It’s easy to understand why hedge funds and other speculators in Fannie Mae and Freddie Mac stock are pushing anew to “recap and release” the companies from conservatorship.  But it’s a lot harder to understand why affordable housing groups are joining this chorus when it will neither expand affordable housing nor necessarily support broad credit access.

The fundamental problem with the recap and release approach is that starting any discussion about a future mortgage finance system with Fannie and Freddie is like looking through the wrong end of a telescope:  the field of vision is very restricted and the details are hard to make out. 

The right place to start is to ask “what are the goals of government engagement in mortgage finance, how should it be structured, and, once that’s settled, what role do Fannie Mae and Freddie Mac have to play?” 

The government’s role should be to ensure a set of critical outcomes:

  1. The broadest possible access to sustainable mortgage credit by the greatest range of credit worthy borrowers, everywhere in the country
  2. A deep and liquid market for mortgage backed securities to ensure reliable investment at all times from the broadest possible range of investors at the lowest possible cost, enabling rate locks for consumers
  3. The choice to have a long term fixed rate mortgages at a reasonable price for consumers who prefer them

The newest affordable housing recap and release champions say that these goals are what drive their recommendations.  They point to the companies’ shrinking capital base and argue that recapitalizing them and ending conservatorship – turning back the clock to the years before the GSE model’s fault lines became so clear – is the best way to assure access to affordable housing finance. 

But the facts don’t support these calls for action.

Access to affordable mortgage credit

As Hector Sanchez from Labor Council for Latin American Advancement said on a Nov. 11 press call about their recommendations for recap and release, “We must encourage wealth building for Latinos because they will continue to play a key economic role in the future.”  These groups decry the GSEs’ current track record on affordable lending, and particularly their low levels of lending to African-Americans and Hispanics.  Many of us agree with both sentiments.  Yet some of these advocates seem to believe that this will improve rather than worsen under recap and release, without offering any explanation why this would be so. They further argue that maintenance of the companies’ charter requirements including housing goals can be protected only through recap and release.

But Fannie and Freddie’s governing charters are the same in conservatorship as they would be under recap and release.  Out of conservatorship, the companies will once again be forced to balance their public purposes against their shareholders’ interests.  This is not a conflict they have to contend with now.  Recent history suggests that it is one that can end badly.  Ending conservatorship will not increase their affordable housing obligations from what they are now.  But it could place much greater pressure on the companies to build profits instead.

Capital punishment

Some recap and release promoters argue recapitalization is critically important because the companies have a thin and shrinking capital cushion. Freddie Mac’s recent quarterly loss, for instance, has encouraged speculation that the GSEs will have to seek support from the Treasury again sooner or later.

But the companies’ swings in capital levels are being driven entirely by accounting treatment of the derivatives they hold against their assets.  The companies’ exposure to actual credit losses is minimal today, given the very high quality of their books.  Both companies are carrying significant amounts of credit insurance from mortgage insurers for lower down payment loans.  Freddie Mac reported loan loss reserves to back up their credit guarantees of $15.8 billion and Fannie $29.7 billion in their third quarter SEC reports. 

Most importantly, there is no economic consequence under conservatorship even if one or both falls below its required capital because of these accounting effects.  They would draw on the Treasury line of credit and issue more senior preferred stock.  Yes, there would be some political fallout and some in the press, punditocracy and Congress who would rant and rave about it.  But in the end there is no chance of swift congressional action or Presidential concurrence as a result. 

On the other hand, recapping and releasing the GSEs would create two new systemically important financial institutions. Investors and management could not operate the companies as they did before, with very thin capital levels and reliance on an implicit guarantee. The result – potentially still higher mortgage costs and less product flexibility.

A broad, liquid and stable market for long term fixed rate mortgage funding

Investors today see the Treasury capital pledge and take comfort from this “don’t ask, don’t tell” form of explicit guarantee.

Under recap and release, investors might go back to assuming the “implicit guarantee” applies again and treat GSE MBS as they did before.  But they might not do so with the same appetite or same requirements, especially if Treasury withdraws its current credit line.  It’s possible the market for these bonds would shrink, raising costs further.  Lower volumes mean less liquidity and higher prices.  Without a blanket guarantee on the securities, investors might demand higher credit standards to further insulate themselves from credit losses. This would restrict the range of borrowers the system could serve. Bonds might be less liquid because they would no longer be a homogenous commodity.  Smaller volumes would further affect pricing, raising consumer costs.

