February 1, 2019

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

GSE Reform – Truths, Myths and Powers

Executive Summary
Today, Senate Banking Committee Chairman Crapo (R-ID) put forward a proposal which
seeks to use Ginnie Mae as a platform for the securitization of agency guaranteed
mortgages. This is not a new concept but is unworkable. Aside from all of the technical
problems this approach would pose, it would primarily benefit Wells Fargo and a small
number of SIFI banks and it runs contrary to the core philosophy once enunciated by
National Economic Council Director Dr. Lawrence Kudlow:
“Adding authority to offer a GNMA-type security program. This would
enable [GSEs] to substantially expand [their] operations while still
closely linked to the Federal Government. By putting the [GSEs] stamp on
mortgage pool securities, a new wave of Federally-sponsored debt will be
created. Crowding out would become a more serious problem, with
interest rate consequences that will affect both housing and non-housing
investment. There would be no legal or practical limit to the GNMA-type
guarantee program. Assuming a considerable volume of these new debt
instruments, an enormous contingent liability will be created against the
[GSEs] balance sheet[s], and, indirectly, the Federal government.”1

Over the past several weeks there has been a good deal of speculation about the Trump
Administration’s intentions regarding the future state of the GSEs and the likely path that
Mark Calabria will pursue if he is confirmed as the Director of the Federal Housing
Finance Agency. Much of this speculation has been driven by commentators who have
demonstrated a lack of understanding of over 30-years of GSE policy discussions and

1
Hearing before the Subcommittee on Housing and Urban Affairs of the Committee on Banking, Housing,
and Urban Affairs, United States Senate. “On proposed changes in the charter of the Federal National
Mortgage Association, (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac)”, May 5,
1983.

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

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who have failed to place their assumptions within the context of what is possible under
Housing and Economic Recovery Act of 2008 (HERA). Below, we provide our
expectations of the path the Administration seems likely to pursue as well as some
historical context in support of those views.

It is worth noting that we believe these reforms cannot be considered in isolation and that
we expect they will pursue further changes, in coordination with other regulators, that
will address parts of the mortgage finance and housing landscape which are outside of the
GSEs. We expect the Administration will seek to make further adjustments to the QM
rule. Further, we expect the Administration will seek to encourage banks to view their
held portfolios as an alternative to, and competition with, the sale of loans to the GSEs.
To that end, there will likely be efforts to reduce or eliminate the financial arbitrages
which create incentives for the largest banks to sell loans into securitizations rather than
hold them in their portfolios.

Table of Contents:
1. What Should We expect? p.1-4
2. A Changing Approach to Legislation p.6-7
3. Legislative Recommendations p.7-8
4. Why Is This What We Expect p.9
5. False Myth #1 – “We Risk Going Back to the Pre-Crisis GSEs” p.9-10
6. False Myth #2 – “Trump Will Kill Affordable Housing” p.10-11
7. False Myth #3 – “The Purpose of GSE Reform Is to Enrich Fat Cats” p.11-12
8. False Myth #4 – “Receivership Is the Only Allowable Path Forward” p.12-13
9. False Myth #5 – “Only Congress can Release the GSEs” p.13
10. False Myth #6 – “Treasury will decide the Path Forward” p.13-14
11. A Little History:
a. Dr. Lawrence Kudlow and the Reagan Years p.14-18
i. Safety and Soundness
ii. Eventual privatization
iii. Reducing special benefits
iv. Shrinking the Government’s footprint
b. The Battles of 1999-2007 p.18-20
c. What HERA has Accomplished p.20-22

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What Should We Expect?

For more than a decade, Fannie Mae and Freddie Mac have been held in a seemingly
perpetual Conservatorship and, since 2012, they have been prevented from retaining
capital. These actions have been in opposition to the clear Congressional intent in HERA
which sought to “enable the regulated entity to become adequately capitalized within a
reasonable time”2. As a result, the two largest financial institutions in the USA remain
dangerously undercapitalized as a result of the actions of many of the same commentators
who had previously served in the Obama Administration and enacted policies to ensure
that the GSEs remain undercapitalized and that the public remains at economic risk as a
result.

As a result, we expect that the Trump Administration will soon reverse the Third
Amendment to the Preferred Stock Purchase Agreements and will direct the GSEs to
begin to retain earnings with the goal of building to the statutory minimum capital
levels.3 Since it could take several years for the GSEs to satisfy these capital
requirements, we expect that, at some time, there will be a public offering of new equity
for the purpose of accelerating the end of the GSE’s conservatorships.

While many of the aforementioned critics will argue the GSEs should not be released
from conservatorship, HERA requires the FHFA to determine if the GSEs can become
adequately capitalized in a “reasonable” period and, if it is determined they are able to
become so capitalized, to begin the process of rehabilitation with the goal of ending the
conservatorships. Such action is strict conformance with the intent of HERA. As a result,

2
HERA, SEC. 1143. SUPERVISORY ACTIONS APPLICABLE TO UNDERCAPITALIZED
REGULATED ENTITIES.
3
SEC. 1111. MINIMUM CAPITAL LEVELS - (transferred from Sec. 1362 of the 1992 Act) The
minimum capital level for each enterprise shall be the sum of - (1) 2.50 percent of the aggregate on-balance
sheet assets of the enterprise (2) 0.45 percent of the unpaid principal balance of outstanding mortgage-
backed securities and (3) 0.45 percent of other off-balance sheet obligations of the enterprise (excluding
commitments in excess of 50 percent of the average dollar amount of the commitments outstanding each
quarter over the preceding 4 quarters).

