EcoFlash

Are the GSEs ready to exit FHFA conservatorship?

ECO FLASH  
N°20-24  
8 December 2020  
ARE THE GSES READY TO EXIT FHFA CONSERVATORSHIP?  
Céline Choulet  
The US mortgage market – the epicentre AN INEVITABLE RESCUE  
of the 2007-2008 financial crisis – has  
yet to be reformed.  
The decisions taken at the height of the 2007-2008 financial crisis made it possible to contain  
the systemic risks posed by the two private mortgage refinancing giants, Fannie Mae and Freddie  
Mac. In early September 2008, faced with numerous payment defaults, the two agencies were  
rescued from bankruptcy by the US Treasury and placed under the conservatorship of a federal  
agency, the Federal Housing Finance Agency (FHFA). The Treasury subscribed for USD187.5 bil-  
Nearly half of the USD 10,000 billion in  
housing loans are guaranteed by the  
Federal government via two private  
agencies (GSE), Fannie Mae and Freddie  
Mac, which were placed under FHFA  
conservatorship after they were bailed  
out in 2008.  
1
lion in senior preferred stock from the two agencies, and guaranteed all their obligations .  
2
Since then, mortgage-backed securities (MBS) issued by the two big government-sponsored  
enterprises (GSE) have enjoyed an “effective” guarantee from the Federal government. This  
guarantee protects investors against all risk of payment defaults on the underlying loans of  
GSE MBS.  
This conservatorship was intended to be temporary. However, twelve years later, none of the  
legislative proposals to determine their longer-term future or to reform the mortgage market  
in general have been adopted. As time goes by, the reform projects have converged around the  
same observation, that government guarantees are essential in ensuring the liquidity and sta-  
bility of the mortgage market. Recent proposals have argued for a hybrid financing model built  
around risk sharing between the public and private spheres, depending on whether the risks  
3
were deemed to be “extreme” or not . Secondary market liquidity would be supported by an “ex-  
In recent weeks, there have been  
growing rumours that the FHFA is  
seeking to hasten the end of its  
conservatorship of the two agencies.  
plicit” government guarantee for securitised loans in return for a commission. At the same time,  
credit risk transfer programmes developed by the FHFA since 2013 would be more broadly de-  
4
ployed. To ensure market stability, only “non-extreme risks would be sold to private investors .  
Everyone seems to agree that the main imperfections suffered by the GSEs prior to the crisis  
should be stripped away from the new guarantor responsible for structuring the loans: the  
moral hazard created by the implicit guarantee which the GSE benefited from at no cost; the  
contradictions between their profitability targets and their public service mission; and the very  
insufficient level of core capital, especially given their risk exposure. In contrast, there is still  
ongoing debate over the status of the new guarantors and the future role of Fannie Mae and  
Freddie Mac within the new system.  
Accelerating this process risks restric-  
ting household access to mortgage loans  
by prematurely ending the GSE Patch.  
The preponderant role played by GSEs in the mortgage market makes any reforms very risky. In  
2
019, we estimate that Fannie Mae and Freddie Mac had on their balance sheets (in the form  
of loans or securities backed by loans) or guaranteed nearly USD 4,500 billion in conventional  
5
housing loans , or 43% of total household mortgage debt (chart 1). This estimate is the sum of:  
Nonetheless, the colossal amount of  
capital that would be needed to carry  
out their exit from conservatorship, as  
well as uncertainty over the terms for  
maintaining the government guarantee,  
are likely to delay this process.  
1
2
/ the stock of MBS issued by Fannie Mae and Freddie Mac and sold to third parties,  
/ the MBS retained by the GSEs (to avoid double counting, cross-holdings are excluded),  
3/ the portfolios of loans and securitisations from private issuers purchased by the GSEs for  
investment purposes.  
1
Under the Preferred Stock Purchase Agreements (PSPA), the US Treasury agreed to refinance the GSE whenever their  
net worth became negative. Given the support provided to the two GSE so far, the residual funds total USD 254.1  
billion.  
2
3
4
Securities backed by mortgage loans.  
