It has been difficult to shake the impact of the 2008 global financial crisis. It required a series of unconventional central bank monetary policy adjustments euphemistically known as quantitative easing that has now raised fears of an asset bubble. One issue has not been addressed, Moody’s noted in a 15-page report on the potential outcomes and likely impact. One of the largest pieces of unfinished business from the crisis is found in resolving the conservatorships of government-sponsored entities Fannie Mae and Freddie Mac, commonly referred to as GSEs, which insure home mortgages in the US.

GSE Reform

Uncertainty lies ahead with GSEs

In the wake of the 2008 financial crisis, when unsustainable mortgage loans threatened to bankrupt not just the major banks in the US but also the re-insurance firms that backed those mortgages, dramatic actions were taken. Banks received unprecedented bailouts and the previously publicly traded Fannie Mae and Freddie Mac was taken under conservatorship by the US government.

With nearly half of all new home mortgages and multifamily building loans insured by Fannie Mae and Freddie Mac, how these entities come out from under the control of the US government is likely to have a major impact on the $11 trillion US residential and multifamily mortgage market.

“Recognizing the great uncertainty over what lies ahead,” Moodys models three primary paths, focusing on the most significant potential consequences.

Very low probability of GSE reform in the near future

Moody’s sees “a very low probability” of major reforms occurring in the next couple of years, but that is “not from a lack of ideas for policy makers to weigh.” The ideas and methods to handle the problem have been numerous as the debate has been boisterous.

If those managing the process are not careful, “one possible outcome is a broad increase in interest rates on new mortgages,” a move that could impact a wide swath of the economy.

The three primary options are:

  • Wind down the GSEs without creating an explicit replacement, allowing the free market to create a comparable re-insurance program for mortgages much like is done in other areas.
  • Re-privatize the GSEs and possibly 1) regulate them more tightly and/or 2) provide them access to federal catastrophic risk insurance, either alone or as part of a broader group of entities.
  • Wind down the GSEs and provide other entities with access to the federal catastrophic risk insurance.

Regardless of the path taken, there are several issues that need to be addressed:

  • The treatment of outstanding GSE securities and current GSE shareholders
  • The ownership structures, capital levels, and risk-sharing to be allowed/mandated for the GSEs or other entities in the new system
  • The nature of any catastrophic risk insurance and whether it will be offered only to MBS or to guarantors
  • The need for utility-like constraints on GSE profitability
  • The need for, and nature of, counter-cyclical regulatory mechanisms
  • The types of mortgages to be covered and scope of access to securitization infrastructure
  • The need to preserve the availability of 30-year mortgages and the so-called To Be Announced (TBA) market for MBS trading.

Watch out for unintended consequences in GSE reform

The Moody’s report notes that the devil is in the details and many paths could lead to unintended consequences.

“Even paths whose effect would seem apparent at a high level could have the opposite effect in practice,” the report noted. Consider the most basic explicit government guarantee of new mortgage-backed securities. Even with this guarantee, mortgage rates could nonetheless rise if market liquidity declines or if private-market participants charge more than anticipated to handle increased risk exposure.

Even under a situation where a well-capitalized version of Fannie Mae and Freddie Mac were created, mortgage rates could still rise if increased capital requirements pressure the GSEs to raise guarantee fees. Such an outcome also occurs if reduced government backing leads to investors receiving less favorable regulatory treatment on GSE debt securities.

“Of course, more than the cost of new mortgages will be at stake,” Moody’s noted. “Wider spreads and lower prices for agency MBS would affect both the value of current portfolios and ongoing investment opportunities.” This includes changes to the special regulatory treatment impacting a banks’ capital and liquidity ratios, for example. Further, Moody’s noted the wind-down or down-sizing of the GSEs could remove a source of “quasi-regulatory oversight” behind the documentation process and the standardization of standards and data used in the process.

In the end, a change could lead to disruption. “Some companies could benefit as new opportunities develop or their pricing power improves, while others could face new challenges as historic drivers of their franchises disappear,” the report noted.