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it appears logical that the GSEs will soon be required to deliver to FHFA their capital
restoration plans.4

Because it would be near impossible to raise new equity capital while the enterprises are
in conservatorship, due to the uncertain rights that new equity holders would have over
companies in conservatorship, we believe that the conservatorships would likely end
upon the completion of such offering for each GSE. To further protect the public during
this transition the FHFA could exercise its authorities to issue regulations that define a
temporary increases in the minimum capital requirements5 and the regulator has the
authority to enter into a consent decree that further limits the GSEs activities even as
publicly held companies.

While many observers believe that the conservatorships could not end until the GSEs
meet regulatory, rather than statutory, capital requirements, it is important to note that
capital adequacy at the GSEs has always been based on the statutory capital requirements
and conservatorship is not required for a failure to meet regulatory capital requirements.
HERA grants the FHFA Director broad authority to address the capital structures of the

4
SEC. 1143. SUPERVISORY ACTIONS APPLICABLE TO UNDERCAPITALIZED REGULATED
ENTITIES: “An undercapitalized regulated entity shall not permit its average total assets during any
calendar quarter to exceed its average total assets during the preceding calendar quarter, unless— (A)
the Director has accepted the capital restoration plan of the regulated entity; (B) any increase in total
assets is consistent with the capital restoration plan; and (C) the ratio of tangible equity to assets of the
regulated entity increases during the calendar quarter at a rate sufficient to enable the regulated
entity to become adequately capitalized within a reasonable time.”
5
Sec. 1111. Minimum Capital Levels: “…the Director may, by order, increase the minimum capital level
for a regulated entity on a temporary basis, when the Director determines that such an increase is
necessary and consistent with the prudential regulation and the safe and sound operations of a regulated
entity… REGULATIONS REQUIRED.—The Director shall issue regulations establishing— (A)
standards for the imposition of a temporary increase in minimum capital…”
“AUTHORITY TO ESTABLISH ADDITIONAL CAPITAL AND RESERVE REQUIREMENTS
FOR PARTICULAR PURPOSES.—The Director may, at any time by order or regulation, establish such
capital or reserve requirements with respect to any product or activity of a regulated entity, as the Director
considers appropriate to ensure that the regulated entity operates in a safe and sound manner, with
sufficient capital and reserves to support the risks that arise in the operations and management of the
regulated entity.”

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GSEs.6 Given the likely intent of the FHFA to quickly begin the process of creating a
roadmap to ending the conservatorships it is reasonable to assume they will either
propose a new regulatory capital rule in the coming months or move forward with the
already proposed rule offered by former Director Watt.

With an end to conservatorships in mind, we believe that the Treasury will probably
begin to charge the GSEs a commitment fee of between 10-35bps on the outstanding
Treasury lines of financial support. This pricing would be akin to the pricing that the
FDIC charges on deposit insurance and would represent a very remote, but funded, line
of credit behind prudent levels of capital the GSEs will be required to retain. While we
have no reason to expect this to be proposed anytime soon it seems fair to consider that,
after the GSEs have demonstrated their ability to function without dislocation is the
mortgage market, the Treasury could eventually propose requiring the GSEs to replace
those lines of backstop financing with company-level private-market reinsurance
contracts. Again, we don’t expect this proposal to be forthcoming in the near-term
because, at least during a transition period, the Administration would probably want to
gauge how newly-private GSEs are viewed by investors.

While the FHFA will probably begin to take those administrative actions required by
HERA, many of which have not been implemented over the past decade, we also believe
they will work with legislators toward a goal of further legislative changes that strengthen
the safety and soundness regimes of the GSEs and reduce their special ties to the
Government. While “full” privatization of the GSEs will likely be ultimate goal of the
Trump Administration it is important to offer a quick point on that issue. The goal of full

6
SEC. 1142. CAPITAL CLASSIFICATIONS: “…the Director may permit a regulated entity, to the extent
appropriate or applicable, to repurchase, redeem, retire, or otherwise acquire shares or ownership
interests if the repurchase, redemption, retirement, or other acquisition— (A) is made in connection
with the issuance of additional shares or obligations of the regulated entity in at least an equivalent
amount; and (B) will reduce the financial obligations of the regulated entity or otherwise improve the
financial condition of the entity.’’

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privatization of the GSEs would be to reduce the implied government guarantee and
special privileges the GSEs receive relative to other regulated financial entities. But
privatization does not mean the GSEs will not be required to fulfill a public purpose.
Remember, all federally chartered banks are considered federal instrumentalities and, as
such, they have accepted that certain regulatory and policy requirements can be foisted
upon them in return for their charters. The goal is not to reduce the public mission of
these chartered firms but to ensure that, as private risk-taking entities, they do not
transmit their reputational and financial risks back to the government.