The loss rate observed during the 2007-2008 financial crisis could be considered “extreme”.  
For an analysis of the role GSE play in the secondary mortgage market as well as reform proposals and credit risk  
transfer programmes, see Choulet C., The fate of Fannie Mae and Freddie Mac is not yet sealed, Eco Conjoncture,  
March 2018.  
5
Loans originating outside of any Federal programmes.  
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2
Credit risks transferred to the private sphere (insurance companies,  
FANNIE MAE AND FREDDIE MAC GUARANTEE 43% OF HOUSEHOLD  
MORTGAGE DEBT  
6
investors) via insurance policies (Primary Mortgage Insurance, PMI )  
7
or structured debt issuances (Credit Risk Transfers, CRT) (chart 2) are  
then subtracted from the total. Although there is not yet enough data  
available to update our estimate for the current year, the numbers  
suggest that the proportion has probably increased. The stress  
generated by the Covid-19 pandemic has resulted in a new drying  
up of the private secondary market and has shifted demand towards  
government-backed securities loans (charts 3 and 4).  
6 USD trn  
100%  
90%  
Fannie Mae and Freddie Mac guaranteed MBS  
(
owned by third parties)  
5
4
3
2
1
0
Fannie Mae's and Freddie Mac's  
investment portfolios:  
Agency MBS (retained)  
Non-agency MBS  
80%  
as a % of  
household  
mortgage  
debt  
70%  
6
0%  
0%  
Mortgage loans  
IS A RAPID EXIT FROM FHFA CONSERVATORSHIP FEASIBLE?  
Credit risk transferred  
5
In recent weeks, there have been growing rumours about an accele-  
rated exit from FHFA conservatorship by the two GSE. Fearing that the  
new Biden administration might further delay this process, the conser-  
vatorship agency is apparently seeking to negotiate with the Secretary  
of the Treasury for their exit as soon as possible, before Joe Biden en-  
ters the White House after his inauguration on 20 January 2021. The  
President-elect has let it be known that ending the conservatorship is  
not a priority for the beginning of his term. Yet several obstacles must  
be cleared before this process can be accelerated.  
40%  
3
0%  
0%  
2
10%  
91 93 95 97 99 01 03 05 07 09 11 13 15 17 19  
89  
CHART 1  
SOURCE: FHFA, FEDERAL RESERVE, BNP PARIBAS CALCULATIONS  
END OF THE GSE PATCH  
The first obstacle pertains to a distortion of competition. Under  
the Dodd Frank Act of July 2010, originators of mortgage loans are  
FROM 2013 TO 2019, THE GSES HAVE TRANSFERRED USD 500 BN OF CREDIT  
RISK TO THE MARKET  
8
required to ensure that borrowers have the ability to repay their loans .  
Qualified mortgages”, which meet strict lending criteria, cannot be  
2
013-2019, USD bn  
contested before a court or an agency. Excluded from this category are  
loans with a maturity of more than 30 years, loans that do not have  
prudent terms for the payment of principal and interest (negative-  
amortization, interest-only and balloon-payment loans) and when the  
debt-to-income ratio exceeds 43% (monthly payment/revenues).  
4
4
3
3
2
2
1
1
50  
00  
50  
00  
50  
00  
50  
00  
Freddie Mac  
Fannie Mae  
156  
So far, the GSE have benefited from a less demanding derogation  
system. Once certain criteria have been met (notably in terms of  
loan features or limits on points and fees), the loans purchased or  
guaranteed by the two GSE are considered de facto as “qualified  
mortgages”, regardless of the debt-to-income ratio, a measure known  
2
41  
53  
5
0
6
2
9
10  
as the GSE Patch . On 26 October , the Consumer Financial Protection  
Bureau (CFPB) postponed the expiration of the GSE Patch (initially  
scheduled for 10 January 2021) to the date when the new definition  
of “qualifiedmortgages” takes effect (in preparation for the past few  
0
Credit risk transferred  
through PMI  
Credit risk transferred  
through CRT programs  
1
1
SOURCE: FHFA  
months ), or when the GSEs exit conservatorship, whichever comes  
first. Ending the conservatorship of Fannie Mae and Freddie Mac  
would hasten the expiration of the GSE Patch, and in the absence of a  
definitive definition of “qualified mortgages”, it would risk restricting  
access to mortgage loans or increasing the cost for nearly a third of  
CHART 2  
1
2
borrowers whose debt benefits from a GSE guarantee .  
