December 15, 2015

Joshua Rosner
646/652-6207
jrosner@graham-fisher.com
@joshrosner

EXECUTIVE SUMMARY
GSE Reform: Something Old, Something New, And Something Borrowed
Seven years after a financial crisis that was precipitated largely by a dysfunctional
housing finance system, it is ironic that reform of the mortgage finance institutions
commonly known as Fannie Mae and Freddie Mac remains an unfinished task for
policymakers, especially since the elements of reform have been available to
policymakers the whole time.
Hindsight is 20-20 but it also improves foresight. The last seven years of study, analysis,
and debate have shown that the best way to serve the public interest is to recapitalize
Fannie Mae and Freddie Mac and make certain they perform their historic mission as
countercyclical sources of capital and stability in the home finance market. They should
have more stringent capital requirements and be regulated more like public utilities. This
paper explains that a complete reinvention of the proverbial wheel would be both
unnecessary and detrimental to the housing finance system and individual citizens.
The government-owned Federal National Mortgage Corporation was established in 1938
in response to the collapse of banking and home prices. Its mission was to provide
liquidity and stability in the housing finance market. Though government-sponsored, this
model ensured that mortgage risks were transferred into the hands of investors rather than
remaining on the governments balance sheet. In 1968 Fannie Mae was transformed into
a publicly-traded and privately-owned firm. In 1970, Freddie Mac was created to expand
the secondary market.
These Government Sponsored Enterprises (GSEs) continued to fulfill their roles with
little controversy or politicization until 1989, when hundreds of savings and loan
institutions failed and the GSEs teetered on the brink of insolvency. This prompted the
first comprehensive Congressional review of the regulation of Fannie and Freddie in 30
years and led to the enactment of laws we now know were poorly conceived. Congress
created a split-regulatory framework and dual mission that was increasingly subject to
political goals but with diminishing or muddled regulatory scrutiny. Fannie and Freddie
became vehicles for advancing social policy objectives of access to affordable housing at
the same time safety and soundness standards were weakened.
Through the 1990s and early 2000s, the Clinton and Bush Administrations used the GSEs
to increase homeownership. However worthy the goal, the American Dream became a
more leveraged experience. This dynamic was compounded in 2002 when a relatively
arcane move by an international regulator most Americans have never heard of
effectively opened the floodgates for new capital to rush into the private label

Please refer to important disclosures at the end of this report.

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securitization market. The Basel Committee of the Bank of International Settlements

lowered the capital risk-weightings of a whole range of securities. This created new
income opportunities for large banks, ratings agencies and investment banks. Before
long, a variety of risky new products, and the possibilities of high, short-term yields
started to add more leveraged risk to the market, to borrowers and to financial stability.
In this fluid new arena, the management of the GSEs sought to maximize returns to
shareholders while fulfilling the GSEs social policy mission to expand homeownership.
Inadequate regulatory oversight, weak capital requirements, an implied government
guarantee and the GSEs low cost of capital relative to that of other private market
players encouraged them to use of their portfolios to generate highly leveraged returns.
By 2007, it was clear a bubble was about to explode and Fannie and Freddie seemed to be
headed for insolvency.
The following year, with markets in free fall, Congress passed the Housing and
Economic Recovery Act. HERA created the Federal Housing Finance Agency and placed
the GSEs into conservatorship under the FHFAs authority. The new law provided for a
short-term conservatorship to get the GSEs back on their feet and to conserve and
preserve their assets. Importantly, HERA also provided the FHFA with the mandate to
design and implement almost all of the regulatory reforms that this paper recommends.
Unfortunately, the law was not followed but instead undermined. Since 2012, as part of
an apparent strategy to wind the GSEs down and eventually replace them, the U.S.
Treasury Department has swept the GSEs revenues into the government coffers. To date,
Fannie and Freddie have paid the Treasury $239 billion, roughly $50 billion more than
the funds the GSEs received from Treasury.
In the last few years, numerous legislative proposals have been put forward. Generally
speaking, these would dismantle the current system and create a new structure with some
of the worst elements of the pre-HERA GSEs or propose a risky alternative to replace
them. Reform proposals rest on a number of myths.
One myth is that private capital can replace what Fannie and Freddie provide. To replace
the GSEs and attract enough private capital to insure only the top 10% of their $5 trillion
mortgage credit book of business, the industry would need to attract close to $500 billion
of capital. However, from the start of 2014 through April 2015, the private capital
investment in agency first-loss deals was only $13.1 billion and available only for the
crme de la crme of cherry-picked loans. The private mortgage insurance industry, in
particular, is still reeling from inadequate capital standards and poor state regulation
leading up to the 2008 crisis and there is simply not enough capital among the remaining
players in the industry. If there is not enough private capital available to support the
market in good times it is hard to see how there would be enough capital outside the
GSEs to support the markets in a highly possible housing crisis in the future.