This approach is in stark contrast to the approach of the former FHFA Acting Director
DeMarco, former Director Watt and the Obama Administration. Both of those former
Directors, and the Obama Administration, held out on implementing the full requirements
of HERA in hope of passage of new legislation that would eviscerate the existing statute.
Instead the new FHFA Director is likely to begin the process of implementing the
unfulfilled requirements, the Trump Administration to work with Congress to further
tighten elements of HERA and both will seek to reduce those ties between the GSEs and
the government that can be reduced without causing significant market disruption.

A Changing Approach to Legislation

It is important to remember that the legislative changes which these parties sought
through Corker-Warner, Crapo-Johnson and legislative proposals by Jeb Hensarling were
intended to dismantle the GSEs and replace them with an entirely new system in which
the largest banks would have had outsized influence over the secondary mortgage market.
If, instead, this Administration focuses on ensuring the safety and soundness of the GSEs
and reducing the risks they pose to the public, it will be unnecessary for future legislation
to be a wholesale replacement of HERA. Instead that legislation would necessarily be
more-narrow and less systemically disruptive. As a result it would be easier to build
consensus, and hardwire into law, items that are currently left to the discretion of a

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politically appointed regulator who is able to ease or tighten oversight in response to

political pressures.

Legislative Recommendations
Given our view of the distinctly different approach this Administration is likely to pursue,
it appears obvious they will not support the idea of legislation which places an explicit
government guarantee behind agency issued mortgage-backed securities and that they
would not likely support the notion of allowing primary market originators to directly
access a common securitization platform. Both of these items would only increase the
government’s footprint in housing and this Administration is certain to prefer private-
market participants to take on a larger percentage of the mortgage market and its risks.

We also believe it is likely that the Administration will seek to repeal the exemptions
from registration of their debt securities which the GSEs currently enjoy. Such a decision
would be intended to further level the playing field between the GSEs and other market
participants. Toward that goal it seems reasonable to believe the Administration would
support legislation that allows the FHFA to charter new GSEs if those new applicants
meet all of the requirements to which Fannie and Freddie are held. To further clarify this,
one should think of it as being similar to the ability of other financial regulators to charter
new banks and insurance companies.

Aside from these obvious legislative recommendations there will be more discrete
changes one could expect the Administration to support. Many of these changes could
seek to enhance the legal authorities which the FHFA already has. These could include
language that explicitly directs FHFA to require that the GSEs reduce their portfolios so
that those portfolios only serve liquidity purposes and cannot be used to take on
investment risks. Similarly, while FHFA already has the authority to do so, we believe
the Administration may seek legislation which provides the FHFA with express authority

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to issue standards regarding the requirements of acceptable credit risk transfer products
(CRT).

To further protect the safety and soundness of the financial system we believe that the
Administration also could propose legislative language that authorizes or directs the
FHFA to establish standards governing an allowable rate of return for the GSEs. With
significantly limited portfolios the GSEs would become little more than insurers who
pass-through risk into the capital markets. As a result, they would have no need for the
massive debt issuance they previously required, would be required to carry capital
sufficient to cover those insured assets and would, as a result, have rates of returns more
similar to utility companies than to the highly leveraged growth companies they were
between 1992 and the financial crisis.

With regulated rates of return, some portion of the income which the GSEs generate
above the allowable rate would be retained as capital and result in the GSEs being more
capable of serving as counter-cyclical providers of liquidity to the primary market in
times of economic weakness. The allowable rate of return could also account for the
funding of underserved markets and would therefore eliminate a repeat of the history in
which the GSEs argued that the more business they did the more support they could
provide for affordable housing. Further, limitations on the GSEs rate of returns would
result cause the GSEs to become dividend growth “granny stocks”. This would ensure
that they have a broader and more stable capital base than they did previously.

Lastly, the goals of HERA were to address five primary areas of concern about the prior
models of the GSEs. We expect the administration to, ultimately, propose legislative
language that further hardwires aspect of these five areas. The areas include: Capital;
Portfolio limits; Receivership/Conservatorship language that the Government cannot
abuse; Bright-line language defining the separation between the primary and secondary
markets and further authorities over new products and programs.

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Why Is This What We Expect?

Any consideration of the probable goals for GSE and mortgage market reform should be
considered through the lens of the original reasons for government support for a
secondary mortgage market.

When Fannie Mae, and its predecessor programs were created, during the Great
Depression, they were intended to serve two primary functions. The first function was to
ensure that borrowers who would be able to carry the obligations of a home mortgage
could access capital for that mortgage when banks and lenders were inclined to pull-back
from the market.

The second function, which is a necessary outcropping of the first, was to ensure that
during such economic periods banks could access the capital necessary to make loans and
could pass-on the risk of having to hold long-term assets on their balance sheets. In other
words, the goal was to ensure that there was a counter-cyclical liquidity buffer to support
economic activity. It is for this reason that a key goal of mortgage market reform should
be to ensure that not only can the GSEs not inch across the border into the primary
market but that primary market players cannot inch across the border into the secondary
market. Any failure to enforce these goals would jeopardize the ability of the secondary
market to act as a counter-cyclical buffer.

