In the aftermath of the financial crisis, public discourse in the US reflected a growing consensus that policy preferences of numerous administrations had encouraged a level of home ownership and real estate investment that was out of proportion with the capacity of households to repay mortgage debt. Ultimately, this left taxpayers holding a large portion of the risks given the implicit government guarantee backing the obligations of government sponsored enterprises (GSEs) operating in this sector.
Poorly supervised, under-capitalised and then effectively nationalised, GSEs such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) were an early target of financial sector reform once the recession had ended. In 2011, the Obama administration adopted a position of seeking to wind down the GSEs over time, a remarkable about-face in light of Democrats’ traditional support for the GSEs as a vehicle for promoting housing affordability.
Given what appeared to be significant momentum and bipartisan support for a shift in government housing policy, it is remarkable just how little the status of the GSEs has changed since the crisis. In this article, we review impediments to meaningfully changing the role of the GSEs, our expectations for reform in the coming years and implications for the agency mortgage-backed securities (MBS) market.
Overall, we expect GSE reform to remain on the political back burner, see scope for political compromise in areas that would not greatly alter the role of the GSEs in insuring home mortgages, and anticipate few if any challenges to maintaining the GSEs’ guarantee on the roughly $5 trillion pool of outstanding agency MBS. In addition, we anticipate that a long period of time would be required to reach consensus on changing the nature of the guarantee on future agency MBS, and that implementing any such changes would occur over an extended period. This backdrop of incremental reform and low risk of a change in the nature of the GSE guarantee should allow MBS investors to remain focused on the interest rate cycle, the outlook for mortgage supply and potential changes to the Federal Reserve’s reinvestment policy as monetary policy normalises.
Reforming government sponsored enterprises: competing priorities
To housing experts and policy makers, there are a number of unattractive features of the current status of the GSEs. Years after the financial crisis, the GSEs remain in conservatorship and the vast majority of new mortgage origination bears a GSE guarantee, leaving taxpayers at risk in any future housing market downturn. In addition, some argue that the GSEs engender uncertainty among originators by maintaining very restrictive standards for guarantee qualifications, and by making claims on originators for nonperforming loans. And with a lack of clarity over the future status of the GSEs, providers of capital may be unwilling to invest in alternative solutions for housing.
Despite these drawbacks, this regime has continued because the divergent policy priorities of the two parties have lessened the scope for compromise. This stems from philosophical differences about the role of government in housing finance. For many Republicans, reducing the socialisation of mortgage credit risk and government involvement in capital markets remains a key objective, whereas most Democrats in Congress still envision a prominent role for the government (and hence the GSEs) in promoting housing affordability. In addition, within each party there can be conflicting views on how best to achieve policy priorities.
Many Democrats acknowledge that the GSEs represent a very blunt and potentially costly tool for promoting housing affordability. For example, pressure on the GSEs before the crisis to increase support for lower-income obligors encouraged the enterprises to lend to riskier market segments, ultimately increasing costs to taxpayers. On the other side of the aisle, many Republicans, particularly in the Senate, are aware of the practical challenges to re-privatising or winding down the GSEs, since such measures would lead to much higher mortgage rates for homeowners.
Thus despite the philosophical appeal of a greatly reduced role for the GSEs, higher borrowing costs for homeowners could jeopardise re-election prospects for many Republicans, and have led many in the party to prefer a more centrist approach. GSE reform has also become less of a priority because some of the steps taken by the GSEs and their regulator, the Federal Housing Finance Agency (FHFA), have served to de-risk the enterprises. These steps include tighter underwriting standards for qualifying mortgages, and higher guarantee fees charged to borrowers. In addition, FHFA has pushed the GSEs to accelerate the pace of winding down their retained portfolios in order to further reduce the potential liability to taxpayers. And the GSEs have further de-risked their portfolios by issuing new instruments that allow investors to participate in the credit risk in reference pools of GSE guaranteed mortgages.
Finally there is ongoing work to create a common securitisation platform that would, among other things, foster market entry by private sector guarantors. Assuming these incremental steps to de-risk the GSEs and promote private sector involvement continue, the likelihood of more substantial reform may diminish further. While the GSEs have de-risked since the financial crisis, they have also generated revenue for the government. Aggregate cash dividends to the Treasury Department now exceed funds received under the conservatorship. This results from the combination of tighter underwriting standards, stronger-than-anticipated recoveries and a revival in agency MBS origination. On the margins, the revenue-generating aspects of conservatorship may further dull the incentive for reform.
Scope for compromise
Even as reform impetus has slowed and philosophical differences prevent either political party from achieving all of its objectives for housing finance, a few “first principles” have emerged and reveal scope for a compromise GSE reform package in the years ahead. First, as a starting point both parties agree that the status quo is untenable, in that taxpayers bear almost all the risk of new mortgage origination. From this follows a second principle, that increased private sector involvement can reduce taxpayer risk while ensuring stable consumer access to affordable and long-term mortgage credit. These principles serve to identify a number of areas where there is likely to be agreement, namely:
- Continued and potentially accelerated reduction in the GSEs’ retained portfolios. This does not require legislative approval and in fact the FHFA continues to takes steps in this direction.
- Ongoing efforts by the GSEs to allow investors to participate in the credit risk underlying agency guaranteed mortgages. These credit risk transfer (CRT) structures also play to a core Republican objective of reducing taxpayer exposure to the GSEs. Importantly, the CRT market can continue to grow without legislative changes.
- Continued work on the common securitisation platform, which reduces the GSEs’ control over the securitisation process, reorients them strictly to their guarantee business, and encourages private capital to flow back into mortgage insurance.
- Developing a loss-sharing system under which private sector insurers assume a portion of the loss on GSE guaranteed mortgages. The GSEs could potentially move to a back-stop guarantor role in the event of losses beyond a particular threshold.
The road ahead for government sponsored enterprises and market implications
We see limited scope for significant movement on GSE reform ahead of the next presidential election, and even thereafter the ongoing efforts to de-risk the enterprises will serve to keep reform on the political backburner. Still, the untenable nature of a housing finance system that is almost exclusively reliant on public sector support implies that change will occur, even if gradually and cautiously over the longer term. Importantly, none of the proposals under consideration would weaken the guarantee on outstanding agency MBS, so we do not envision any change in the credit profile of the agency MBS market.
Thus, in our view, we continue to see little to no distinction between the credit risk profile of Treasury securities and agency MBS. In addition, we do not expect reform efforts to result in reduced agency MBS issuance or market liquidity. Until reform is fully implemented, the GSEs will largely remain the only game in town for efficiently connecting homebuyers with end-investors in insured MBS. [divider] [/divider]
Written in New York City, March 2016