Faith Schwartz: Given your insight on the Housing Reform plans prepared by the Treasury and HUD in response to the Presidential Memorandum, what do you think are the chief impediments to ending the conservatorships of Fannie Mae and Freddie Mac and can you articulate a path forward that would work?
Craig Phillips: I believe the Administration is firmly committed to the reform of our federal housing finance system. I also believe that there is not only consensus but complete cooperation between all the relevant parties, particularly Secretary Mnuchin and Director Calabria. I am very supportive of the recommendations in the Treasury report and believe they are possible to achieve.
Congress should do its rightful role and pass the legislative reforms called for in the report. Frankly, achieving that goal may be an impediment. The plan calls for taking administrative actions to end the conservatorships, in the absence of legislation, a step that I completely support. Director Calabria has repeatedly made the point that the statute itself requires him, as Conservator, to do so.
The Administration’s principles are straight forward – returning the GSEs to private ownership with strong regulation and oversight; having private capital absorb losses first to protect the taxpayers; opening the system to responsible competition; operating the GSEs as a guarantee model and minimizing the use of balance sheet; and preserving sensible allocation of resources towards affordable housing goals.
The Administration advocates for a full faith and credit guarantee of the mortgage-backed securities issued by the GSEs, a step that requires legislative action. I believe that ending the conservatorships administratively with the Treasury line as the basis of credit support is a viable plan. The current ratings of the GSEs are conditioned on Treasury support and must be maintained to assure their sound operation. The Treasury will likely make the terms of that commitment more clear, explicit and permanent to achieve the stability in the housing system that is required of a reform plan arising from administrative actions.
The reforms laid out in the HUD report are important as well. Through the FHA mortgage insurance and the Ginnie Mae securitization programs, HUD plays an enormous role in financing affordable housing and helping first time homeowners. It is critical that we assure they are working with the right tools and the right technology. An accountable budget process is required to achieve those goals, as advocated in the HUD report.
FS: Can the Administration’s Housing Reform plan be carried out in an election year?
CP: The GSEs have been in conservatorship for over eleven years and Washington has consistently concluded that “it is not the right time” to do housing reform. I think it is the right time and it just so happens to be an election year – let’s get on with it!
I believe bipartisan agreement can be achieved working from the Administration’s plan as a blueprint. Perhaps concerns on both sides of the aisle about resolving the conservatorships administratively propels Congress to act. But far too much time has passed to not address the issue.
We now have extremely strong economic conditions, favorable interest rates, low mortgage delinquency rates and strong housing prices. There are also robust conditions in our equity capital markets. The time to pursue reform is not when there is a crisis but when we can focus on enhancing what is already a well-functioning housing finance system and when the required capital can be accessed on advantageous terms.
Providing affordable housing to all Americans and focusing on disparity of home ownership rates among minorities is a tremendous national priority and is a key part of the reform plan. In my mind leaving the GSEs in perpetual conservatorship has not been particularly effective in achieving those important goals.
FS: With FHFA’s plans to re-propose a Capital Rule, how does that impact the timing for implementing the Treasury Plan?
CP: I believe the decision to re-propose the Conservatorship Capital Rule clearly delays the timing of achieving the goals laid out in the plan. I support Director Calabria’s judgement on this matter, but I do hope the changes that are ultimately proposed justify the cost of the delay.
This is a unique situation where policy must be conformed with market expectations, since an important part of the plan is raising new capital. Achieving a framework that assures the safety and soundness of the GSEs and provides a market rate of return on the required capital is the delicate balance that must be struck.
Changes to the originally proposed rule might have included adjustment to the leverage ratio; reducing its pro-cyclicality by decreasing the frequency and impact of current loan-to-value adjustments; and incorporating explicit capital provisions for operational risk. I believe it is important to retain the appropriate capital treatment of the credit risk transfer tools the GSEs have developed to better manage their risk.
One topic in the public narrative concerns the nature of “bank-like capital” and whether the proposed rule was too lenient relative to the capital requirements of our largest banks. The logic holds that if the GSEs don’t have the same capital as banks it gives them an unfair advantage operating in the market and that will, in turn, contribute to over-sized market share.
The GSEs operate as an insurance model and not a balance sheet-funded model. Because the GSEs primarily finance themselves through asset sales, by issuing guaranteed mortgage-backed securities, unlike banks they do not have funding roll-over and interest rate management risk. It is a matter of opinion, but I believe the risk weighted capital requirement in the originally proposed rule was aligned with the capital treatment for a bank that engaged in similar activities to those of the GSEs. Numerous private sector calculations based on historic losses have validated that judgment.
