The Fannie Mae and Freddie Mac endgame
What should we do with Fannie Mae and Freddie Mac?
This question has been asked since 2008 when the two government sponsored enterprises (GSEs) were taken over by the Federal Housing Finance Agency (FHFA) after markets lost confidence in them. Fourteen years later, government control of the companies seems to have no end in sight.
Nevertheless, the two companies remain by far the largest sources of mortgage credit, financing over 50 percent of $12 trillion-plus outstanding first-lien U.S. home mortgages. Their fate is the last unresolved issue from the Great Recession of 2007-2009.
Through about 2016, both sides of the political spectrum had a proposed answer: wind the GSEs down and replace them. This was the official position of the Obama administration. It reflected that post-mortem analysis of the Great Recession showed how flawed the government sponsored enterprise business model had become. Fannie Mae and Freddie Mac went well beyond their congressionally-granted mission in order to pursue extra profit, took too much risk, benefitted heavily from a subsidy that officially did not exist, and had top executives focused too much on lobbying to protect subsidies and avoid robust regulation. It took nearly $200 billion of taxpayer money to bail them out.
But replace them with what, exactly? Year after year, none of the many replacement proposals — which came from several academics, government officials and think tanks on the right and left — made it anywhere near the finish line, mostly because further examination revealed fatal flaws. It turns out that the core of the GSE business model — which protects the availability of the 30-year fixed-rate mortgage for the typical American homeowner — was really quite effective within the complex system of U.S. housing finance and unexpectedly hard to replace.
In parallel, the government has been directing the GSEs to implement major reforms to fix their business model flaws and improve operations. For example, risk was cut dramatically by reducing the GSEs’ outsized investment portfolios and selling mortgage credit risk to institutional investors. Newly-installed management focused not on lobbying but on quality customer service, improved technology and proper safety and soundness. The GSEs led the way in treating troubled borrowers better through updated modification options and a natural disaster forbearance program. And all this was done within a strengthened regulatory envelope of safety and soundness.
The effectiveness of these reforms is very visible. A key measure of risk — the official stress test result of how much the GSEs would lose in a Federal Reserve-defined “severe adverse” economic downturn — declined by 98 percent from $196 billion in the test’s first year in 2013 to under $5 billion in 2021. Improved technology and operating effectiveness showed up as the two companies handily accommodated a rough tripling of volume due to the pandemic-induced refinancing boom, all while employees worked remotely. Credit quality measures continue to be better than for almost all other sources of mortgage finance.
With the passage of time, the question of what to do with the two GSEs has, therefore, been answered: keep them in place, but with today’s reformed business model, which includes formalizing the existing utility-style price regulation to protect borrowers from being overcharged. This general approach first publicly emerged about 2017 and has gained traction since, including because it has little risk of disrupting housing and mortgage markets. Realistically, there is simply no other approach broadly considered workable, other than keeping them under “temporary” government control forever.
The shorthand for this approach is reform, recapitalize and release. The reforms are substantively already in place, and recapitalization began in 2019 when the GSEs were permitted to retain their earnings, which has so far grown their combined net worth up to $90 billion.
To make progress toward release, the Biden administration does not first need to develop a comprehensive plan; it just needs to take a few well-chosen steps. My suggestions would include revising the GSE regulatory capital requirement to more accurately reflect risk and setting the long-awaited fee to be paid by the GSEs to the Treasury for ongoing taxpayer support. Ideally, Treasury and the FHFA would also jointly begin planning further steps in what will be a complicated, multi-year process likely to take a minimum of 5 years.
Naturally, given how important housing finance is to the economy and how dominated it is by the government, any steps taken will likely face criticism — both for political reasons and from industry groups that fear making less profit. However, by proceeding incrementally, the Biden administration should be able to readily deal with such headwinds.
It really is time, after more than 14 years, to stop kicking this can down the road.
Donald H. Layton, a long-time banking and finance executive, was CEO of Freddie Mac (2012 to 2019). He is currently a senior visiting fellow at NYU’s Furman Center.” The views reflected in this piece are solely those of the author.
Editor’s note: This piece was updated on Oct. 21 at 1:32 p.m.