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Another myth is that Fannie and Freddie need competition. This would make sense if the
GSEs had used their duopoly power to take advantage of consumers or distort prices.
In fact, the GSEs, when functioning as intended, have a function akin to a utility. They
perform an essential public service that other entities cannot or will not perform. The
GSEs, when properly capitalized and regulated, act as countercyclical providers of capital
when the primary-market private funding sources evaporate in the face of economic
downturns. This activity would not be enhanced by trying to create alternative providers
of capital.
In fact, the answer to fixing the nations housing finance system begins with HERA and
the path that it has already established for recapitalization of Fannie and Freddie.
Considering that the GSEs have more than paid back the $187-billion cash infusion of
2008, even without raising any private capital, and without even counting the value of
warrants for 79.9 percent of the GSEs common stock or the Preferred Stock Purchase
Agreements (PSPA) the government holds, the GSEs could amass $ 150-$200 billion in
capital over 10 years. If they were to issue additional stock for purchase or assume the
value of the outstanding warrants, rebuilding adequate capital buffers could take even
less time.
The recapitalized entities should also be regulated in a manner consistent with their size
and reach in the financial marketplace. With current portfolios of roughly $5 trillion,
they epitomize the concept of Too Big to Fail. The GSEs also have an important creditrisk pricing function. Accordingly, this paper explains why the Federal Stability
Oversight Council (FSOC) established in the Dodd-Frank Act along with the Federal
Reserve would be appropriate backup regulatory entities to FHFA to reduce systemic
risk. These regulators would better support the mission of the GSEs, as originally
intended, to act as liquidity tools for the funding of new mortgages rather than as risk
transfer mechanisms.
In terms of the appropriate capital requirements for the GSEs, the Basel III framework,
largely adopted by the U.S. government in 2013 for the nations largest banks, serves as a
useful model. This paper presents various capital requirement models and recommends
capital levels of three to five percent.
In addition, the government backstop role would be clearer and more narrowly tailored.
Stringent capital standards that incorporate security level requirements, real transfer of
first-loss and stringent capital standards for private mortgage insurers or other first-loss
holders, should give the public comfort that an explicit government guarantee is unlikely
to ever be employed. But this government guarantee would also serve the historic
purpose of maintaining liquidity and stability in the mortgage marketplace.
As noted, this historic and prospective role for the GSEs is akin to a public utility.
Therefore, once FHFA exercises the authority already provided for in HERA to

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recapitalize the GSEs and undertake other reforms recommended in this paper, Congress
should create a de facto public utility commission for the GSEs. Like any PUC, it would
be responsible for determining the activities, cost recoveries, guarantee pricing and
allowable rates of return for Fannie and Freddie.
In summary, it is no surprise that antipathy toward Fannie and Freddie grew broader and
more intense the more policymakers deliberately or inadvertently tampered with their
original roles as countercyclical providers of liquidity in the mortgage market. Instead of
trying to create an entirely new model, it would be wiser for FHFA to restore the original
public utility-like concept for Fannie and Freddie with the powers provided by HERA
and with appropriate capitalization requirements and regulatory reforms. This would
serve the interests of capital markets, aspiring homeowners and taxpayers for years to
come.

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