The TBA market that enables borrowers to choose long term fixed rate loans and to get rate locks well in advance of their loan closing depends on the homogeneity of guaranteed bonds.  Under recap and release this market could shrink  or operate with much less efficiency if the bonds carry no explicit guarantee and  investors seek more granular information on the mortgage assets themselves to hedge a perceived risk with an implicit guarantee.  

Some recap and release advocates argue that investors will come back and nothing will change.  They might be right.  But they haven’t made a persuasive case that service to low and moderate income borrowers would be enhanced by recap and release. The rules for investors are pretty clear today and the market is functioning to attract and distribute housing capital. 

An explicit federal guarantee that Fannie and Freddie would pay for, another option some recap and release advocates mention, is only possible if Congress authorizes it.  Of course the chances of Congress doing so and the Obama Administration concurring without enacting further more radical changes to the pre-crisis structure are zero.

Comprehensive Reform

The burden of proving that recap and release will not raise costs to consumers and jeopardize the mortgage finance system’s current benefits is on those calling for it.  They haven’t yet.  For example, the National Community Reinvestment Coalition (NCRC) this week posted a white paper laying out their case for recap and release.  It is long on defending the importance of home ownership and the need for affordable mortgage credit, sentiments many of us share.  But it doesn’t explain how recap and release would actually work.  It does give a nod to the need for more comprehensive reform – under the heading “Continuing GSE Reform” it notes,

“Congress should also reform the government guarantee so as to ensure that the secondary market remains liquid and deep, credit remains affordable for low- and moderate-income borrowers and investment remains robust for their MBS.” (Emphasis added)

At the Nov. 11 press call, Center for Responsible Lending (CRL) President Mike Calhoun noted the need to

“…support the housing market and the entire economy, by strengthening broad access to all sustainable homebuyers and all responsible lenders, improving fair lending, and properly structuring and incentivizing the GSEs.” (Emphasis added)

Recap and release advances neither of these important goals.  How doing so will be easier after Fannie and Freddie are back on their feet is isn’t explained.  Why it is even necessary, after making the case for recap and release, is not either. 

As it happens, there already is a remarkable consensus on how to sustain the market outcomes that matter and fix the system’s pre-crisis aspects that have long been a challenge.   Financial services trade groups, consumer advocates, academics and the Bipartisan Policy Center’s housing commission all have recommended a system where the US government provides an explicit worst case guarantee on mortgage backed securities that meet its standards and that is paid for by a fee on the securities.  Private entities would provide the primary credit insurance ahead of this catastrophic government guarantee, and they would be required to meet government requirements for capital and other critical features. The government guarantee would not protect their shareholders or creditors.  Critically, most of these plans agree on the need for an obligation to serve the full range of credit worthy borrowers or lose access to the government’s support for their bonds.

While all of these plans envision Fannie Mae and Freddie Mac ceasing to exist as they are currently chartered, most of them also see a likely role for them as restructured companies participating with other competitors to provide the first layer of credit insurance and issue securities backed by the US guarantee.  These plans would make only a few, but critical, changes to the system that existed pre-conservatorship, including converting the implicit guarantee of the companies to an explicit guarantee of the securities alone.

Some critics keep insisting that all reform plans promote the winding down of Fannie and Freddie without any adequate replacement.  But this is just not true for the consensus proposals, including the Johnson-Crapo legislation from 2014.  Instead they seek to keep what works and reform what should be fixed.

On the other hand, recap and release might well undermine the very system some of its advocates promote.  And once that happens, rebuilding becomes immeasurably harder. 

Strange bedfellows

Hedge fund investors and speculators in the companies’ outstanding stock have an obvious interest in seeing recap and release.  They have no long-term stake in whether the system serves American households.  They made a bet buying cheap and they want a chance to sell dear as share prices spike through re-privatization.  It’s legal and they have a right to promote their own interests. 

It’s less clear why some affordable housing advocates are embracing their arguments.  For better or worse, conservatorship assures  clear government sponsorship; a very large standby line of credit from the Treasury  that reassures investors; the 2008 affordable housing provisions with housing goals and new “duty to serve” requirements; a robust TBA market that continues to deliver liquidity and funding for long term fixed rate mortgages; and the time to develop workable, durable solutions that will reset the mortgage finance system in a robust way when the stars align to do so. 

The frustration with the stalemate around comprehensive reform that underlies these calls is widely shared.  But foregoing real reform that addresses affordable housing needs as well as the structural shortcomings of the pre-crisis GSE structure isn’t the answer.  It’s time for everyone in the affordable housing community to reground their advocacy in the things that matter in this debate – preservation of long term fixed rate financing; a deep and liquid mortgage finance market; and broad access to sustainable credit.  Recap and release would be very good for Wall Street, but not for Main Street.