False Myth #1 – “We Risk Going Back to the Pre-Crisis GSEs”

It is worth noting that many of those interested party commentators have regularly
misconstrued or intentionally misstated what the Administration can, or is likely to, do
and have regularly espoused as fact that which can only be dismissed as myth. These
parties have perpetuated a false narrative that if we recapitalize Fannie Mae and Freddie
Mac, and begin the process of releasing them from Conservatorship without legislation,
we will go back to the pre-crisis period. This view is not only a self-serving

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rationalization for actions with violate the clear intent of HERA but ignores the
significant legislative changes advanced through HERA. These changes include:
- Replacing the split mission of the Office of Federal Housing Enterprise
Oversight and the Department of Housing and Urban Development with a
properly empowered Federal Housing Finance Agency (FHFA);
- Empowering the FHFA with the responsibility to create robust regulatory
capital requirements;
- Empowering the FHFA with the responsibility to significantly curtail the
GSEs use of their portfolios for pro-cyclical, risky and speculative investment
purpose;
- Empowering the FHFA with the ability to prevent the GSEs from introducing
new products or programs without prior public comment and regulatory
approval;
- Empowering the FHFA with authorities to ensure that the GSEs secondary-
market functions remain separate and distinct from primary market functions;
- Legislating a meaningful receivership regime; and
- Eliminating Presidential appointments to the GSE’s boards of directors.

False Myth #2 – “Trump Will Kill Affordable Housing”

Those who seek to stymie the reform efforts of the Administration have sought to
exacerbate fears that the White House, and the FHFA Director, will seek to destroy
affordable housing goals, the GSE’s duty to serve and the affordable housing trust funds.
But they offer no support, and in fact there can be no support, for this view.

While civil rights and affordable housing groups would clearly like to see a strengthening
of requirements affecting these issues there is no question that a baseline exists in law
and that cannot be eliminated by the Administration without legislation. Further, it is our
understanding that the relevant language in HERA was mostly negotiated between Mark
Calabria (Sen. Shelby (R-AL)) and Kara Stein (Sen. Reed (D-RI)).

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These issues are covered, in detail, in HERA:

- SEC. 1313. DUTIES AND AUTHORITIES OF DIRECTOR: “…the
operations and activities of each regulated entity foster liquid,
efficient, competitive, and resilient national housing finance markets
(including activities relating to mortgages on housing for low- and
moderate-income families involving a reasonable economic return
that may be less than the return earned on other activities)…”
- ‘‘SEC. 1331. ESTABLISHMENT OF HOUSING GOALS: “The
Director shall, by regulation, establish effective for 2010 and each
year thereafter, annual housing goals, with respect to the mortgage
purchases by the enterprises”
- SEC. 1332. SINGLE-FAMILY HOUSING GOALS
- SEC. 1333. MULTIFAMILY SPECIAL AFFORDABLE HOUSING
GOAL
- SEC. 1334. DISCRETIONARY ADJUSTMENT OF HOUSING
GOALS: “An enterprise may petition the Director in writing at any
time during a year to reduce the level of any goal… The Director
may reduce the level for a goal or subgoal pursuant to such a
petition only if— ‘‘(1) market and economic conditions or the
financial condition of the enterprise require such action; or (2) efforts
to meet the goal or subgoal would result in the constraint of liquidity,
over-investment in certain market segments, or other consequences
contrary to the intent of this subpart…”
- SEC. 1129. DUTY TO SERVE UNDERSERVED MARKETS: “To
increase the liquidity of mortgage investments and improve the
distribution of investment capital avail- able for mortgage financing
for underserved markets, each enterprise shall provide leadership to
the market in developing loan products and flexible underwriting
guidelines to facilitate a secondary market for mortgages for very
low-, low-, and moderate-income families with respect to the following
under- served markets…”
- SEC. 1131. AFFORDABLE HOUSING PROGRAMS
- SEC. 1337. AFFORDABLE HOUSING ALLOCATIONS
- SEC. 1338. HOUSING TRUST FUND
- SEC. 1339. CAPITAL MAGNET FUND

False Myth #3 – “The Purpose of GSE Reform Is to Enrich Fat Cats”

This is a popular meme that was originally created by the former chief executive of one
of the largest trade associations but it ignores important facts. The Government should do
the right thing for the nation and the mortgage systems without regard to whether

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unpopular constituencies may benefit. Therefore, it should be irrelevant who the

shareholders are.

The motivation to create this narrative was to support legislation which would have
replaced the GSEs with a system that benefits the largest mortgage lenders at the expense
of regional banks, credit unions, community banks, independent lenders, leading builders,
civil rights groups and affordable housing supporters.

While many in the press have perpetuated the “evil investors” meme they have often
ignored the clear public statements, published positions and concerns of important trade
and affordable housing groups - nearly all of which explicitly have noted that the GSEs
should begin to retain income and eventually be released from conservatorship in order to
avoid further economic harms and to reduce competitive disparities in mortgage-lending.

