Ed DeMarco’s Uncharted Post-GSE World by Investors Unite

As former Federal Housing Finance Agency Acting Director Ed DeMarco’s public service career recedes farther in the rear-view mirror, the more prone he is to revising history and fantasizing about a future without Fannie Mae and Freddie Mac.

The latest salvo in his war on the GSEs is a new paper titled, “Why Housing Reform Still Matters,” published by the Milken Institute, where he is now a senior fellow. His co-author is Michael Bright, a former aide to Sen. Bob Corker, R-TN, who is also a dogged foe of the secondary mortgage market enterprises.

DeMarco argued for putting Fannie and Freddie “out of the taxpayers’ misery” last summer. The new paper puts some meat on the bone on how he thinks this can and should be accomplished. The upshot is that Fannie and Freddie would be dismantled and mostly handed over to large lenders. The lenders would reconstitute the GSEs in an arrangement akin to a private-sector mutual insurance company. This lender-owned enterprise would sell insurance against defaults instead of buying and securitizing mortgages.

There will be more details in subsequent papers, but some elements of the authors’ initial framing of housing finance policy past, present and future cannot go unchecked. The phrase “life support” is used several times to characterize the conservatorship of the GSEs, which is now in its eighth year. But the paper omits any reference to the Net Worth Sweep in 2012, which started the process of turning highly profitable enterprises into captives of the Treasury. This was a policy DeMarco championed, as has become ever more evident as documents in shareholder suits are unsealed. As noted in a blog earlier this year, just as the patient was ready to come off life support DeMarco and his colleagues induced a coma and initiated organ harvesting.

In addition, the paper explained, “The government life support given to them at the height of the financial crisis was meant to be temporary, followed by legislation replacing the toxic aspects of their activities and reforming our market structure.”

The dismantling of the GSEs may well be how DeMarco interpreted the Housing and Economic Recovery Act (HERA) but here is what it actually said: FHFA powers as conservator, as outlined by HERA: is to “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.” [12 USC § 4617(b)(2)(D).]

Thus, DeMarco and Bright can decry the fact that what was supposed to be temporary conservatorship has gone on for eight years, but DeMarco is dancing past his role in creating this untenable arrangement in the first place. HERA actually vested power in FHFA, not Congress, to facilitate most of the reforms that would be needed. Sen. Corker’s Jump Start bill, lauded in the paper, was actually a power grab by Congress not to expedite reform but to perpetuate the status quo for at least another year, and probably more.

Taking stock of the current situation, the paper presents a false choice of continuing the conservatorship in perpetuity or going back to what is described as a “failed model.” In fact, as we have pointed out, no credible analysts or commentators advocate reverting back to the structure and operation that was in place leading up to the 2008 financial crisis. In fact, everyone agrees reforms are needed, but the DeMarco-backed Sweep has actually hindered real reform.

Instead, DeMarco boasts about crafting the 2012 FHFA Strategic Plan for Enterprise Conservatorships and the scorecards that set in motion credit-risk transfer (CRT) and the common securitization platform (CSP). After devoting considerable space to showing the rapid changes underway, the paper proclaims, “Either way, both of these initiatives—the CRT and the CSP—are meaningful undertakings that faced skepticism in the beginning but are now largely recognized as worthwhile endeavors. These changes alone, so long as they are continued, help ensure that the post-conservatorship secondary market segment traditionally served by Fannie and Freddie will not look the same as it did before the crisis.”

This assertion is only partially correct. It is true that with risk sharing and the CSP Fannie and Freddie have been forced to slowly shed their core business to private investors on terms that lack a compelling business rationale. The longer this “reform” by bureaucratic fiat continues, the more likely it is that they “will not look the same as it did before the crisis.” But we should not rush to assume this undertaking is a “worthwhile endeavor.” There are more questions than answers on that.

In fact, the very day that the paper was released, FHFA issued a progress report on the status of risk sharing and request for suggestions on how to undertake more front-end risk transfer transactions – those that take place before or at the same time Fannie or Freddie acquires a loan.  In essence, FHFA is conceding that it is drifting into uncharted waters on a boat that is leaking capital, thanks to the Net Worth Sweep.

In their inaugural paper, DeMarco and Bright give lip service to affordable housing, the political realities of undertaking radical reform, whether there is enough capital to replicate what Fannie and Freddie have done over the decades, interest rate stability, and whether a lender-owned mortgage insurer could handle the stress of another financial crisis. These issues must be addressed in any serious discussion of housing finance policy. One matter on which there was clarity in the paper is that HERA’s obligation to shareholders in Fannie and Freddie would be negated. So much for reform.

Fannie Mae & Freddie Mac