December 15, 2015 Joshua Rosner 646/652-6207 jrosner@graham-fisher.com @joshrosner

Please refer to important disclosures at the end of this report.

EXECUTIVE SUMMARY GSE Reform: Something Old, Something New, And Something Borrowed Seven years after a financial crisis that was precipitated largely by a dysfunctional housing finance system, it is ironic that reform of the mortgage finance institutions commonly known as Fannie Mae and Freddie Mac remains an unfinished task for policymakers, especially since the elements of reform have been available to policymakers the whole time. Hindsight is 20-20 but it also improves foresight. The last seven years of study, analysis, and debate have shown that the best way to serve the public interest is to recapitalize Fannie Mae and Freddie Mac and make certain they perform their historic mission as countercyclical sources of capital and stability in the home finance market. They should have more stringent capital requirements and be regulated more like public utilities. This paper explains that a complete reinvention of the proverbial wheel would be both unnecessary and detrimental to the housing finance system and individual citizens. The government-owned Federal National Mortgage Corporation was established in 1938 in response to the collapse of banking and home prices. Its mission was to provide liquidity and stability in the housing finance market. Though government-sponsored, this model ensured that mortgage risks were transferred into the hands of investors rather than remaining on the government’s balance sheet. In 1968 Fannie Mae was transformed into a publicly-traded and privately-owned firm. In 1970, Freddie Mac was created to expand the secondary market. These Government Sponsored Enterprises (GSEs) continued to fulfill their roles with little controversy or politicization until 1989, when hundreds of savings and loan institutions failed and the GSEs teetered on the brink of insolvency. This prompted the first comprehensive Congressional review of the regulation of Fannie and Freddie in 30 years and led to the enactment of laws we now know were poorly conceived. Congress created a split-regulatory framework and dual mission that was increasingly subject to political goals but with diminishing or muddled regulatory scrutiny. Fannie and Freddie became vehicles for advancing social policy objectives of access to affordable housing at the same time safety and soundness standards were weakened. Through the 1990s and early 2000s, the Clinton and Bush Administrations used the GSEs to increase homeownership. However worthy the goal, the American Dream became a more leveraged experience. This dynamic was compounded in 2002 when a relatively arcane move by an international regulator most Americans have never heard of effectively opened the floodgates for new capital to rush into the private label

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securitization market. The Basel Committee of the Bank of International Settlements lowered the capital risk-weightings of a whole range of securities. This created new income opportunities for large banks, ratings agencies and investment banks. Before long, a variety of risky new products, and the possibilities of high, short-term yields started to add more leveraged risk to the market, to borrowers and to financial stability. In this fluid new arena, the management of the GSEs sought to maximize returns to shareholders while fulfilling the GSEs’ social policy mission to expand homeownership. Inadequate regulatory oversight, weak capital requirements, an implied government guarantee and the GSEs’ low cost of capital relative to that of other private market players encouraged them to use of their portfolios to generate highly leveraged returns. By 2007, it was clear a bubble was about to explode and Fannie and Freddie seemed to be headed for insolvency. The following year, with markets in free fall, Congress passed the Housing and Economic Recovery Act. HERA created the Federal Housing Finance Agency and placed the GSEs into conservatorship under the FHFA’s authority. The new law provided for a short-term conservatorship to get the GSEs back on their feet and to conserve and preserve their assets. Importantly, HERA also provided the FHFA with the mandate to design and implement almost all of the regulatory reforms that this paper recommends. Unfortunately, the law was not followed but instead undermined. Since 2012, as part of an apparent strategy to wind the GSEs down and eventually replace them, the U.S. Treasury Department has swept the GSEs’ revenues into the government coffers. To date, Fannie and Freddie have paid the Treasury $239 billion, roughly $50 billion more than the funds the GSEs received from Treasury. In the last few years, numerous legislative proposals have been put forward. Generally speaking, these would dismantle the current system and create a new structure with some of the worst elements of the pre-HERA GSEs or propose a risky alternative to replace them. Reform proposals rest on a number of myths. One myth is that private capital can replace what Fannie and Freddie provide. To replace the GSEs and attract enough private capital to insure only the top 10% of their $5 trillion mortgage credit book of business, the industry would need to attract close to $500 billion of capital. However, from the start of 2014 through April 2015, the private capital investment in agency first-loss deals was only $13.1 billion and available only for the crème de la crème of cherry-picked loans. The private mortgage insurance industry, in particular, is still reeling from inadequate capital standards and poor state regulation leading up to the 2008 crisis and there is simply not enough capital among the remaining players in the industry. If there is not enough private capital available to support the market in good times it is hard to see how there would be enough capital outside the GSEs to support the markets in a highly possible housing crisis in the future.

