In the first article of this series, I discussed the argument for turning Fannie Mae and Freddie Mac into public utilities, which would result in more Americans having fair access to mortgage services. However, regulating government-sponsored enterprises (GSEs) as public utilities is not without its detractors.
Privatization is often presented as an alternative option, but as I mentioned in the previous article, it’s not always the ideal approach. Strictly speaking, privatizing means zero federal connection and no limit on the number of GSEs. Without a national market, local supply and demand for mortgages could become unbalanced.
The mortgage markets of 2007 and 2020 remind us that there is no durable mortgage market without federal backing (including the banking system). Nongovernment-backed lending disappeared in both cases virtually overnight.
The subprime mortgage crisis offers a great example of why national guarantor standards are critical. In 2006, nonagency securitizations — which were more likely to involve teaser-rate mortgages and high-risk borrowers without even measuring whether they could afford the mortgages they were getting — made up almost 40% of new originations. Two years later, mortgage lenders issued more than 3.1 million foreclosure filings.
Beyond storytelling, what does economic theory say about strict privatization? Consider these questions:
1. Are there gains to being large and diversified?
Markets can be efficient on their own when there are no barriers to entry or gains from scale. Neither assumption is true in the U.S. mortgage guarantor and securities markets, so it’s best to avoid strictly privatizing. This could lead to a U.S. housing market with few firms that might not be nationally diversified and which would often destructively compete with one another on price and standards.
2. How long do the consequences of credit decisions take to reveal themselves?
Markets can be efficient when the costs and benefits of transactions occur at the time of the transaction, but not when the consequences occur long after. Defaults can occur years after origination and depend in part on external factors. Therefore, unregulated guarantors won’t reliably hold enough capital to survive future stress. How do we know that? Consider this: Are there any significant financial services firms without external regulation and capital standards?
Furthermore, firms are incentivized to drop standards and prices to gain short-term market share rather than emphasizing longer-term stability. These delayed consequences generally lead to undercapitalized firms that underprice risk.
3. Do the benefits of nondiscrimination accrue beyond individual transactions?
Yes — firms can maximize their own profits while still doing damage to society, and the overall benefits of fair lending can be much greater than the profit and loss of one mortgage. Without regulation, local economies hoping to spur fair lending practices will be less likely to attain this goal, while those preferring to encourage lending to their own selected groups are free to do so.
4. Does the damage to the economy of institutional failure extend beyond company owners?
One small mortgage lender or GSE bond investor shutting down has little impact on the larger economy, the flow of mortgage funding, homelessness, or the U.S. housing market. However, breaking the link between origination and capital has consequences throughout the housing and mortgage ecosystem beyond an individual transaction. Firms that are left to their own devices could grow more fragile.
Final Thoughts on GSE Reform
Ultimately, GSE reform is a partisan issue; generally, the left supports a transition to utilities and the right pushes for privatization.
Privatizers might respond by saying that they don’t mean strict privatization. But then begins the regulation journey. Like civil rights laws, anti-discrimination standards must be federal. Who enforces that? Are credit and fair lending standards needed? Who enforces that? Are capital standards necessary? Who sets that? Are secondary markets valuable, or are gigantic mortgage balance sheets OK? Who creates and regulates that?
These are complicated questions that require wise solutions, but it seems hard to argue that standards are unnecessary or that secondary markets aren’t an efficient way to connect origination with investment.
Nonetheless, the left needs the right’s buy-in to transition GSEs to public utilities, so it could behoove them to at least consider these conservative leanings. On the other hand, the right wants private capital to invest in the U.S. housing market. Fortunately, setting up GSEs as utilities will help us do just that.
The Treasury and FHFA could formally set up GSEs as utilities and crucially, continue requiring that they intermediate most of their risk into the private market through the competitive mortgage-backed securities, credit risk transfer and debt markets. Then, the GSEs will intermediate more risk that investors can flock to.
This is the crucial common ground between the groups — namely, to maximize the amount of private capital invested in mortgages. GSEs as regulated utilities intermediate the vast majority of mortgage risk to private capital while positioning taxpayer exposure as remote. Concurrently, effective federal regulation can assure fair lending and the utility mission in exchange for the resiliency of the federal backstop.
When the United States Supreme Court ruled that Biden could remove the Federal Housing Finance Agency director at will, it reinvigorated a long-held debate about what to do with Fannie Mae and Freddie Mac. Sandra Thompson, the current agency director, has a significant job ahead of her, but she also has a great deal of influence when it comes to running GSEs like utilities and allowing legislation to catch up.
I, for one, would not be opposed.
Richard Cooperstein, Ph.D., is the director of partnerships and policy at Andrew Davidson & Co., Inc..
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