Why 2018 Could Be Big for Fannie, Freddie

Jan 23, 2018
Finance

Mortgage-finance Giants Face Mounting Pressure

SMITH BRAIN TRUST – Could these be the end of days for Fannie Mae and Freddie Mac?

Shares of the two mortgage-finance giants have been under pressure in recent weeks, amid word that some lawmakers in Washington are looking to close the chapter on conservatorship for the two government-sponsored enterprises (GSEs).

And that could bring big changes to housing finance in the United States, says Clifford Rossi, executive-in-residence and professor of the practice at the University of Maryland’s Robert H. Smith School of Business.

The two mortgage-finance giants provide two vital functions, Rossi says, guaranteeing investors in mortgage-backed securities against credit loss, and providing liquidity in the mortgage market by issuing securities backed by mortgages, Rossi says. “Those activities help lower the cost of mortgages across the country and have supported the largest housing finance system in the world.”

Fannie and Freddie, as the pair are commonly known, set the underwriting standards under which they’ll buy and guarantee mortgages from lenders. And those standards are critically important.

When an economy has both weak regulatory oversight and highly competitive markets, Rossi says, it “invariably induces a race to the bottom,” in terms of underwriting standards. The result: Greater risks.

“That is exactly what happened in the years before the financial crisis,” Rossi says.

A draft Senate bill would place Fannie and Freddie into receivership, allowing the creation of successor companies, ones free from government control. Fannie and Freddie have been under conservatorship since September, 2008.

“A fundamental question policymakers should to be asking now,” says Rossi, “is what does competition mean for companies such as Fannie and Freddie?”

“Competition really boils down to pricing, service and/or product,” he says. “In the case of the GSEs and any others that come along, these three competitive levers are virtually indistinguishable since, for all intents and purposes, this market has become commoditized.”

Both GSEs, for example, use the same credit standards and pricing and offer the same products.

“Adding more competitors to the mix would reduce the systemic exposure to taxpayers from a failure of any single firm,” Rossi says, “but it increases the risk that these companies could spark an underwriting war that spirals out of control if left unchecked.”

As Americans learned 10 years ago, when Fannie and Freddie’s balance sheets posed a risk to the wider economy, prompting the George W. Bush administration to put the lenders into conservatorship, that kind of spiral has broad implications.

“This potential is one reason why some form of utility model might work,” says Rossi.

Utilities are highly regulated entities that operate under strict product and pricing policies. In a heavily regulated environment, Rossi argues, the securitization and guarantor roles could be effectively performed by just one or two entities, particularly if there is an explicit guarantee made by the federal government.

To ensure a large stable investor base, he argues, would require a federal guarantee.

“We saw that portion of the mortgage market not supported by the GSEs – the private label securitization market – implode during the crisis, never to return, as investors fled in droves,” says Rossi. “If housing is deemed to be a significant sector of the U.S. economy from a social welfare perspective, then a federal guarantee where taxpayers pick up any remaining losses only after private investors first absorb the vast majority of losses is warranted.”

Such a guarantee could be set up in such a way as to virtually assure that taxpayers would never again face the prospect of having to fund another bailout in the mortgage industry, says Rossi.

Critics will charge that reconstituting Fannie and Freddie will merely set them up again as too big to fail. But Rossi sees it another way.

“Interestingly,” he says, “the things that placed Fannie and Freddie into conservatorship have been addressed – poor oversight, risky products and a retained portfolio. Making sure that they have risk-based capital standards that are at least as strict as systemically important banks must be part of any reform package.”

He adds that there are other key matters to be weighed in any overhaul of the GSE process. Among them, says Rossi, is how to address affordable housing.

“One argument is that if the federal government is going to subsidize housing, then market participants must focus on promoting affordable housing opportunities,” he says. He cautions against allowing Congress “to fiddle with the housing goals” of entities engaged in securitization and guarantees, warning, “Market interference from Congress never turns out well for borrowers, investors or taxpayers.”

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About the Expert(s)

RossiCliff

Dr. Clifford Rossi is an Executive-in-Residence and Professor of the Practice at the Robert H. Smith School of Business, University of Maryland. Prior to entering academia, Rossi had nearly 25 years' experience in banking and government, having held senior executive roles in risk management at several of the largest financial services companies. His most recent position was Managing Director and Chief Risk Officer for Citigroup's Consumer Lending Group where he was responsible for overseeing the risk of a $300+B global portfolio of mortgage, home equity, student loans and auto loans with 700 employees under his direction. While there he was intimately involved in Citi's TARP and stress test activities. He also served as Chief Credit Officer at Washington Mutual (WaMu) and as Managing Director and Chief Risk Officer at Countrywide Bank.

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