[author: Rick Jones]
I am joining the hordes occupying the chatter-sphere to opine about what the GSEs should look like, post conservatorship. Having reviewed loads of opinions about the future of the Twins, I’m pretty sure the bar on looking stupid is pretty low. To be honest, I’m more instinctually a critic than a warrior on these types of policy issues. As one wag once said, a critic is someone who enters the battlefield after the war is over and shoots the wounded. That may be a little harsh, but you take the point. It rather suits. In other words, I’m more comfortable pontificating about someone else’s stupid idea than assaying my own, but I’m tired of waiting for clarity here, so here goes.
Before I start, let me make absolutely clear that views expressed in this commentary are mine alone. While I continue to serve as an officer of CREFC, nothing in this reflects the current policy or the current positions of CREFC nor indeed even reflects any discussions along the lines of my thinking (of which I am aware) about the future of the GSEs within the CREFC community.
I will be talking here about a private spinout of the Twins. Notwithstanding my skepticism about the motives of most of the messengers supporting a private alternative and their tub-thumping and self-serving faux balanced bloviation, I remain convinced that release into private hands is the right answer.
The question we should be spending considerable time considering is not whether these enterprises should be released, but released to become what? What should these enterprises actually do? Across the spectrum of opinion, for and against, there has been less attention paid to what the Twins will look like, post release, than how they should get there. Are we talking about a continuation of the semi-dirigisme arrangement under which they have operated in conservatorship (or indeed pre-GSE), or something new? Our current GSEs, these platypus-like, Rube Goldberg, semi-public constructs, zoftig in scale and with multiple and often conflicting missions should now be rationalized. We need to take up this opportunity and rethink the GSEs’ multifamily value proposition.
To avoid both jeremiad and hagiography, let’s stipulate that, generally speaking, Fannie and Freddie have done…pretty good. The notion that if it ain’t broke, don’t fix it is powerful. The Twins did muscular service for the economy, and continued to serve as important pillars of the mortgage finance marketplace in conservatorship. But, is that a sufficient argument for keeping them exactly the way they have been?
When we reimagine the GSEs, we should look at both sides of the balance sheet. We can agree that Fannie and Freddie have done an awful lot of good work and delivered on the promise of liquidity to our markets. But at what cost? Remember, there’s always two sides to a balance sheet. On the cost side, we will find distorted pricing, an artificial governor (paid for by the taxpayer) placed on the conventional private market resulting from the Yeti-like footprints of the GSEs, the exposure of the Treasury to extraordinary risk and the impact on credit and underwriting when decisions of quasi-public enterprises, with sometimes conflicting missions, are inevitably influenced by politics and social policy? We should not ignore the risks resulting from continuing to concentrate the enormous market power they have today in one or two semi-public vehicles. We should not ignore the reality that such concentration of power and scale makes errors exponentially more expensive.
I’d argue that the organizational purpose of the GSEs was to provide an emergency brake on a free-falling mortgage finance marketplace when something goes horribly wrong and to provide sufficient credit when the conventional marketplace seizes up. That should remain our touchstone when thinking about post release. When we again experience a GFC-type event (or something worse), when liquidity dries up, financing becomes broadly unavailable, and values plummet for any lack of buy-side bids, the GSEs should step in and provide a bottom to ensure the folks (e.g., voters) get an opportunity to embrace the American Dream of home ownership. That said, neither their purpose nor any negative externalities of their operation should result in the replacement of private capital.
Thinking afresh about what mechanics are necessary to address the core mission for which the GSEs were organized should be the predicate inquiry here. Admittedly, that can be hard because of the almost religious fervor that large segments of the market and governmental elites have for the status quo, but shame on us if we don’t try.
Captain Obvious might observe what we have today isn’t the only way to get what we need (sly Rolling Stones reference).
As we think this through, it’s worth remembering that there was a time when the GSEs’ footprint was vastly smaller than it is today. Back in ancient times, before wood was invented (let’s say 1980), the GSEs were standing behind only about 10% of the mortgage market. Until considerably more recently, in the multifamily space, they mostly just bought bonds off of conventional securitizations backed by sufficient amounts of multifamily debt.
What happened? How did we get from there to here? Well, it’s pretty straightforward, isn’t it? Like all organizations, left to their own devices, their remit will grow and grow like topsy. It’s fun to do more, it’s lucrative to do more, it’s good for the headcount to do more, particularly when you only look at the plus side of the balance sheet and ignore, or are allowed to ignore, the price. We’ve suffered a classic case of mission creep where, as they say, price was no object. Can we unequivocably say it’s better today than it was before?
Time for a rethink. The GSEs need to go on a diet. Not to bury the lede, we surely should not slavishly replicate Fannie and Freddie as they were and we should build enterprises that truly focus on protected liquidity.
While there are lots of ways to fabricate a lender of last resort (including housing this function in a governmental agency as an explicit governmental backstop), I’m going to stick with a private spinout where our new baby GSEs buy or guaranty mortgage debt and finance this through the securitization. (Sounds rather familiar, doesn’t it?).
