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A Tipping Point

March_CoverFeatureOf all the questions one could ask about government-sponsored entity (GSE) reform, there is one that keeps coming up: Will it be something the Trump administration can get to soon, or is the issue just too complicated for a speedy solution? 

Everyone and no one seems to have an answer. Almost daily, news outlets, analysts, pundits, and financial experts present the idea that administration officials want to tackle the issue immediately, yet it is just as frequently followed with explanations to why it won’t happen any time soon.

Even Treasury Secretary Steven Mnuchin, whose stance on releasing Fannie Mae and Freddie Mac from federal conservatorship and recapitalizing the GSEs with private investor funds was of major appeal to President Donald Trump, has already waffled on that idea—something that Tim Rood, Chairman of the Collingwood Group in Washington, D.C., says strikes him a bit like the movie Fight Club.

“The first rule of GSE reform is that you don’t talk about GSE reform,” Rood told MReport. In other words, talking about reforming the GSEs and actually having a real plan to do it without crippling the future solvency of the mortgage and housing industries are rather different endeavors.

But if there is one thing that seems largely agreed upon, it’s that taking the government out of the mortgage business is an immensely risky proposition. After all, housing comprises a fifth of the U.S. economy. And in an economy struggling to grow at a steady 2 percent, retooling housing and mortgages can be a risk too great to attempt. At least right now. Still, the question of what effect the Trump administration can have on the GSEs looms.

Reforming for ROI

Part of the issue about what to do with the GSEs centers on that $187 billion infusion the enterprises got after they went insolvent in 2008. Investors are currently suing the federal government for a return on that investment in the wake of the GSEs having paid back the Treasury and turned a profit. 

On the one hand, the business-friendly Trump administration and its reform-friendly Treasury chief could exert considerable pressure over the GSEs, leading to some kind of settlement. On the other hand, there is little, if any, public outcry to fix the GSEs now that the system has been in a relatively good working stasis for the past few years. 

Christopher Whalen, Senior Managing Director of Financial Institutions at Kroll Bond Rating Agency in New York, says the only people crying out for GSE reform are the investors who seem to want to get paid and just walk away.

That, of course, doesn’t mean it couldn’t happen. Rood says there are enough influencers in the Trump camp who want the GSEs dealt with that there could be some kind of settlement that would benefit investors and not hurt the mortgage industry or the public.

To get there, though, would require a solution not mired in what Rood calls “political calculus.” He says it’s hard to argue against reform in purely capitalistic terms—investors have put up money and want it back. But, he explains, it’s not really possible to remove politics from an inherently political issue that has a strong rallying cry for both sides. 

For conservatives, there’s the notion of sound financial machinations. For progressives, there’s the call to help the underserved and financially struggling. This dynamic, Rood says, is one of the things holding up easy answers as to what to do about GSE reform.

Complicating things is the fact that the Obama administration withheld 11,000 documents related to the Treasury’s profit sweep of the GSEs, claiming various forms of executive privilege as reasons not to release the files. If those files get released—a real possibility in the Trump administration—and they show any kind of malfeasance on the government’s behalf, it could be a real opportunity for the new administration to blame the old one.

But even that, says Rood, is not a guarantee of smooth sailing. Just as easily as Trump could make a show of reimbursing investors, his enemies could cry cronyism, which would return us to no resolution. And even if there is a settlement with investors that works out for taxpayers and the government, he says, that alone doesn’t mean the system is reformed.

The Impracticality of Privatization

A word thrown around frequently when considering the Trump administration’s potential effect on the GSEs is privatization. This, of course, is what Mnuchin started off advocating for and then quickly backed away from soon after. From most standpoints, it seems that wholesale privatization of Fannie and Freddie is a practical impossibility. 

Also, it would take an act of Congress, which isn’t entirely out of the question, but it would certainly nullify any chance of swift action. 

“The idea of a private GSE is a misnomer,” said Michael Bright, Director of the Center for Financial Markets at the Milken Institute in Washington, D.C. He says the idea of privatizing the mortgage market and shutting down the GSEs or of reforming the market by reforming the GSEs makes at least some kind of procedural sense to him. But privatizing the GSEs themselves? “I don’t even know what that means,” he said. “There’s nothing private about the GSEs.”

Indeed, the GSEs, chartered by Congress and backed by the Treasury, are not private companies and are not run like private companies. So the idea that Trump or even Congress could privatize the enterprises wholesale, Bright says, is, charitably put, impractical. “Not only is it terrible policy, but I don’t see how they could pull it off,” he said.

Daryl Jones, Director of Cornerstone Advisors in Indianapolis, agrees. “There are a lot of moving parts to this,” Jones said. “This is not a flip-of-the-switch kind of issue.”

The largest moving part is the government backing (i.e. the full faith and credit of the United States that makes sure the housing market can be saved from utter and irreparable ruin). For Whalen, this is the backbone of the argument as to why privatization is what he calls “a ridiculous idea.”

It takes the full faith and credit of a sovereign nation to withstand the potentially seismic repercussions of another mortgage market meltdown, Whalen says. One of the reasons the crisis happened in the first place is that businesses were not well regulated by the government. And despite how terrible things got when the meltdown settled in, imagine how much worse things would have gotten if there was no backstop there to absorb the debt. Only a sovereign, he says, has that kind of wherewithal.

Fundamentally, all the plans and all the ideas that involve privatizing the GSEs, in total or in part, hinge on sovereign support. No matter what privatization proponents claim, Whalen says there is a component to the plan that looks to the Treasury to take the ultimate hit should a new disaster loom.

