that housing finance can go back to its pre-crisis form, and proponents of this dream should stop blocking progress on building a new platform for housing finance in the United States.

Holtz-Eakin, former director of the Congressional Budget Office and current president of the American Action Forum