First, and most critically, the focus must be on building out a lender of last resort that will respond when markets seize up and to ensure there is enough credit available for the efficient operation of the multifamily market at all times. That should be 100% of their job.
I’d separate the do-good mission from the liquidity mission. There are a lot of good reasons (I hear tell) to provide non-market-based credit to folks in need. That sounds like a governmental function that cannot be comfortably housed in a private enterprise (pesky shareholders). The GSEs’ embrace of a dual mandate has been as discomforting to the Twins as the dual mandate of price stability and full employment has been to the Fed. Some of this mission should go to Ginnie with a little (Hah!) tweaking or to a new enterprise with a clear social policy mission.
Let’s talk governmental participation. Frankly, I can’t think of a way to get where we need to go without it. There’s simply not a level of entirely private capital that can meet the policy goal of liquidity certainty. (If you’re still wondering, think about what happened to MBIA and AMBAC in the lead up to the Great Recession.) If we stick with this private(ish) plan, these enterprises will need to be capitalized with sufficient equity and available credit support from our glorious government to support a high investment grade rating of their senior bonds in any securitization.
All securitization issuances backstopped by mortgage loans should have a non-investment grade tail. Maybe that stands to reason, but it’s worth saying. Guaranty the investment grade bonds if that’s the right answer here, but there should always be a non-investment grade tail. These tails are a way of ensuring credit quality and pricing that will not be wildly distorted in comparison to the conventional multifamily debt marketplace. If whole loans are entirely transmogrified to investment grade paper, that gets these enterprises out of the liquidity business and deep into the cheap credit business…not where they should be.
This is worth repeating…these enterprises should not have a competitive advantage in competing for investor dollars on one side and borrower engagement on the other. They should not provide subsidized credit. They should not distort pricing in the conventional market. They should not, in good times, capture an outsized segment of the CRE multifamily marketplace.
The governmental backstop, which provides security for the liquidity promise, should not be an explicit or implicit guaranty of the federal government. The explicit guaranty, from a GAAP point of view, would explode the government’s balance sheet and the implicit guaranty is just a silly way to run a business. That suggests that the Treasury should provide its backstop through lines of credit that would be largely structured on market-based terms.
Uncle Sam’s warehouse will facilitate the extension of credit and be used to protect the bonds when problems arise. P&I will continue to be guaranteed. Troubled loans would be removed from underlying pools to protect the ratings of the senior bonds. We know when liquidity or credit conditions deteriorate, conventional repo-based finance warehouses respond by reducing advance rates, repricing and tightening underwriting and, if conditions are severe enough, leverage would become effectively unavailable.
Here’s where these new credit warehouses must be different. These warehouses would have to serve as a true backstop. They would always have to be available to the enterprises when liquidity dries up or when conditions deteriorate. However, the Treasury needs to be compensated for enhanced risks so advance rates may be reduced and credit spreads widened in a stressed environment (this will amount to actually asking private capital to step up, but that’s what it’s there for and that’s what it’s getting paid to do, right?). No matter what happens, the governmental warehouse will make sure that liquidity will never approach the zero bound of credit unavailability).
Ah, but how to make the Treasury, as warehouse lender, actually do its job and not succumb to the politics of cheap credit (how indeed to prevent the immediate recommencement of mission creep)? Good question. Some isolation of the “lender” function from the broader exigencies of policy will be needed. Hey, if the Fed can withstand the onslaught of the current occupant of the White House (or with its new ballroom, is it now Nero’s Golden Palace?), we can insulate this lender function from polities. Okay, we can at least try.
And by the way, there’s no magic to two of these new enterprises. One, and even two, gets me twitchy because of my concern about concentration of risk and the consequences of bad decisions by trillion-dollar enterprises. Consequently, I’d consider creating as many as ten of these institutions, mirroring our home loan bank system, and getting the business closer to the customer. Like the common securitization platform between Freddie and Fannie, these mini-GSEs could partner up to issue securitization and probably will.
I get that these suggestions would result in a vastly different financing landscape, but I would argue a more sensible one. Yes, let’s concede that this will increase the cost of credit in the multifamily space and therefore, in a knock-on sort of way, reduce the artificially elevated values in multifamily assets due to the elimination of the current subsidization of the cost of credit.
That’s not a bad thing. Market distortion is not good. The transition won’t be fun, but following transition we will have restored rational pricing and valuations. We will better protect the taxpayers from bad outcomes. We will allow private capital to do what it’s good at doing and provide the bulk of the credit for these marketplaces as it did before the GSEs exploded in the last several decades.
Just a thought[1].
Post Script: As I finish this, I see reporting that the White House is now fixing for some sort of public offering of some securities from the GSEs late this year. That’s got the cart so far in front of the horse that makes planning the NY Yankees World Series’ celebration today sound sensible. Can we be that witless as to do something without really thinking what that something is? Regrettably, the answer is probably yes.
[1] For whoever it is that reads me from the Commission of the European Communities, I’d love to chat with you. Ping me, will you?