Further, the false narrative ignores that investors in the GSEs include current and former
employees of the GSEs’, pension investors and individuals. Conversely, the institutions
that have fought to replace the GSEs are several of the very same banks whose practices
were key drivers of the financial crisis and who now seek another area of consumer
lending growth to exploit – to the detriment of smaller firms and consumers.

False Myth #4 – “Receivership is the Only Allowable Path Forward”

Over the past several months there has been a rising chorus of commentators who have
argued that the GSE’s only path out of conservatorship is through receivership. This is
incorrect as a matter of law. There is little doubt that the GSEs could have been placed in
Receivership anytime between the time the GSEs were placed into Conservatorship
(2008) and the time their renewed profitability was in view (2012). Beyond the technical
hurdles that exist, including those that require FHFA to implement HERA’s capital
classification and reporting requirements, there is little economic justification for placing
the GSEs in Receivership:

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SEC. 1367. AUTHORITY OVER CRITICALLY

UNDERCAPITALIZED REGULATED ENTITIES: “…The grounds for
appointing conservator or receiver for any regulated entity under
paragraph (2) are as follows… there is no reasonable prospect for the
regulated entity to become adequately capitalized”

False Myth #5 – “Only Congress can Release the GSEs from Conservatorship”
Many of the same commentators and interested parties who have sought to replace the
GSEs’ secondary-market role have argued that the GSEs cannot be released from
conservatorship without congressional action. This is not correct.

While there is no dispute that Congress is free to pass legislation that would make
changes to the GSEs’ charters, functions or powers such changes are not required to
rehabilitate the GSEs or to release them from conservatorship. After all, Congress’ intent
was clearly stated in the 2008 HERA law. Among other clear statements, the law states:

False Myth #6 – Treasury will Decide the Path Forward

There is no question that the Obama Administration’s Treasury Department, under both
Secretary Geithner and Secretary Lew, regularly sought to direct or influence the actions
of the FHFA. As a matter of law, this was not only inappropriate but violated the clear
language of HERA.
SEC. 1367. AUTHORITY OVER CRITICALLY
UNDERCAPITALIZED REGULATED ENTITIES: “When acting as
conservator or receiver, the Agency shall not be subject to the direction or
supervision of any other agency of the United States or any State in the
exercise of the rights, powers, and privileges of the Agency… The Agency
may, as conservator, take such action as may be— ‘‘(i) necessary to put
the regulated entity in a sound and solvent condition; and (ii) appropriate
to carry on the business of the regulated entity and preserve and
conserve the assets and property of the regulated entity.”

Going forward, it is fair to consider that the FHFA will exercise its lawful authorities
under HERA. As a result, the proper role of the Department of Treasury will be to
negotiate with FHFA to ensure the public is treated fairly in regard to its investments in

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the GSEs. Currently, the Treasury holds warrants in, and senior preferred stock of, the
GSEs. In its 2013 Motion to Dismiss, before the Court of Federal Claims, the Treasury
stated that its role was not of “the Government” but, instead, “Treasury acted as the
United States in its commercial or proprietary capacity with respect to the Third
Amendment”.7 The Treasury further stated:
“When it chose to modify the Stock Purchase Agreements by executing the
Third Amendment (and indeed when it chose to invest in the Enterprises in
the first place), Treasury was merely a commercial actor.”

As a result, should the FHFA begin the process of releasing the GSEs from
conservatorship, we expect that Treasury will have a seat at the negotiating table that is
commensurate with its position in the capital waterfall of the GSEs and that investors in
other classes of securities will probably have seats at the negotiating table that are
proportional to their positions in the capital stack.

A Little History
To provide a bit more context on the modern history of mortgage market regulations and
proposals to reform the GSEs we will review a concise review of the key-elements in the
political landscape over the past three decades.

Dr. Lawrence Kudlow and the Reagan Years

During the early and mid 1980s the US housing market was beginning to recover from
economic crisis and weathering the early stages of the S&L crisis. Then as now, the
appropriate scope of federal housing policy was being actively discussed both in the
White House and on Capitol Hill. From 1981-1985, the current Director of President
Trump’s National Economic Council, Lawrence Kudlow, served as Associate Director
for Economics and Planning in Ronald Reagan’s Office of Management and Budget
(OMB). Given Director Kudlow’s clear views at that time, it seems worth reviewing
those views and placing them within the context of existing law (HERA) and within the

7
P.16 n.11.

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context of the current operations of the GSEs. Such a review may well inform policy-
makers, investors, private firms and the Government Sponsored Enterprises about the
likely direction of the Administration’s path forward.

During this period Congress proposed significant changes to the role of the GSEs.
Among these proposals were legislative proposals allowing the GSEs to invest in
commercial real estate (such as shopping centers and malls) and to eliminate the loan
limit requirements of the GSEs. The Reagan Administration rejected these proposals and
stated a clear preference for a two-step approach to GSE reform. The first step the
Administration proposed was to improve the oversight of the GSEs with the goal of
restoring them to well-capitalized, safe and sound operations and support the recovery of
primary-market players and their functioning.

