According to a recent report from the Urban Institute, there is simply nothing the FHFA or the Obama administration can do in terms of administrative reform to “fix” the key issues with Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC). The report concludes that any real change to the mandate of Fannie Mae and Freddie Mac must be made by Congress. The Urban Institute report is authored by Jim Parrot and titled “Why Long-Term GSE Reform Requires Congress”.
Impossibility of administrative Fannie Mae and Freddie Mac reform
A quote from the overview of the report summarizes Parrot’s perspective on Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) reform. “The appeal of that view [reform through administrative action] is understandable, but it is unfortunately based on a misunderstanding of the options. For better or worse, the only path available in long-term reform is through the halls of Congress.”
Exiting conservatorship with government backstop
Most Democrats and a few from other political persuasions believe that Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) should be exit conservatorship as restructured entities with a government backstop guaranteeing investor capital.
The problem with that idea is that section 3.2 of the Preferred Stock Purchase Agreements between Fannie Mae and Freddie Mac and the Treasury requires that the enterprises pay a fee equal to the backstop’s value. A fee equal to the $265 billion line of credit would be extremely high high (a 5% fee, for example would be $13 billion), far more than Fannie Mae and Freddie Mac could pay over the next few years.
This would result in a situation Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) would have to borrow against their line of credit to cover the shortfall every quarter. Investors would see that the enterprises were likely to exhaust their line of credit and would start to price in the risk that they might not be completely protected by the full faith and credit of the U.S. government. Fannie and Freddie would have to charge higher fees for the guarantee to cover the rising premium required by investors, inevitably increasing the cost of mortgages.
Only Congress has the authority to change the terms of the bail out deal with Fannie Mae and Freddie Mac.
Exiting conservatorship without a government backstop
Parrot also points out two major problems with taking most Republican’s preferred alternative for GSE reform — a new entity with a government backstop. First, investors would immediately demand a much higher interest rate to reflect the risk. Furthermore, given that sovereign funds, mutual funds and other large investors who will not take on this kind of credit risk will leave the market, demand for Fannie Mae and Freddie Mac’s securities would plummet. This significant decrease in demand, together with the higher returns new investors will demand, will make Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) charge much less for their securities and by the same token, much more for their guarantees. When the cost of guarantees increased, demand would fall dramatically, along with revenues, leading to a collapse of the business model.
Second, Fannie Mae and Freddie Mac’s creditors would also demand higher rates. Given Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) would own trillions of dollars of liability, but have no backstop from the government, and minimal capital cushion, Fannie Mae and Freddie Mac’s credit ratings would plummet. This would mean limited access to funds at higher rates, again essentially obviating the current business model.
Full report can be found here H/T Nick Timiraos of WSJ
