HOUSING FINANCE POLICY CENTER BRIEF
Early Steps Down the Path
of GSE Reform
Jim Parrott
March 2015
It is easy t o be pessimistic about GSE reform t hese days. The effort to pass legislat ion
out of t he Senat e last year showed t he subject to be remarkably complex, bot h
subst ant ively and polit ically. And early signs are t hat t his Congress won’t even bother t o
t ake it up in earnest , making another concert ed legislat ive effort unlikely unt il aft er t he
president ial elect ion. Meanwhile, the forces that favor ret urning t o the pre-crisis st at us
quo grow st ronger by t he day, as t he causes of the crisis fade int o memory and indust ry
grows increasingly uneasy wit h anyt hing t hat might upset t he fragile recovery.
There is, however, one cause for opt imism: through the effort in the Senat e, a relatively broad,
bipartisan consensus emerged on what a future syst em should look like. The key parties agreed that the
nation’s housing finance system needs to provide broad access t o affordable, long-term, fixed-rat e
lending; t hat t he privat e market should bear the lion’s share of the credit risk; and t hat what ever risk
the t axpayer bears must be insulated behind significant privat e capit al. While negot iations among the
like-minded event ually stumbled over how best t o accomplish these objectives, the broad alignment
around what we were trying to solve for provides us wit h a compelling framework for reform.
It also provides t he framework within which to underst and a recent speech by Michael Stegman,
counselor t o the Treasury secretary and increasingly the Obama administ rat ion’s public face on housing
finance issues. Though on it s surface t he speech appeared simply to lay out st eps t o put the current
system onto sturdier ground, what it also did—and what makes it a more important speech than most
appreciat ed—is make the case for beginning down t he path of longer-t erm reform over which we
reached important alignment.
The Case for Reform
Stegman begins his speech by reminding us why we need reform. Aft er all, reform does not come free; it
introduces a host of risks not to be taken lightly.
First, taxpayers bear too much risk in the mortgage market right now. The GSEs and the FHA
together back the credit risk of almost the ent irety the market, and except where t here is mort gage
insurance, the taxpayer’s risk is not insulat ed behind any privat e capit al whatsoever. Second, the
government, not t he privat e market, is driving key decisions about who should get a mort gage and at
what cost. Third, those looking to invest in the space are frozen by the lack of certainty over how long
this awkward equilibrium will hold and what will follow it. Surely we won’t remain with a nationalized
system forever, but when will it change, and how?
These t hree factors have given us a syst em t hat is the worst of all worlds: it attract s too little
privat e capit al, provides too little mort gage credit, and still poses too much risk t o the taxpayer.
What Should Be Done
Before mapping t he path out of the quagmire, Stegman reminds us t hat what can be done
administrat ively is limit ed. Embedded in the chart ers of both GSEs is a t ension that proved devast ating
in the crisis. By providing private shareholders with an implicit taxpayer backstop, t he chart ers creat ed
an incent ive for profit-seeking act ors to take excessive risk, knowing that if their aggressive bets failed
to pay off t hen the taxpayers would foot the bill. No reforms can pret end to be final until and unless this
fundamental flaw is addressed. Yet t hese chart ers are Congressional charters, so only Congress can fix
them. For more on t his issue, see Why Long-Term GSE Reform Requires Congress.
That said, much can be done in the mean time t o improve the stability of t he current system and lay
the groundwork for eventual legislat ive reform. Fortunately, as St egman points out, the FHFA has
already begun much of the critical work.
The FHFA’s Effort s
In discussing the st eps t hat t he FHFA is taking, St egman focuses on the two most crit ical to long-t erm
reform: reducing t he risk t hat the GSEs pose to t he taxpayer and building a securit ization platform.
To reduce taxpayer risk, the FHFA is pushing the GSES t o sell off pools of nonperforming loans t hat
they hold in t heir portfolio and share some of t he risk on loans that they guarantee going forward.
Reducing the portfolio of legacy loans lessens not only t he overall level of taxpayer risk, but also its
volatility. To get a sense of just how volatile t hat risk is, we need only look to Freddie Mac’s most recent
quart erly earnings, in which it suffered a $3 billion accounting loss on a position held to hedge its
portfolio risk. If the loss had been only slightly higher, Freddie would have required a draw on t he
Treasury (for more on the issue, see What t o Make of the Dramatic Fall in GSE Profits). By reducing t he
GSEs’ portfolios, the FHFA will help decrease that kind of volat ility.
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By building a common securitization platform, the FHFA and t he GSEs are increasing the efficiency
and stability of a core funct ion of t he enterprises. With t wo separat e securities running off two separat e
platforms, Fannie retains a liquidity advantage over Freddie that reduces the already minimal
compet ition in the duopoly. For more on why, see Charting the Course to a Single Security. Moving
toward a single security issued off a single plat form will address t his and t he many other inefficiencies in
maint aining two unique syst ems.
What More Can Be Done
Though t hese st eps represent significant progress toward reform, the Obama administ ration contends
that more can be done. The administrat ion doesn’t propose a different pat h, however, only a more
aggressive pace.
