After 9 years of sweeping Fannie and Freddie under the rug, risks begin to emerge
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When mortgage giants Fannie Mae and Freddie Mac were put into conservatorship, few thought the two agencies would still be wards of the federal government nearly nine years later. But they are, and taxpayers are still on the hook for any losses they may suffer. This is becoming a more meaningful threat; under the terms of their agreement with Treasury, the agencies will have no capital to absorb any losses by the end of the year.

Mel Watt, the director the Federal Housing Finance Agency, the agencies’ regulator, is rightly worried about this possibility. He recently testified before the Senate Banking Committee that he may curtail the dividend that the agencies pay the Treasury each quarter with their profits — the current arrangement the FHFA has with the Treasury — so that they can instead rebuild their capital.

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The FHFA director argues that this action is necessary to ensure that investors in the mortgage-backed securities backed by the agencies don’t worry about their investments if the agencies were to suffer a loss. That’s because without capital of their own, a loss would require the agencies to fill the financial hole with the limited capital available to them from the Treasury.

  

As the agencies draw funds against that increasingly binding limit, investors will eventually grow concerned that their investment in the agencies’ securities may not be safe from credit-driven losses.

Investors currently believe that investing in a Fannie and Freddie mortgage security is almost as safe as buying a U.S. Treasury bond. This is because they believe that the government is sheltering them from any credit risk — the risk the mortgages backing the agencies’ securities default. If they ever come to doubt this, however, they will demand more compensation for the perceived credit risk they are taking, or simply refuse to invest at any price, which means higher mortgage rates and fewer mortgage loans.

While Director Watt is right to recognize a problem, allowing the agencies to withhold their profits from taxpayers to build capital isn’t the right solution. This runs the risk of putting us on a path back to the future. By allowing the agencies to recapitalize, he is allowing them to begin the process of reprivatization, which cannot take place until and unless they rebuild capital. While Director Watt has made it clear that he would not go any further down the road of administrative reprivatization, to take even this step is concerning.

What's more, there are much better ways to address the concerns created by the agencies’ lack of capital. Most straightforward is to have the agencies move from a quarterly dividend payment to Treasury to an annual one. The likely reason why the agencies would suffer a loss, at least in the foreseeable future, is simply their accounting, which results in temporary ups and downs in their reported earnings due to swings in interest rates. While they may have a quarterly accounting loss, it won’t matter because it would be made up for before they would need to make their annual payment.

An even more prudent step would be to establish a mortgage insurance fund, or MIF, with the agencies’ profits. The MIF would be similar to the existing deposit insurance fund that protects depositors in failing banks from losing their savings. Like the deposit fund, the MIF would be held at Treasury to be used if the agencies ever suffered losses and required capital.

However, since the MIF isn’t Fannie and Freddie’s, it does not put them on the path of reprivatization. Indeed, because it could be used to support any future housing finance system, allowing them to begin to fund the MIF would allow us to begin the process of capitalizing whatever system Congress ultimately chooses to replace the current one.

Finally, to minimize the risk that Fannie and Freddie would suffer losses and need more capital from Treasury, the FHFA should require the agencies to continue to expand their risk-transfer efforts. In these transactions, an increasingly long list of private sources of capital, from asset managers and hedge funds to mortgage insurers and reinsurers, take on the risk of defaulting mortgages.

The agencies and FHFA deserve credit for successfully building the risk-transfer process from scratch in a short period of time, but there is still much more they can do to realize its full potential. Private investors are very interested in taking more risk from the agencies. The more risk private investors take on, the less left for the agencies, and thus, the less likely the agencies will suffer losses requiring capital from the Treasury.

The housing finance system is in desperate need of reform. With Fannie and Freddie languishing in conservatorship with no capital, the system will steadily degrade, ultimately weighing on the availability of mortgage loans and homeownership. However, using taxpayer money to recapitalize the agencies, which is what FHFA Director Watt is effectively contemplating, is not the answer. Much better to use that money to prepare for the future system. 

Mark Zandi is the chief economist for Moody's Analytics, one of the three largest credit ratings agencies in the world.


The views expressed by contributors are their own and not the views of The Hill.