Years After Crisis, Housing Finance System Still in Need of Reform

As we inch closer to the seventh anniversary of the government’s conservatorship of Fannie Mae and Freddie Mac, it is easy to be lulled into a false sense of complacency about the state of our nation’s housing finance system.

After all, Fannie and Freddie are now turning a profit. Their cumulative payments to the Treasury Department while under conservatorship exceed the $187.5 billion drawn from Treasury to keep them financially afloat. It appears that an element of stability has returned to the mortgage market.

Not so fast says a recent report by the Federal Housing Finance Agency’s (FHFA) Office of Inspector General (OIG), which offers a sobering reminder that our nation’s housing finance system continues to operate on an unsustainable foundation.

While the current financial condition of Fannie Mae and Freddie Mac may look positive, the OIG report tells us that the two institutions face some very real challenges:

• Fannie and Freddie are required by law to reduce the size of their retained investment portfolios, their largest source of past earnings. As a result, these portfolios cannot serve as the basis for long-term profitability.
• In 2013, 60 percent of the net income of Fannie and Freddie came from tax-related items and large settlements of legal actions and business disputes rather than from earnings generated by their core businesses. These tax-related items and settlements are “non-recurring,” meaning they cannot be relied upon as future sources of income. In addition, earnings from the GSEs’ core business segments comprised only 55% of net income in 2014.
• Fannie and Freddie are unable to build a financial cushion to protect against future losses. The two institutions are required to pay Treasury a quarterly dividend equal to the excess of their net worth over a specified capital reserve amount. This reserve amount will decrease to zero by January 1, 2018.

The bottom line: If there is a significant downturn in the housing market, it is conceivable that the two GSEs will require another drawdown of taxpayer dollars.

In the absence of Congress providing a legislative solution, the center of gravity for reform has now shifted to FHFA and to Fannie and Freddie themselves.

Consistent with the goal of encouraging more risk-bearing private capital in the mortgage market, the two GSEs are entering their second year of selling a portion of their credit risk to private market participants. Fannie and Freddie have also undertaken other forms of risk transfers that include reinsurance contracts and recourse agreements.

Greater risk-sharing between the GSEs and the private sector is critical to reducing taxpayer exposure and introducing some market discipline into the mortgage system. Let’s hope these efforts continue and expand. As Treasury Department official Michael Stegman explained this past March: “Such credit risk transfer activities serve to field-test the role of government as a guarantor of catastrophic risk while private capital bears the risk of the majority of potential losses.”

FHFA and the GSEs are also making progress on developing a Common Securitization Platform that will modernize the current securitization infrastructure and improve market liquidity and efficiency. Going forward, it will be critical for this platform to have an open architecture that is fully accessible to private participants in the secondary mortgage market.

While these administrative actions are laudable and necessary, they essentially amount to ad hoc applications of battlefield medicine. As the BPC Housing Commission emphasized in its 2013 report, it is ultimately the responsibility of Congress to develop the blueprint for our nation’s housing finance system and to define the role that the two GSEs will—or will not—play in that new reformed system.

That’s why we are heartened by the thoughtful reform proposal that Representatives John Carney (D-DE), John Delaney (D-MD), and Jim Himes (D-CT) recently reintroduced. Their constructive effort builds on the work of Senators Tim Johnson (D-SD), Mike Crapo (R-ID), Bob Corker (R-TN), and Mark Warner (D-VA), who led the reform charge last year and were able to report a bipartisan bill successfully out of the Senate Banking Committee.

Under today’s government-dominated mortgage system, the taxpayers bear unacceptable levels of risk. At the same time, large segments of the U.S. population are excluded altogether from the mortgage market as access to credit has narrowed considerably. A cloud of uncertainty hangs over the entire system.

The American people deserve better. Ultimately, it will be up to Congress, working with the current or a future administration, to show the way forward.