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Another myth is that Fannie and Freddie need competition. This would make sense if the GSEs had used their “duopoly” power to take advantage of consumers or distort prices. In fact, the GSEs, when functioning as intended, have a function akin to a utility. They perform an essential public service that other entities cannot or will not perform. The GSEs, when properly capitalized and regulated, act as countercyclical providers of capital when the primary-market private funding sources evaporate in the face of economic downturns. This activity would not be enhanced by trying to create alternative providers of capital. In fact, the answer to fixing the nation’s housing finance system begins with HERA and the path that it has already established for recapitalization of Fannie and Freddie. Considering that the GSEs have more than paid back the $187-billion cash infusion of 2008, even without raising any private capital, and without even counting the value of warrants for 79.9 percent of the GSEs common stock or the Preferred Stock Purchase Agreements (PSPA) the government holds, the GSEs could amass $ 150-$200 billion in capital over 10 years. If they were to issue additional stock for purchase or assume the value of the outstanding warrants, rebuilding adequate capital buffers could take even less time. The recapitalized entities should also be regulated in a manner consistent with their size and reach in the financial marketplace. With current portfolios of roughly $5 trillion, they epitomize the concept of Too Big to Fail. The GSEs also have an important credit-risk pricing function. Accordingly, this paper explains why the Federal Stability Oversight Council (FSOC) established in the Dodd-Frank Act along with the Federal Reserve would be appropriate backup regulatory entities to FHFA to reduce systemic risk. These regulators would better support the mission of the GSEs, as originally intended, to act as liquidity tools for the funding of new mortgages rather than as risk transfer mechanisms. In terms of the appropriate capital requirements for the GSEs, the Basel III framework, largely adopted by the U.S. government in 2013 for the nation’s largest banks, serves as a useful model. This paper presents various capital requirement models and recommends capital levels of three to five percent. In addition, the government backstop role would be clearer and more narrowly tailored. Stringent capital standards that incorporate security level requirements, real transfer of first-loss and stringent capital standards for private mortgage insurers or other first-loss holders, should give the public comfort that an explicit government guarantee is unlikely to ever be employed. But this government guarantee would also serve the historic purpose of maintaining liquidity and stability in the mortgage marketplace. As noted, this historic and prospective role for the GSEs is akin to a public utility. Therefore, once FHFA exercises the authority already provided for in HERA to

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recapitalize the GSEs and undertake other reforms recommended in this paper, Congress should create a de facto public utility commission for the GSEs. Like any PUC, it would be responsible for determining the activities, cost recoveries, guarantee pricing and allowable rates of return for Fannie and Freddie. In summary, it is no surprise that antipathy toward Fannie and Freddie grew broader and more intense the more policymakers deliberately or inadvertently tampered with their original roles as countercyclical providers of liquidity in the mortgage market. Instead of trying to create an entirely new model, it would be wiser for FHFA to restore the original public utility-like concept for Fannie and Freddie with the powers provided by HERA and with appropriate capitalization requirements and regulatory reforms. This would serve the interests of capital markets, aspiring homeowners and taxpayers for years to come.