6
Borrowers whose down payment is less than 20% of the value of the financed housing must take out a private insurance policy. This type of insurance reduces the exposure of  
the GSE to credit risk, but it exposes them to high counterparty risk.  
7
Structured debt issuances are the main vehicle for risk sharing implemented under the CRT programmes. These securities are unguaranteed, unsecured, floating-rate bonds.  
Issues are relatively rare but they are backed by relatively large portfolios. These transactions, which are similar to securitisations, do not expose GSEs to any counterparty risk.  
1
1 CFPB would like to replace debt-to-income limits with restrictions on loan’s pricing: it would exclude from the definition of “qualified mortgages”, any loans with an annual  
interest rate exceeding the average prime offer rate by 2 percentage points for a comparable operation.  
2 Based on data at year-end 2018, CFPB estimates that 16% of residential loans would not have been originated without the GSE Patch (i.e. 31% of the 52% of residential loans  
held by or guaranteed by GSEs).  
1
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3
A COLOSSAL AMOUNT OF CAPITAL TO RAISE  
IN THE FIRST NINE MONTHS OF 2020, ISSUANCE FROM THE GSES  
ACCOUNTED FOR 71% OF TOTAL RMBS ISSUANCE  
The second obstacle that must be dealt with is the colossal amount  
of capital that would have to be injected to exit conservatorship.  
On 18 November, FHFA finalised the new prudential framework  
RMBS issuance, USD bn  
3
000  
1
3
applicable to Fannie Mae and Freddie Mac . This framework calls for  
the creation of risk-based capital requirements, capital buffers and  
leverage requirements that are generally comparable to the capital  
adequacy requirements for banks. Based on balance sheets at 30 June  
Private issuers  
Fannie Mae  
Freddie Mac  
Ginnie Mae  
2 500  
2
1
1
000  
500  
000  
500  
0
2
1
020, FHFA estimates the aggregate amount of Common Equity Tier  
capital required for the two GSEs at USD 207 billion, the aggregate  
amount of Tier 1 capital at USD 265 billion and the aggregate amount  
of total regulatory capital at USD 283 billion. The GSE will have to  
report their capital ratios as of 1 January 2022, but the requirements  
will not become binding until they have exited FHFA conservatorship,  
and possibly later if they are granted a consent order. Finalisation of  
a stronger regulatory capital framework can be seen as a pledge of  
stability for the mortgage market: it is a key step in the process of  
reforming the mortgage market and ending the conservatorship of  
87  
90  
93  
96  
99  
02  
05  
08  
11  
14  
17  
9M  
20  
SOURCE: SIFMA, FNMA, FHLMC, GNMA  
CHART 3  
1
4
Fannie Mae and Freddie Mac .  
Although the GSE accumulated heavy losses between 2008 and 2011  
GSE RMBS REPRESENTED 65% OF RMBS OUTSTANDING AT END-JUNE 2020  
RMBS outstanding, USD bn  
(
more than USD 250 billion altogether), they have returned to profit  
since 2012. Yet most of the net worth created has been transferred  
to the US Treasury in the form of dividends (at least through mid-  
2
019). At 30 September 2020, these dividend payments amounted to  
10 000  
a cumulative total of USD 301 billion (chart 5). Since the second half  
of 2019, Fannie Mae and Freddie Mac have not paid any dividends to  
the Treasury. Under the modified terms of the Preferred Stock Purchase  
Agreement (PSPA) reached with the Treasury in September 2019 , they  
were able to conserve USD 25 billion and USD 20 billion, respectively, in  
quarterly net worth created (up from USD 3 billion under the previous  
PSPA of December 2017), or the full amount created over the past five  
quarters. This agreement will probably be renewed, which will help  
the GSE rebuild their core capital base, but a complete recovery will  
require colossal volumes of capital.  