Testing the Waters

Various ideas about what should be done with the GSEs are floating about. There are ideas about changing the duration of mortgages from 30-year fixed to maybe 20- or 25-year fixed with more substantial prepayment penalties. There are plans to introduce floating-rate mortgages like Denmark has done. There are proposals to privatize the capital infusion into the mortgage market itself.

But all of them do seem to mention that if private capital fails to buoy a mortgage and securities market, the federal government would have to step in. For Whalen, this is part of the have-your-cake-and-eat-it-too wish that shareholders would find highly agreeable. It would, after all, eliminate risk and exponentially ramp up reward.

Even from within the administration, the privatization conversation is, so far, a lot of speculation and general ideas.    But privatization efforts in other areas do offer a chance to test the waters, to a degree. For doomsayers who feel that turning over a massive financial endeavor to private investment would only succeed in making interest rates soar, leading to foreclosures, and leaving already-wealthy investors with cash spilling out of their pockets as everyday Americans lost their homes, there are examples like Chicago’s $1.2 billion effort to privatize its parking meters. That was disastrous enough for the Chicago Tribune to call the attempt “an epic fiasco” last summer. 

For privatization plans to work, there are examples like the public-private partnership Indiana set into motion for its toll roads. That highly successful $3.2 billion endeavor worked largely because of a long discussion and thoughtful approach before implementing anything. 

The careful approach is a good starting point for something as far-reaching and complex as mortgages, yes, but it does bring up the all-important issue of timing. The administration has no shortage of major issues to contend with, from immigration policy to Obamacare. 

This, Whalen says, puts the priority of housing reform lower on the list. Rood says that unless the administration could get to this in the first year, it could turn into a court battle that ends with a settlement in a second term. “I could see a settlement, but settlement is not wholesale reform,” he said.

Something to keep in mind when taking lessons from other privatization programs is that neither Chicago’s parking meters nor Indiana’s roads carries the potential to destroy a national economy like mismanaging housing would. To be distinct, Trump has never stopped advocating for housing reform, but that might not necessarily involve retooling the GSEs in a major way. 

A Slow Exit

Perhaps a more apt case study might be what Rood says is kind of a GSE but for student loans: Sallie Mae. At the beginning of the century, Sallie Mae wanted out of its government charter. Rather than just cutting the charter, the government gave the agency a few years to wean off subsidy. 

“I wonder if there aren’t lessons to be learned from Sallie Mae,” Rood said. Perhaps the federal government could find a way to let Fannie and Freddie off the hook slowly over a few years.

But then, there’s the risk of simply sticking a future administration with a gigantic problem. There’s also the fact that when Sallie Mae was considering its postcharter future, Fannie and Freddie were actually asking the same question. The result? “They ran the numbers a hundred ways to Sunday, and they couldn’t make the case to give up the subsidy,” Rood said.

The idea of following Sallie Mae’s example, though, is similar to the Corker-Warner bill, a Congressional proposal from a few years ago that calls for the termination of the existing GSEs and also calls their existing hybrid public/private structure a failure. The bill outlines that the GSEs should cease operations within five years of enactment. In the interim, the bill would require a reduction in the size of the portfolios held by the GSEs, and it would eliminate the requirement for the GSEs to meet targeted housing goals.

This, Whalen says, may be the administration’s best bet on where to start any conversation on GSE reform—more so than the Hensarling proposal that made little traction but would essentially seek to sift all responsibility for the GSEs to the Federal Housing Finance Agency and then liquidate the enterprises.

Of course, there is the dim possibility that a lot of what is being worried about right now, this nebulous mention by Trump administration officials to look into housing reform, may just be noise—at least for the time being. There are some, like Whalen, who say that while Trump could have an effect on the mortgage industry, he hasn’t had—and likely won’t have—much of an effect on the GSEs themselves. 

Risk vs. Reward

Then again, the chatter may have more substance than it seems. Bright says he’s been in Washington for six years studying such issues as housing reform, and it’s the first time he’s comfortable saying the tide is 50/50. It could be chatter; it could be set to become policy at any time. One way or the other, all the talk has certainly brought the GSEs to a tipping point.

If it is more than just noise, Bright says a few things need to be looked at soberly. A main component will be the need to define very clearly what the government’s role (or roles) will be in relation to the GSEs. And that will include making sure there is a backstop in place that could withstand a catastrophe (aka, the Treasury, he says). Remember, no one yet has found a way to take the Treasury subsidy out of the picture without making the whole system collapse.

And if the talk has merit, the GSEs are going to need to position themselves to show just how valuable they can be.

“For the GSEs to continue, they’ll need to find creative ways to show a solid and growing public purpose,” Rood said. A major drum they could beat is offering help for underserved markets—minorities, millennials, and the low- and moderate-income borrower. When all is said and done, he says, Trump’s effect on the GSEs might just be to let them do that job and otherwise leave them be.

If some new level of privatization does happen, competition between the GSEs would become more free-market competition, which is something they’ve never had to contend with, Jones says. Competition, he says is generally a good thing, and it could drive more loan products. “The flipside is, it could make it harder for smaller banks to offer those [products],” Jones said.

Whatever happens, Rood says, the administration and all the players involved in decision making will need to keep a fundamental question of risk vs. reward in balance: Is this risk harmful or good to the economy? “If that’s not the first question asked, that’s dangerous,” Rood said.

About Author: Scott Morgan

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Scott Morgan is a multi-award-winning journalist and editor based out of Texas. During his 11 years as a newspaper journalist, he wrote more than 4,000 published pieces. He's been recognized for his work since 2001, and his creative writing continues to win acclaim from readers and fellow writers alike. He is also a creative writing teacher and the author of several books, from short fiction to written works about writing.

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