The second-step the Reagan Administration sought was the ultimate privatization of the
GSEs. But, as the OMB’s Lawrence Kudlow then stated:
“At the present time for a variety of reasons, it seems clear that radical
changes in the relationship between the Federal government and the
Federally-sponsored agencies would be disruptive and undesirable.
Privatization will not occur overnight. However, with housing conditions
showing solid improvement, generating substantial new interest in the
financial side of the economy, it appears to be an appropriate moment to
develop a clear policy strategy for these agencies and to make progress
toward implementation.”8

However, towards the goal of eventual full-privatization of the GSE’s Dr. Kudlow made
clear:
“There are 11 special benefits and 6 Federal controls which firmly tie
FNMA to the Federal government. These special advantages and
privileges generate the strong Federal character that is associated with
FNMA and has led to the judgement of the financial markets that the

8
Hearing before the Subcommittee on Housing and Urban Affairs of the Committee on Banking, Housing,
and Urban Affairs, United States Senate. “On proposed changes in the charter of the Federal National
Mortgage Association, (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac)”, May 5,
1983.

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Federal government has a moral obligation to back the agencies'

commitments and operations. Among the most widely known and
significant of the special benefit items are: U.S. Treasury line of credit of
$2.25 billion; Eligibility of FNMA securities for open market purchases
and as collateral for Federal Reserve Bank advances and discounts;
Exemption from SEC registration and related accounting and disclosure
requirements; FNMA securities counted as legal investments for
Federally-supervised institutions; FNMA securities eligible to
collateralize public deposits, including Treasury tax and loan accounts,
and most state and local deposits; and Use of the Federal Reserve Banks
as fiscal agents…the Administration has no fixed or predetermined views
as to which of the special Federal characteristics should be reduced or
removed in order to supplement the group of 5 non-objectionable
amendments and create an expanded proposal that would be eligible for
Administration support. Instead, we recommend a consultative process to
discuss these and other related issues in the hope of gaining agreement for
an expanded proposal…It would also be useful to solicit views from the
public... Such adjustments must be given considerable study and
forethought so as not to disrupt the normal activities of the mortgage
markets or the operations of the agencies themselves.”9

Then, as now, market participants sought to expand the footprint of the Government’s
commitment to housing in ways that would benefit those participants at the expense of
the stability of the Government. Associate Director stated a clear opposition to that
approach:
“The avalanche of new Federal and Federally-sponsored debt issues
continuously offered to the market will keep interest rates higher than
would otherwise be the case, forcing all private firms to shoulder more
expensive financing costs and in many cases crowding out unsubsidized
private borrowers who cannot absorb the higher interest expense…In
recent years the rapid expansion of Federal and Federally-assisted
borrowing in all areas -- direct loans, loan guarantees and government-
sponsored agency debt -- has generated a number of seriously adverse
economic and financial consequences. As a result, this Administration has
consistently sought to implement a Federal credit policy of reduction, not
expansion.”10

9
Ibid.
10
Ibid.

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As a result of Dr. Kudlow’s stated views, we do not believe the Trump Administration
will support providing a new federal backstop behind private mortgage backed securities.
Similarly, we do not expect the Administration to support expanding access to the CSP so
that other firms can issue MBS with a government backstop. Instead, we believe that the
Administration will seek to reduce the ties between the GSEs and the government and
will try to foster an environment in which primary market players provide a larger role in
normal economic environments and the GSEs stand ready to fulfill their counter-cyclical
role in weak economic periods.
“On the… point of adding authority to offer a [GSE]-type security
program, we think this too would be unwarranted expansion. We would
have a tremendous new wave of debt securities with the [GSE] stamp.
Again this would exacerbate the borrowing problem and the crowding
out problem. Suddenly all kinds-indeed maybe all-secondary mortgage
market paper would become [GSE] paper. It would also generate a new
increase in the contingent liabilities of the [GSE’s] balance sheet[s] and
indirectly the Federal Government.”11

To be clear, readers should not assume that Dr. Kudlow’s views are dogmatic or that he
sees no role for the GSEs in a robust housing market. Indeed, his positions clearly
acknowledged the importance of the GSEs:
“Now,…insofar as the credit for the housing area, which is vitally
important, it's not obvious to me that this credit has to be absorbed or run
through federally backed agencies. It could be available for private
companies and private firms. Indeed, private firms might be more creative
and provide better services to the home industry. In fact, it's interesting-
you go back and look at the genesis of these agencies- take FNMA - I was
informed in one of our reviews that in the Franklin Roosevelt
administration, the first term of the Roosevelt administration, when
housing was in very bad shape, the initial legislation and proposal from
the Roosevelt White House was to invite in private sector firms to develop
a secondary mortgage market, to put liquidity in that area. That's what
they wanted to do. If my memory serves me, they had this proposal on the
shelf to Congress for 4 years. I think from 1934 to 1938. Nobody came in.
Nobody came in because the economic and financial situation was so
devastating. So what happened after that is they went toward the
Government approach and they developed the Federal National Mortgage

11
Ibid.

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Association. But it was not meant to dominate the market. It was only done
at the time because they couldn't find any private firms…What I'm saying
is, however, rather than enable them to acquire more powers which will
close out any possibility of future growth in the private markets, I would
like to hold them where they are. I'd like them to continue to function with
their present operations and their present charter, consolidate their
financial positions and give the private sector some room to grow. If the
public agencies want to move a little more in certain areas, then I feel they
have the right to do so as long as they are moving toward the private
sector so we have some fair competition.”12

The Battles of 1999-2007

Between the late 1990s and the onset of the financial crisis, several key legislators as well
as the Federal Reserve raised concerns about the oversight of the GSEs and the outsized
risks to which the public was exposed as a result of the GSEs unnecessary risk-taking.
During these years several pieces of important legislation were introduced in an effort to
address these risks.