FS: Is the market ready to absorb new offerings of common stock from the GSEs? How do the interests and concerns of the current holders of common stock and junior preferred stock factor into all of this?
CP: Properly positioned, I believe there is sufficient demand in the capital markets to recapitalize the GSEs. In fact, through the combination of retained earnings and capital raises both entities could be fully recapitalized to a reasonable capital standard within a four-year period.
Why do we need capital in the first place? It is not to enrich shareholders or Wall Street – it is to protect the interest of taxpayers. Virtually all the earnings of the GSEs in conservatorship have been distributed as dividends to the U.S. Government. Any insurance provider needs reserves to cover claims resulting from realized losses on the guarantees they have issued. At present, the GSEs have over $5 trillion of obligations and virtually no reserves. That is not sound and is the biggest reason for the urgency of reform.
There are a few key requirements for a successful capital raise. These requirements are also aligned with sound policy for our federal housing finance system. First, a clear and consistent policy environment must be established concerning the regulatory oversight of the GSEs and the impact on their activities and footprint. Second, we need an explicit capital standard and an operating framework that that creates a path for the GSEs to earn a market return on such capital. Third, we need a criteria to exit conservatorship. Finally, we need clarity on all key obligations of the GSEs, such as obligations toward supporting affordable housing or the cost of a periodic commitment fee for the Treasury line.
It is important that the treatment of the historic holders of common stock and junior preferred stock are also considered as part of the final policy on executing the end of the conservatorships. Fannie Mae and Freddie Mac are public companies, with the rights of the existing holders suspended, not eliminated, by conservatorship. The government left these shares outstanding and freely trading in the market since 2008. The ultimate manner of treating the shareholders has tremendous precedent value for U.S. Government capital markets policy.
The junior preferred stock should be exchanged for common stock on a basis that is viewed as fair, based on capital markets standards and the prevailing market value of those securities. The U.S. Treasury should exercise its warrants to acquire 79.9% of the common stock of the GSEs, as agreed in the PSPAs. Since the beginning of the conservatorships, Treasury has received dividends totaling over $300 billion on its original capital infusion of $191 billion. Consequently, the liquidation preference of the senior preferred stock should be reduced to zero and the Treasury should be considered “repaid”. These actions are aligned with the interests of the U.S. Government to move forward in recapitalizing the GSEs, namely in eliminated the current significantly negative net worth of Fannie Mae and Freddie Mac and removing claims that negate the value of the very common stock that must be offered to the public to raise capital.
While putting the GSEs into receivership is a possibility, and is an option established in the statute, it introduces numerous complexities. Receivership is potentially unsettling to the stability of the housing finance system by leaving the future of that system in doubt.
FS: FHFA has recently announced a pause on innovation by the GSEs on appraisals, is this a step consistent with entreating private capital and greater competition into the mortgage markets?
CP: It is critical that the GSEs continue to focus on their mission of creating secondary market conditions that minimize the cost to mortgage borrowers. Innovations in technology can play a large role in not only lowering costs but improving the speed, efficiency and predictability of the consumer experience. Technology also can improve the risk management environment at the GSEs. I hope we find a way to move forward on advancing initiatives in technology and innovation even as the priority of ending the conservatorships proceeds.
The banking regulatory agencies, namely the Federal Reserve, the OCC and the FDIC, have finalized a rule that allows banks to use discretion on obtaining an appraisal on residential loans up to $400,000, modifying a previous threshold of $250,000. Just last week, the NCUA proposed a rule, with a similar modification of thresholds for appraisal standards, which would apply to credit unions, which collectively provide a large amount of residential mortgage credit annually.
The FHFA should consider turning its attention to creating a policy for alternative appraisal methods, which can be informed by alternatives which make increased use of data and modernized analytical techniques such as automated valuation models (or AVM). Establishing thresholds for appraisal standards for the GSEs that are consistent with those adopted or being adopted by the banking regulators is important to create a level the playing field in regulatory standards. Such a step would also provide clarity for non-bank originators that comprise a very important share of the residential mortgage lending market.
This issue requires thoughtful consideration and policy development on the part of the FHFA and building on the experience of the GSEs. Market standards should not evolve in an ad hoc manner or through a waiver process that is not transparent and may favor certain lenders by size or type. In that sense, a pause to develop a comprehensive policy is appropriate.
The GSEs hold a tremendous amount of proprietary valuation data on the home loans they have purchased. Making this proprietary data available to market participants would meaningfully increase transparency and decrease asymmetries in information between the federally chartered housing finance companies and the private sector. The FHFA should consider conducting a policy review on this issue as well.