Private issuers  
Fannie Mae  
Freddie Mac  
Ginnie Mae  
9
8
7
6
5
4
3
2
1
000  
000  
000  
000  
000  
000  
000  
000  
000  
0
1
5
At 30 September, the aggregate book value of equity for the GSE was  
USD 34.6 billion, but at the same date, they display a negative core  
87  
90  
93  
96  
99  
02  
05  
08  
11  
14  
17 Q2 20  
1
6
capital amount of more than USD 160 billion . The scale of this deficit  
was not brought up during the finalisation of the regulatory require-  
ment framework for the two GSE. Nonetheless, it will make implemen-  
tation much more difficult. After taking into account regulatory capital  
requirements, nearly USD 450 billion in capital will have to be injected  
to recapitalise Fannie Mae and Freddie Mac. Without calling on the  
market, this would be equivalent to setting aside 18 years of net ag-  
gregated earnings of USD 25 billion (and the suspension of dividend  
payments to the Treasury).  
CHART 4  
SOURCES : SIFMA, FNMA, FHLMC, GNMA  
Without new legislation, once they have exited FHFA conservatorship,  
the two agencies will no longer be (officially) under the protection of  
the Treasury and their securitisations will no longer benefit from a  
government guarantee. Investors in GSE MBS (at least newly issued  
ones) will no longer be covered against the risks of payment defaults  
(
principal or interest) on the underlying loans. Only Congress is in a  
position to grant GSE MBS with an explicit “full faith and credit” gua-  
rantee from the Federal government, the same as the guarantee  
granted to Ginnie Mae MBS (the only mortgage refinancing agency  
wholly-owned by the Federal government).  
WHAT ABOUT THE EFFECTIVE GUARANTEE?  
The third obstacle pertains to the nature of the government guarantee  
benefiting GSE securitisations. This “effective” guarantee is conditioned  
on maintaining Fannie Mae and Freddie Mac under conservatorship.  
Accelerating the exit from conservatorship without first defining the  
legal terms for maintaining the government guarantee on new secu-  
1
4 Before entering conservatorship, the two GSEs were not restricted by very tight leverage standards. Core capital had to cover at least 0.45% of mortgage loans outstanding  
used as underlying instruments in the GES MBS held by third parties, 0.45% of off-balance sheet commitments, and 2.5% of other balance sheet assets. After entering conserva-  
torship, the GSE were required to report the minimum amount of required capital, even though these requirements were not binding. In September 2020, the deficit in core capital  
1
In counterparty, the asset value of the stock of preferred shares in Fannie Mae and Freddie Mac subscribed by the US Treasury should gradually increase by USD 22 billion and  
USD 17 billion, respectively.  
1
6 In GSE’s financial statements, the book value of the stock of preferred shares subscribed by the Treasury is included in equity.  
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4
destabilising the financing of the mortgage market. It would also risk  
undermining investor confidence, which is vital for the successful re-  
capitalisation of Fannie Mae and Freddie Mac. Lastly, eliminating the  
effective guarantee that currently benefits GSE MBS would also hit a  
large number of investors since these securities are commonly used as  
collateral in the short-term repo markets and they offer an advanta-  
FANNIE MAE AND FREDDIE MAC: A NEGATIVE CORE CAPITAL OF MORE THAN  
USD 160 BN  
USD bn  
160  
1
20  
1
7
geous regulatory treatment .  
Net income  
8
0
0
0
Dividend payments to Treasury  
4
-
-
40  
80  
-
-
-
120  
160  
200  
Core capital  
08  
09  
10  
11  
12  
13  
14  
15  
16  
17  
18  
19 9M20  
SOURCE : FNMA, FHLMC  
CHART 5  
1
7 Under banking regulations, GSE MBS are given a low risk-weighting and recognised as high-quality liquid assets (level 2A) when calculating capital and liquidity ratios.  
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