The Problems

The GSEs have a legal problem and a capital problem that are irreconcilable with each other while in conservatorship. These problems need to be resolved in order for the GSEs to raise sufficient private capital to exit conservatorship.

Put briefly, the GSEs’ legal problem is that SCOTUS in the Collins case has interpreted the governing statute for the GSEs’ conservatorship (HERA) as permitting the FHFA as conservator to do essentially what ever it wants during conservatorship.

This legal conclusion is a total non-starter for Wall Street…which creates the capital problem for the GSEs.

The GSEs’ capital problem is that the GSEs require substantial private capital to exit conservatorship, and Wall Street will not provide this capital to the GSEs while the GSEs are in a conservatorship governed without any discernible limits on a FHFA director’s authority under HERA.

I have set forth below what I consider to be the best solution that permits the GSEs to raise substantial private capital, exit conservatorship and (together with the LIH Cos discussed below) accomplish the twin goals of providing a deep secondary mortgage market for conventional loans, and a superior funding mechanism to support low-income housing mortgage finance. This proposed solution utilizes conventional tools of corporate finance and structuring to reform the GSEs without any resort to drastic measures such as “winding down” the GSEs, and can be implemented by FHFA without any new legislation.

To do this, the GSEs will need to separate their two “lines of business”. Currently, the GSEs “cross-subsidize” the higher risk/lower profit low-income housing mortgage finance line of business with the lower risk/higher profit conventional secondary mortgage finance line of business within each GSE, acting as a single entity.

If the GSEs are to raise money as currently structured, they raise money for both lines of business. If the federal government seeks to provide a federal backstop for the low-income housing mortgage finance business, it must also do so for the much larger conventional secondary mortgage business, since risks presented by both lines of business are borne by the same entity that would require the backstop.

While the two lines of business are being conducted within the same GSE entity, both lines of business benefit from the “implicit” guaranty that the federal government will bail out the GSEs. As a matter of federal housing policy, a well capitalized conventional secondary mortgage finance business should enjoy neither an explicit nor implicit federal guaranty, whereas the low-income housing mortgage finance business should enjoy either a paid for explicit federal MBS backstop guaranty (which would require new federal legislation) or an implicit federal guaranty focused solely on the low-income housing market business.

This is a highly inefficient way to structure the two multi-trillion GSEs.

However, it would be foolhardy to separate the two lines of business without allowing both lines of business to continue to use the substantial human capital, infrastructure and business processes that are uniquely present in the GSEs, and that would be required to run these two lines of business after separation. Of course, it would be insanity to “wind down” the GSEs when a far simpler and effective solution is readily available that would use the GSEs as part of the solution, and focus solely on their misguided mixed public/private corporate and operating structure as the problem to be fixed.

The Solution

As a matter of corporate finance, private investors would prefer to be shareholders of an entity that conducted only the conventional secondary mortgage finance business. GSEs that focused exclusively on the conventional secondary mortgage finance business would continue to be able to support a deep market for 30 year prepayable mortgages. As a matter of housing policy, the federal government should provide direct financial support only to the low-income housing mortgage finance business that is currently being done by the GSEs. As the GSEs are currently structured, this cannot be done.

The GSEs should be reformed to permit this to be done, and all this would take is to perform the corporate restructuring suggested below, which can be implemented by the FHFA director during conservatorship. Once this is done, the federal government can focus its policies, governance and financial support on the low-income housing mortgage finance business, and leave the GSEs to conduct the conventional secondary mortgage finance business subject to the discipline of the private mortgage and capital markets (with continued prudential regulation by FHFA after conservatorship exit).

1. Each GSE would drop its low-income housing mortgage finance business into a subsidiary (LIH Co) and spin all of the ownership interest in LIH Co to Treasury in redemption of Treasury’s Senior Preferred Stock interest.

2. Each GSE would grant to its LIH Sub a perpetual, cost free license to use all of the existing business infrastructure existing at the GSE in order for LIH Sub to conduct the low-income housing mortgage finance business. In essence, the GSEs would continue to provide operational but not financial support to the LIH Subs to conduct the low-income housing mortgage finance businesses.

3. Treasury would capitalize each LIH Co with the proceeds from the sale of its 79.9% common stock ownership interest in each GSE.

4. Upon completion of Treasury’s common stock sales in 3. above, Treasury will own 100% of the equity ownership interest in each LIH Co conducting the low-income housing mortgage finance business formerly conducted by the GSEs (and zero equity interest in the GSEs). Each LIH Co would guaranty low-income housing MBS and charge its own separate guaranty fee (as well as provide whatever additional forms of support it deems advisable). Each LIH Co would be very well capitalized to conduct this business from the proceeds of the sale of Treasury’s GSE common stock, which would enable LIH Co guaranteed MBS to be sold to institutional investors. If the federal government wants to further support the low-income housing mortgage finance business, it can provide a federal government backstop guaranty focused solely on LIH Co guaranteed MBS.

5. Each GSE would conduct primary issuances of common stock coincident with Treasury’s secondary sales, in order to adequately recapitalize the GSEs in order for the GSEs to exit conservatorship and continue to conduct their conventional secondary mortgage finance businesses.

6. Each GSE would convert its federal charter to a state charter in order to become a conventional for-profit corporation and no longer be exempt from paying state taxes where applicable, and FHFA would relieve each GSE from any low-income housing mortgage finance business mandate. Treasury would eliminate its line of credit supporting the GSEs under the PSPAs.

7. In order for Treasury to obtain the highest possible sale proceeds from the sale of GSE common stock so as to capitalize the LIH Cos to the greatest extent possible, and for the GSEs to adequately capitalize their continuing conventional secondary mortgage finance businesses, FHFA should enter into consent decrees (essentially contracts) with the GSEs, and promulgate a revised capital standard while in conservatorship.

8. The consent decrees would formalize the important GSE reforms made to date, such as eliminating the funding of toxic mortgages that arose prior to the Great Financial Crisis.

9. FHFA’s revised capital standard would be a truly risk-based standard for non-banking mortgage finance guaranty companies without excessive conservatism, and would reflect the de-risking that will have been accomplished by transferring the low-income housing mortgage finance businesses out of the GSEs.

10. Perhaps most importantly, this restructuring should serve to depoliticize the GSEs, which should improve their capacity to raise capital. The GSEs would become conventional for profit finance companies that would be subject to continued prudential oversight by FHFA due to their size, but would no longer benefit from any implicit federal backstops (other than to the extent that all large banking and other financial institutions do so currently).