The Future of the GSEs: Explicit Guarantees, Repurchase Requests Outstanding, Targeted Initiatives

Two high rankingrnofficials testifying before congress this week made it clear that, when itrncomes to the future of Freddie Mac and Fannie Mae, the Departments of Treasuryrnand Housing and Urban Development are reading from the same play book,</p

FederalrnHousing Finance Agency Acting Director Edward J DeMarco and AssistantrnTreasury Secretary Michael Barr spoke before a HousernSubcommittee on Capital Markets, Insurance, and Government SponsoredrnEnterprises. rnIt was clear from the prepared remarks of each that the Administrationrnfeels it is essential that the government continue to support the housingrnindustry, but it is not a given that that support will include governmentrnguarantees or that any guarantees would be in the same form they are today. </p

Each testimonyrnrecounted the history of the two government sponsored enterprises (Enterprisesrnor GSEs), with DeMarco also devoting some of his testimony to the background ofrnthe Federal Home Loan Banks and their current situationrnand recounted some of the accomplishments since the GSEs were placed inrnconservatorship in August 2008, including a recap of the their loss mitigationrnactivities and efforts to recoup losses through repurchase demands.  </p

In this context, DeMarcornmade several remarks that might signal some interesting enforcementrnactivities. First, he said that, givenrnthe extent of the loss mitigation options available to borrowers he wasrnsupportive of Enterprise efforts to discourage borrowers from strategicallyrndefaulting on their mortgages.  </p

He alsornmade it clear that the Enterprises were expected to enforce lender compliancernwith their contractual obligations, including outstanding repurchasernrequests.  At the end of the secondrnquarter, Fannie and Freddie had a combined 11.1 billion in outstandingrnrepurchase requests, one-third of which have been outstanding for over than 90rndays.  DeMarco said if discussionsrnbetween the Enterprises and their lenders do not yield reasonable outcomesrnsoon, “FHFA may look to its supervisory and conservatorship authoritiesrnprovided under statute to resolve the situation.”</p

DeMarco also referencedrnthe 64 subpoenas issued by FHFA in July for records and information regardingrnEnterprise losses on private label MBS. rnThe subpoenas had been issued because the GSEs had difficulty obtainingrnthe requested information.  As therninformation is received, he said, “FHFA will determine whether private-labelrnMBS issuers and others are liable to the Enterprises for certain losses theyrnhave suffered on private-label MBS and, when appropriate, will seek to recoverrnthese losses.   </p

Both men noted thernrecently published finding that the biggest losses to the Enterprises have comernfrom their single-family credit guarantee business rather than from their ownedrnportfolios.  Of the $226 billion inrnlosses since the end of 2007, $166 billion or 73 percent was attributable tornthe guarantee business.  $148 billion ofrnthis was borne by the tax payers while $78 billion came from the Enterprises’rnstockholders.  The Enterprises are nowrnpricing the guarantee to a level sufficient to cover model lifetime estimatedrncosts, including a return on economic capital at a rate commensurate with therninterest rate on Treasury-held senior preferred stock.  One exception is pricing of Home AffordablernRefinance Program (HARP) loans which does not cover anticipated costs.  However, those loans are improving creditrnrisk and have improved pricing relative to the existing Enterprise loans theyrnreplace.</p

DeMarco said thatrnthe future design of the housing finance system should give consideration to targetingrnsubsidies to specific groups that lawmakers determine warrant thatrnbenefit.  He cited as examples the FHArnand Veterans administration guarantees that reflect policymaker’s judgment as tornthe public benefits from targeting certain borrowers.  “It is reasonable to question whether allrnconventional mortgages warrant a government guarantee,” he said.  </p

While recent calls for some form of explicitrnfederal insurance have certain merit and some attractive features, thernpotential costs and risks of that framework have not been fully explored.  “To put it simply, replacing thernEnterprises’ ‘implicit’ guarantee with an explicit one does not resolve all thernshortcoming and inherent conflicts in that model, and it may produce its ownrnproblems.”  </p

Such an explicitrnguarantee presumes that the market either cannot evaluate and price the tailrnrisk of mortgage default, at least not at an acceptable cost, or cannot managernthat amount of risk on its own. rn”But we might ask whether there is reason to believe that therngovernment will do better?  If therngovernment backstop is underpriced, taxpayers eventually may foot the billrnagain.”</p

Second, he said, ifrnthe government provides explicit credit support for the vast majority ofrnmortgages, it would likely want a say about the allocation or pricing ofrnmortgage credit for particular groups or geographic areas which has thernpotential to distort pricing of risk and risks further taxpayer involvement andrncosts. </p

Third, explicit credit supportrnfor the majority of mortgages coupled with the tax deductibility of mortgagerninterest, would further direct the nation’s investment dollars toward housing.  Lawmakers must weigh such incentives againstrnthe alternative uses of funds. </p

Barr and DeMarcorneach stressed the necessity for a smooth and gradual transition into arnpost-conservatorship era and highlighted the progress already made in upgradingrnthe risk in the Enterprises portfolios.  DeMarco said that in conservatorship thernEnterprises must continue to focus on their core business activities, lossrnmitigation, and remediation of internal weaknesses, and not introduce newrnproducts. </p

The FHFA acting director saidrnhe is frequently asked how much more money the Enterprises might require underrnthe Preferred Stock Purchase Agreement with Treasury.  In April he said $400 billion and, becausernFannie and Freddie each use different models to predict future losses, he willrnhold to that projection.  However, workrnis underway to develop projections that are comparable between the two and whenrnthis is completed it may be that under less severe stress scenarios thosernprojected losses could be lower.  </p

Barr said that HUDrnand Treasury working together had laid out goals for a new stable andrnwell-functioning housing market that would achieve the following objectives. </p<ul class="unIndentedList"<liMortgage credit would be widely available andrndistributed in an efficient manner to a wide range of borrowers even when marketsrnare under stress.</li<liBoth ownership and rental affordable housingrnoptions should be available for low-and moderate-income households.</li<liConsumers should have access to mortgagernproducts that are easily understood and effective consumer protection to keep unfair,rnabusive, or deceptive practices out of the market.</li<liCredit and interest rate risk should berndistributed in an efficient and transparent manner that minimizes risk to thernbroader economic system and does not generate excess volatility. It should not contribute to systemic risk orrnoverly increase interconnectedness from the failure of any onerninstitution.</li</ul

Any system that achievesrnthese goals should be characterized by:</p<ol