On the Senate side these efforts were led by Senate Banking Committee Chairman
Shelby and later by Senators Hagel, Dole and Sununu. On the House side they were led
by House Financial Services Capital Markets Subcommittee Chairman Richard Baker.
These efforts were also strongly supported by Federal Reserve Chairman Greenspan.

None of the proposals sought to eliminate the GSEs or to substantially change the
structure of the secondary mortgage market. Instead, these efforts were focused on
addressing the weak oversight and operational, economic and reputational risks posed by

12
Ibid.

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the GSEs. In fact these calls from within the White House13, Congress,14 and Senate15
sought meaningful GSE reform that was not tied to political interests and did not pose a
meaningful risk of disruption to the mortgage market. The key elements of those efforts
to reign in the GSEs and reduce the risks they posed focused primarily on (a) stringent
capital standards to be imposed by a regulator that could raise or lower requirements as
prudent, (b) “bright line” language which sought to prevent “mission creep”, (c)
receivership language that would allow the enterprises to be resolved if they failed, (d)
elimination of the conflicting oversight by a mission regulator and safety-and-soundness
regulator so safety and soundness would have primacy and (e) efforts to reduce or
eliminate the GSEs investment portfolios. The portfolios, especially with inadequate
capital, amplified the risks that the GSEs could fail. In fact, the portfolios were central
contributors to the only other episodes of instability at the GSEs.16

13
Stephen Labaton, “New Agency Proposed to Oversee Freddie Mac and Fannie Mae” New York Times,
September 11, 2004, available at: http://www.nytimes.com/2003/09/11/business/new-agency-proposed-to-
oversee-freddie-mac-and-fannie-mae.html (See: “The Bush administration today recommended the most
significant regulatory overhaul in the housing finance industry since the savings and loan crisis a decade
ago…The new agency would have the authority, which now rests with Congress, to set one of the two
capital-reserve requirements for the companies. It would exercise authority over any new lines of business.
And it would determine whether the two are adequately managing the risks of their ballooning portfolios.”)
14
“Homesick blues,” The Economist, April 13, 2000, available at: http://www.economist.com/node/302764
(See: “This week a Republican congressman, Richard Baker, was fretting about the growing risk of these
agencies. He argued that they might eventually land the taxpayer with a bill that dwarfs the savings-and-
loan mess of a decade ago. The agencies have been increasing their lending at a 20% annual rate in the past
couple of years, as, to rather less attention, has the Federal Home Loan system. The federal mortgage
agencies already have combined debts of $1.4 trillion. On current trends, by 2003 they will be bearing
some of the risk on half of America's residential mortgages, up from one-third in 1995.”) and “Freddie
Mac, Fannie Mae May Face Rival Bills in U.S. Congress,” Bloomberg, July 8, 2003, available at:
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aCsCZExf0_0c (See: “Representative Ed
Royce, a California Republican, plans to introduce a bill this week to create a new regulator for the
government-chartered companies, Royce spokeswoman Julianne Lignelli said. Fellow Republican
Representative Richard Baker introduced a separate bill in late June, after Freddie Mac ousted its three top
executives amid an earnings restatement.”)
15
Stephen Labaton, “New Agency Proposed to Oversee Freddie Mac and Fannie Mae” New York Times,
September 11, 2004, available at: http://www.nytimes.com/2003/09/11/business/new-agency-proposed-to-
oversee-freddie-mac-and-fannie-mae.html (See: “After the hearing, Representative Michael G. Oxley,
chairman of the Financial Services Committee, and Senator Richard Shelby, chairman of the Senate
Banking Committee, announced their intention to draft legislation based on the administration's proposal.
Industry executives said Congress could complete action on legislation before leaving for recess in the
fall.”)
16
Congressional Budget Office “Fannie Mae, Freddie Mac, and the Federal Role in the Secondary
Mortgage Market,” Congressional Budget Office Report, Pub. No. 4021, December 2010, available at:

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These efforts at meaningful reform were opposed by the GSEs and key legislators who
claimed that the risks the GSEs posed were overblown.17 As the financial crisis began to
batter the economy, those legislators who had long claimed GSE reform was unnecessary
began to realize the reputational and political risks to which they were exposed if they
continued to stymie efforts at meaningful GSE reform. The result was the passage of the
Housing and Economic Recovery Act of 2008. Had this legislation been passed early in
the decade, there is little doubt that even if the primary mortgage market had shut down
during a crisis the GSEs would have remained safe, sound, solvent and able to fulfill their
counter-cyclical role of ensuring the allocation of ongoing liquidity to the housing
market.

