With the advent of the second Trump administration, many mortgage-backed securities market participants are uncertain — and concerned — about the fate of government-sponsored enterprises Fannie Mae and Freddie Mac.
Since September 2008, the GSEs have been under conservatorship by the US Government.
This was never intended as a permanent solution, but any route to end conservatorship risks raising mortgage rates — by increasing their cost of capital.
Under the current GSE arrangement, Fannie and Freddie can borrow marginally above 10-year treasury rates, as participants view them as a quasi-government entity backstopped by the government. After all, they still can receive about $254bn in direct funding from the US Treasury if need be.
The best solution would be to make the status quo permanent: this would be the optimal way to preserve market stability while avoiding any kind of disruption to the agency MBS market.
Political realities, however, complicate this choice: the Trump administration is steadfast in its desire to shrink the government.
Trade-offs
Ending conservatorship requires regulators to choose what to prioritize along a spectrum: more resilient GSEs, at the risk of being less affordable; or GSEs that are more focused on housing affordability at the expense of being less capitalized.
In any case, any solution would raise their cost of funds and result in more expensive mortgages.
They could have stricter capital rules and limitations, raising their cost of funds, which would increase protections for taxpayers in adverse scenarios but also make mortgages more expensive.
Or, they could have looser regulations and capital rules, which could make financing cheaper — but at the expense of being less protected during a crisis like the GFC.
Should the Trump administration decide to end conservatorship, the public utility model would be the best solution.
In this model, a regulatory body like the FHFA would oversee the GSEs, establish their how much they can charge in guarantee fees on mortgages they purchase, what kinds of loans they can purchase, and place limits on return on equity.
Equity return caps would limit profit-seeking behavior, and ensure that any excess returns are held as capital or used to support housing affordability.
Fannie and Freddie would pay a risk premium to the government based on their risk exposure. This would help ensure that taxpayers are able to share some of the GSEs profits in return for backstopping losses.
No better option
There is no other option that would allow the GSEs to be privatized with similar benefits for the economy as they provide enjoy today.
If the GSEs exited conservatorship with simply an "implicit" guarantee, the market would take a dim view of their credit risk, so their borrowing costs would rise and so would agency MBS spreads.
One way to combat that would be an explicit guarantee — for which only Congress can grant permission.
Yet this would also be problematic, bringing back the moral hazard of the taxpayer taking the risk yet private assets the profits. Indeed, before 2008, when the implicit guarantee was believed to be real, the GSEs would borrow cheaply and add leverage to chase returns at the taxpayers’ expense. Then during the GFC, everyone realized they were too big to fail, even if the government guarantee was only implicit.
Whatever fee the government might impose on the GSEs so that taxpayers share some of the gains would be directly passed onto borrowers in the form of higher mortgage rates. And unlike the public utility model, an exit from conservatorship with only an explicit guarantee would do little to mitigate the moral hazard at play.
Being regulated as a public utility — with limits on profits and sound regulation — could mitigate the agencies’ incentive to engage in risk-taking when they don’t bear the full costs of those risks.