Political activity related to reforming Fannie Mae and Freddie Mac has picked up over the last few months and additional legislative activity is expected this fall. As Goldman notes, while there is still substantial political disagreement, a loose consensus has begun to emerge on some issues. However, despite somewhat greater agreement on certain aspects of GSE reform, lawmakers still face a basic dilemma. Housing finance reform has languished in large part because of the disagreement over the appropriate federal role, as well as a concern that reform would ultimately lead to an increase in borrowing costs. Recent GSE reform proposals such as Corker-Warner appear to have attracted support by calling for high levels of private capital. However, such high levels of capital would require a return to investors, increasing borrowing costs. Overall, Goldman's expectation continues to be that GSE reform is unlikely to be enacted this year or next.
Goldman Sachs: The GSE Reform Dilemma
- Political activity related to reforming Fannie Mae and Freddie Mac has picked up over the last few months and additional legislative activity is expected this fall. As Goldman notes, while there is still substantial political disagreement, a loose consensus has begun to emerge on some issues. The Corker-Warner bill, a bipartisan proposal which the President endorsed two weeks ago, builds on previous efforts that pair significant private capital in a first-loss position with a government backstop for catastrophic risks. This seemingly bridges the gap between supporters and opponents of a large federal role in the mortgage market.
- Despite somewhat greater agreement on certain aspects of GSE reform, lawmakers still face a basic dilemma. Housing finance reform has languished in large part because of the disagreement over the appropriate federal role, as well as a concern that reform would ultimately lead to an increase in borrowing costs. Recent GSE reform proposals such as Corker-Warner appear to have attracted support by calling for high levels of private capital. However, such high levels of capital would require a return to investors, increasing borrowing costs.
- Overall, our expectation continues to be that GSE reform is unlikely to be enacted this year or next. Beyond the fundamental issues of borrowing costs and the appropriate role for the government, there is no deadline to force action, which has been a necessary factor over the last few years to reach political agreements on economically significant issues. The GSEs' positive contributions to federal finances at the moment may also present an obstacle.
The debate on housing finance reform has become more interesting lately. President Obama highlighted housing finance reform as a priority in a speech earlier this month. The President's nominee to head the FHFA is also before the Senate as well, with a vote possible sometime after Congress returns from its August recess. Several pieces of legislation have been introduced in Congress on the issue, some of it bipartisan, and more activity is expected over the next several months.
Among recent developments, the most interesting may be the legislation introduced in June by Senators Corker (R-TN) and Warner (D-VA). The proposal seems to be something of a breakthrough for several reasons.
First, it has bipartisan support in Congress: it was written jointly by a Republican and Democratic member of the Senate Banking Committee, and the bill counts eight other members of the Senate Banking Committee (i.e., nearly half the members of the committee) as co-sponsors.
Second, President Obama recently gave the bill a soft endorsement, describing it as "pretty consistent" with his own views on how the GSEs should be handled.
Third, the bill appears to walk the middle ground between removing federal support from the housing finance system, as some conservatives would prefer, and establishing explicit federal guarantees on much of the market, as some progressives have advocated.
In broad strokes, the bill would wind down Fannie Mae and Freddie Mac over five years, replacing them with a securitization platform that is currently under development by the GSEs and their regulator, the Federal Housing Finance Agency (FHFA). Securities issued through the platform would be backed by bond guarantors that would be required to hold 10% capital against losses. Losses over that amount would be borne by federal catastrophic reinsurance provided. In return for the backstop, issuers would pay premiums sufficient to capitalize a mortgage insurance fund to 2.5% of the outstanding principal balance backed by the fund within ten years.
Further movement on GSE reform appears likely over the next several months. Senate Banking Committee Chairman Johnson (D-SD) and Ranking Member Crapo (R-ID) may offer legislation which builds on several aspects of the Corker-Warner bill. If they do, action on the issue in the Senate, at least at the committee level, would be possible. House Financial Services Committee Chairman Jeb Hensarling (R-TX) has passed legislation in his committee that would wind down the GSEs and phase out federal support. His bill may come up for a vote before the full House of Representatives this fall. Given what appears to be some momentum behind the sort of structure envisioned in the Corker-Warner bill, could GSE reform actually have a fair chance of becoming law this year or next?
Despite the momentum, at this point our view is that the likelihood that legislation could be enacted in the next year is still quite low. The main reason is the tension between two competing political goals. On one hand, Congress will only enact legislation if it is not expected to increase mortgage rates significantly. This need not necessarily present an obstacle. Our mortgage strategists have shown that even assuming stress losses of 2.7% (the loss experienced in the 2007 vintage of prime mortgages of credit quality and documentation similar to current production) and a 15% return on equity, a guarantee fee of only 28bps would be needed, less than the roughly 50bps charged currently (guarantee fees had typically hovered in the 25bps range, but FHFA has mandated multiple increases over the last few years). FHFA's own analysis indicates that for recent mortgage vintages, guarantee fees charged in 2010 and 2011 were adequate to cover expected losses and meet an expected rate of return.
On the other hand, political consensus on the appropriate role of government in the mortgage market has been difficult to reach, with many Republicans opposing any permanent support for the GSEs, and many Democrats opposing a system that lacks a federal backstop. The Corker-Warner proposal bridges this gap, but establishing a backstop only after private capital has absorbed very large losses. As noted above, the Corker-Warner bill would require a 10% first loss private capital buffer as well as a separate federal capital buffer of 2.5%, also funded out of mortgage guarantee fees. This capital level is more than three times the overall mortgage losses experienced by the GSEs since 2007.
It is precisely this "belt-and-suspenders" level of capital that has attracted support from lawmakers who might otherwise object to a federal backstop. However, in bridging differences over the role of government in the mortgage market, the proposal would probably lead to increased borrowing costs. If one assumes that private capital will target a pre-tax return on equity of 10%, guarantee fees would need to rise to more than 100bps once other charges (for example, additional fees to capitalize the mortgage insurance fund) are factored in. The upshot is that the emerging consensus in support of a catastrophic federal backstop appears to have reduced opposition to institutionalizing an explicit federal guarantee in a reformed GSE system, but it could ultimately make Congress more wary of the effect on mortgage pricing.
Beyond the substance of the reform proposals, the main obstacle to reform is simply that there is no forcing event. Almost every major piece of legislation enacted since control of Congress was split between the parties has been motivated by a deadline. The Treasury's capital agreement with the GSEs is open-ended, and the GSEs are profitable in any case so there is no obvious event that will force Congress to intervene.
That said, pressure to reform the GSEs could increase gradually. FHFA has instructed the GSEs to raise guarantee fees more than once over the last year, which reduces the disparity between GSE and private sector pricing. There is a limit to how high FHFA will raise guarantee fees, but if they continued to rise absent reform, support for a legislative approach might build.
From a budget bookkeeping perspective, this could also give Congress motivation to act. The Congressional Budget Office currently estimates that the subsidy provided through the GSEs will cost the federal government $35bn over the next ten years, so establishing a new system could eliminate that cost and be a source of deficit reduction. However, the projected cost of the federal subsidy through the GSEs continues to decline, and soon the GSEs may be estimated to be a source of net deficit reduction. As the projected cost of the GSE subsidy declines, the estimated fiscal effect of a given set of reforms will rise. Neither of these gradual changes is likely to force Congress to consider reform in the near term, but they may on the margin add pressure to enact reform.