The clock has effectively run out for FHFA Director Calabria to release Fannie Mae and Freddie Mac from their 12-year captivity under conservatorship following the great financial crisis. The incoming Biden administration has an opportunity now to reshape the housing finance system for the long term by taking the next logical step in the evolution of the GSEs by combining both entities into one housing finance market utility.
Under conservatorship, major aspects of the GSEs’ businesses, processes and pricing are scrutinized and approved by the FHFA, making this market a de facto regulated duopoly. For years, much of the debate over the final disposition of the GSEs centered on the systemic risk these housing finance behemoths posed to taxpayers.
Some early proposals called for a more competitive market where more than two credit guarantors operated. The fundamental problem with any scenario where more than one credit guarantor exists is that they amplify rather than dampen systemic risk. That is because the mortgage banking cycle is volatile, the firms are singularly dependent on the performance of the mortgage business and these two attributes promote cutthroat competition that in its worst form manifests in a financial crisis.
The GSEs compete on price, product, or service. Due to charter limits and credit policy, GSE-eligible mortgages are homogeneous, providing little room for product differentiation other than through changes in key risk attributes such as credit score, loan-to-value or debt-to-income ratio or loan documentation, among others.
During the mortgage boom, as large originators marketed their own versions of Alt-A and subprime mortgage securities under their own label, they cut into GSE market share, which led to such highly risk-layered GSE products as expanded approval loans. Further, the largest originators imposed enormous pressure on the GSEs to reduce guarantee fees in return for market share that undercut pricing for credit risk during that period.
On the service dimension, the Fannie Mae and Freddie Mac compete to deliver highly automated underwriting and collateral valuation services, some of which I used and developed during my tenure at both GSEs, that would come to dominate the secondary market by vastly improving mortgage process efficiency while also managing risk.
These tools, along with GSE mortgages shaped in part by the Qualified Mortgage rule, have become largely commoditized, leaving any real competition by the GSEs nibbling around the edges of product or service.
That then leaves price, or the guarantee fees and adverse market delivery fees charged by the GSEs as a competitive lever. And that too has effectively been nullified by the FHFA’s tight management of that part of the GSEs’ single-family business.
Recognizing the benefits to the secondary market from the implementation of the Common Security Platform, another differentiator between the GSEs was removed by the FHFA. No longer do Fannie Mae or Freddie Mac issue their own versions of MBS as they had done for decades, but rather a universal mortgage-backed security is now issued by each company.
Taking this commonality theme further, both GSEs maintain three virtually identical business lines for single family, multifamily and capital markets. And their credit risk transfer (CRT) initiatives mirror each other.
We then must ask: Why do we need two carbon copies of these firms?
The conservatorship period has proven that a strong regulatory presence can maintain market discipline, manage risk, and provide required stability and liquidity to mortgage markets while maintaining profitability of each entity. Recapitalizing and releasing the GSEs is a potentially viable option under certain strict conditions. These conditions require a strong, capable, and vigilant regulator augmented with tough risk-based capital standards.
But in the end, this scenario would pose greater systemic risk than a regulated monopoly as competition under a model with less regulatory reach would eventually lead to extra-normal risk-taking under the right market conditions.
Some will contend that a monopoly is inherently inefficient, stifles innovation and could put mortgage originators at a disadvantage. The counter argument here is that with the commoditization of GSE mortgages, innovation is not as critical as it would be in other industries such as technology.
Moreover, the GSEs in their current form are not exactly paragons of efficiency. Any purported anti-competitive effects of a monopoly are removed with a regulator charged with overseeing and approving of GSE pricing.
Lastly, for the regulated monopoly model to work, the primary objectives of the regulator would be to maintain stability and liquidity of housing finance, as well as actuarial fair guarantee fees plus a reasonable return to monopoly shareholders. Conversely, affordable housing objectives would not be the purview of the regulator under this model for this model to function effectively.
Combining the two GSEs into a single housing finance market utility achieves the objectives that have long been sought after since both companies were created. After all, let us not forget that for years Fannie Mae operated without its smaller sister, and even when Freddie Mac did come along, the GSEs’ market focus was segmented between banks and thrifts for a long time.
The FHFA has proven that it can modulate GSE pricing to conform with changes in the credit profile of GSE mortgages and could continue to do so with the agencies as one private company, recapitalized and set free over time subject to similar regulatory oversight as is in place today.
The GSEs have served an invaluable service over the years as stabilizing forces that brought down the cost of homeownership in America. The next stage in their evolution is within reach to ensure that legacy while protecting taxpayers.
This column does not necessarily reflect the opinion of HousingWire’s editorial department and its owners.
To contact the author of this story:
Clifford Rossi at crossi@umd.edu
To contact the editor responsible for this story:
Sarah Wheeler at swheeler@housingwire.com
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