What HERA Accomplished

If one reviews the key elements of HERA18 it becomes clear that the five-elements of
reform, which had long been pushed for by the most conservative legislative voices on
the issue were addressed. Below, we have highlighted key sections of HERA which
address those items:
Capital
SEC. 1110. RISK-BASED CAPITAL REQUIREMENTS: “The Director
shall, by regulation, establish risk-based capital requirements for the
enterprises to ensure that the enterprises operate in a safe and sound

http://www.cbo.gov/sites/default/files/12-23-fanniefreddie.pdf (See: “Initially, Fannie Mae and Freddie

Mac pursued different strategies with regard to creating mortgage-backed securities. Although the 1968
Charter Act gave Fannie Mae the power to securitize loans, the GSE was slow to adopt that practice,
preferring to buy mortgages to hold in its port- folio. In the late 1970s and early 1980s, Fannie Mae
suffered a series of deeply unprofitable years that put its viability in doubt. Much like the savings and loan
industry, it had financed its mortgage investments by issuing shorter-term debt, seeking to take advantage
of lower short-term interest rates. That strategy exposed Fannie Mae to interest rate risk—when interest
rates rose, its borrowing costs increased commensurately, while its income from existing mortgages
remained fixed… Freddie Mac, in contrast, initially adopted Ginnie Mae’s approach and concentrated on
securitizing conforming mortgages rather than assembling a large portfolio… Freddie Mac, conversely,
steadily increased its holdings of mortgages in the early 1990s. (Until the recent financial crisis, portfolio
holdings were generally much more profitable for the GSEs than their guarantee business because those
holdings took advantage of the lower borrowing costs that the GSEs enjoyed as a result of the implicit
federal guarantee.) By 2001, the operations of the two GSEs looked virtually the same ”)
17
Morgenson and Rosner, 2011, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption
Led to Economic Armageddon. Times Books/Henry Holt and Co.
18
https://www.govinfo.gov/content/pkg/PLAW-110publ289/pdf/PLAW-110publ289.pdf

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manner, maintaining sufficient capital and reserves to support the risks

that arise in the operations and management of the enterprises.”
SEC. 1141. CRITICAL CAPITAL LEVELS: “…the critical capital level
for each enterprise shall be the sum of -(1) 1.25 percent of the aggregate
on-balance sheet assets of the enterprise…; (2) 0.25 percent of the unpaid
principal balance of outstanding mortgage-backed securities and
substantially equivalent instruments issued or guaranteed by the
enterprise; and (3) 0.25 percent of other off-balance sheet obligations of
the enterprise” (Transferred from Sec. 1363 of the 1992 Act)
“Not later than the expiration of the 180- day period beginning on the
date of enactment of this Act, the Director of the Federal Housing
Finance Agency shall issue regulations pursuant to section 1363(b) of the
Federal Housing Enterprises Financial Safety and Soundness Act of 1992
(as added by this section) establishing the critical capital level under
such section.”

Portfolio limits (The key driver of the GSEs’ debt issuances and outsized risks)
SEC. 1369E. REVIEWS OF ENTERPRISE ASSETS AND
LIABILITIES: “The Director shall, by regulation, establish criteria
governing the portfolio holdings of the enterprises, to ensure that the
holdings are backed by sufficient capital and consistent with the
mission and the safe and sound operations of the enterprises… The
Director shall monitor the portfolio of each enterprise. Pursuant to
subsection (a) and notwithstanding the capital classifications of the
enterprises, the Director may, by order, require an enterprise, under such
terms and conditions as the Director determines to be appropriate, to
dispose of or acquire any asset, if the Director determines that such action
is consistent with the purposes of this Act or any of the authorizing
statutes.’’

New Products/Programs
SEC. 1321. PRIOR APPROVAL AUTHORITY FOR PRODUCTS: “The
Director shall require each enterprise to obtain the approval of the
Director for any product of the enterprise before initially offering the
product… Immediately upon receipt of a request for approval of a
product, as required under paragraph (1), the Director shall publish
notice of such request and of the period for public comment pursuant to
paragraph (3) regarding the product, and a description of the product
proposed by the request. The Director shall give interested parties the
opportunity to respond in writing to the proposed product.”

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Receivership
SEC. 1367. AUTHORITY OVER CRITICALLY
UNDERCAPITALIZED REGULATED ENTITIES

Independence from Politics

SEC. 1162 Removes Presidential appointments to the GSE’s Boards

HERA accomplished all of the key items that Shelby, Hagel, Dole, Sununu and
Greenspan supported prior to the crisis and we do expect that there will be a need for
Congress to make technical changes to the language in HERA to tighten the language
therein. But it is important to remember that HERA was only a down-payment on the
long-term goal that Dr. Kudlow recommended years ago – shrinking the Government’s
footprint in housing to the original purpose of the secondary-market and then moving
toward the privatization of the GSEs. Over thirty-five years later it appears, to paraphrase
U2, Dr. Kudlow still hasn’t found what he is looking for.

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