First, t he administration recommends that the FHFA de-risk the GSEs more aggressively, by both
selling off their portfolios more quickly and doing more risk-sharing on new originat ions. The market
has shown significant appetite for the risk, so better to get it out of the taxpayers’ hands more quickly.
Second, the administ rat ion also recommends broadening the range of ways in which the GSEs share
their risk on new originat ions, in particular pushing more pilots in which they share t heir “first-loss risk.”
This would mean t hat an investor would suffer the first losses as loans in a pool default, leaving the
GSEs on the hook only when losses exceed a certain severity. To dat e, most of t he risk shared has been
“second-loss risk,” leaving t he GSEs and t axpayers in first-loss posit ion. More experimenting wit h firstloss risk sharing will help policymakers explore how best to push the GSEs int o the role of reinsurer,
with taxpayers deeply insulated behind private capital.
Third, the Obama administration recommends building a common securit izat ion platform that the
entire market can use, not just Fannie and Freddie. This common platform will make it easier t o
transition to a syst em less beholden t o the current duopoly, in which other guarant ors can compet e on
equal footing for the same mainstream credit long guaranteed by the ent erprises.
If we combine these three st eps, we can begin t o see the pieces for long-term reform coming
together, along precisely the lines of t he consensus framework coming out of the effort in the Senate.
If we were t o take this path, over t ime we would see the securitizat ion function in the current
system separat ed from t he guarant ee function, and the guarant ee function further separat ed into firstloss risk coverage and catastrophic risk coverage. Breaking up the functions of the system like t his will
make it much easier to push all but t he most remot e credit risk out into t he privat e sector. This would
not only insulat e t he t axpayer behind more privat e capital, but it would also put t he responsibility for
deciding who should get a mort gage and under what terms int o the privat e sector—that is, make t his
market genuinely “privat e” in the traditional sense. The government could t hen retain what it is bett er
positioned t o manage: t he catastrophic risk t hat t he private market simply won’t bear in any volume,
and t he highly mechanized process of securitization.
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The steps that Stegman advocates aren’t enough to get us all the way there, however. As he point s
out, Congress needs to make key decisions about what t he end stat e ultimat ely looks like: whet her
Fannie and Freddie remain a part of it, what role the government should ultimat ely play, and so forth.
As Direct or Watt has pointed out repeatedly, these end-state decisions are not the FHFA’s to make.
The agency can, however, take steps that will improve the current system and make Congress’s job of
deciding the endgame much easier. The FHFA can begin to move us down the consensus path of reform,
and in doing so show us what works and what doesn’t, where our assumptions are sound and where
they aren’t.
But it is ult imat ely t he FHFA’s call whet her t o take t hese st eps, not Treasury’s; the FHFA is the
independent regulator with ultimat e jurisdiction over the administ rat ive pat h forward. Though t he
Obama administration may have a compelling map, it is FHFA at the wheel.
What Will Not Be Done
Stegman finishes his remarks by addressing the group that opposes t he consensus path most loudly:
those who advocat e releasing the GSEs from conservat orship as fully privatized institutions wit h an
implicit government guarantee. Giving a market duopoly back t o institutions with flawed charters t hat
incentivize excessive risk-t aking would be “irresponsible”—and futile, if int ended to restore the stat us
quo before t he crisis. The institutions would almost cert ainly be designat ed by the Financial St ability
Oversight Council as Strat egically Important Financial Institut ions, requiring them t o hold significantly
more capital against their risk. This would force the GSEs to manage t heir risk, and price their credit,
very differently t han t hey did before the crisis. As St egman points out, there is no going back to the old
days, whet her we want t o or not.
Though t he rest of Stegman’s speech merely lays out a set of recommendations, which are up t o the
FHFA t o adopt, adapt or ignore as it sees fit, the concluding comment about what the Obama
administrat ion will not endorse is in a sense disposit ive. Any effort to recapitalize and reprivatize the
ent erprises will require an amendment of t he cont racts by which t he Treasury st epped in t o back t he
GSEs’ obligat ions. So, if the administrat ion doesn’t want the GSEs t o be recapitalized and privatized,
they will not be.
Conclusion
This brings us back to t he fundamental quest ion raised by the speech, which is perhaps more import ant
than anything act ually said: if we largely agree that we stand on unstable ground, and we agree on the
direct ion in which we’ll find the ground more firm, why not begin walking? Like the Obama
administrat ion, I find t he answer relat ively st raight forward. But also like the administrat ion, this
decision is not mine to make.
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About the Author
Jim Parrott is a senior fellow at the Urban Institut e and owner of Falling Creek
Advisors, which provides financial inst itut ions with st rat egic advice on housing finance
issues. He spent several years in the Whit e House as a senior advisor at the Nat ional
Economic Council, where he led the t eam of advisors charged with counseling
President Obama and the cabinet on housing issues. He was on point for developing
the Obama administration’s major housing policy positions; articulating and defending
those positions with Congress, the press, and the public; and counseling Whit e House
leadership on related communicat ions and legislative st rat egy. Parrott was previously
a senior advisor to Secret ary Shaun Donovan at the Department of Housing and Urban
Development. He has a BA from the University of North Carolina, an MA from the
University of Washingt on, and a JD from Columbia University School of Law.
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