On Monday, Treasury Secretary Mnuchin sounded the death knell for GSE reform in this Congress and didn’t seem all that sorry to do so.  Why not?  With Mel Watt’s term as FHFA director coming to a close, Treasury will have ample opportunity to redefine Fannie and Freddie without the bother of working with Congress.  And, even if Treasury were otherwise disposed not to use its power, the ability of a Treasury-redesigned mortgage market to pick winners and losers for years to come is not only understood, but also sought.  Facing the 2020 election, who could resist making so much of a difference in so important a sector, especially given that failing to act quickly could lead to near-term crisis on President Trump’s watch.

What near-term crisis?  As an in-depth FedFin Report earlier this week laid out, the GSEs’ 2018 stress test will be a killer.  It is based on the Fed’s 2018 CCAR round which, as we noted, is particularly punitive to residential and multi-family real-estate obligations.  More credit-risk transfers might cushion some of these blows, but entities with the infinitesimal capital buffers allowed the GSEs that are also coming under current expected credit loss (CECL) accounting have zero margin for error.  A draw or two from Treasury ahead of the 2020 election would be more than embarrassing, especially given Republican angst over the deficit even before Fannie or Freddie make it worse.

Assume, though, that there’s no draw and nothing even worse.  Treasury surely will act rather than allow mortgage finance to be defined by default for yet another decade.

The scope of its authority under current law was detailed in a recent report and American Banker story on it.  Using its power soon advances Treasury’s policy objectives for a more privatized mortgage market, a political win for the White House, and a new secondary market that favors those closest to the Administration’s ears.

And, even if none of this stirs Treasury – and Mr. Mnuchin’s comments show that all of it has – there’s a third reason Treasury will need to act in 2019:  the impact of an array of pending rules on the largest U.S. banks.  We have issued in-depth reports on the new stress-capital buffers, the eSLR, and CECL along with another report summarizing the cumulative impact of all of these rules on the secondary mortgage market.  In short, all of these rules will push the largest banks to portfolio only the shortest-term mortgages with the greatest underlying collateral and hold loans or RMBS with significant amounts of eligible third-party credit enhancement.  The U.S. government is of course the most eligible credit enhancer of all.

Each big bank will balance all of these rules in concert with broader market realities to define what’s left of their portfolio-mortgage strategies.  Slicing underlying mortgage books into credit-risk tranches with varying terms, layers of credit enhancement, and LTV ratios creates considerable scope for putting private capital – including that of the very biggest banks – ahead of the companies that will come to succeed Fannie and Freddie.  Why would big banks play in credit risk transfers given that they are now sitting them out?  The rebalanced framework of risk-based and leverage rules combines with CECL to create a new playing field, with each bank then carefully defining its position in it based on an array of complex factors. 

Is this enough to make a TBA market for thirty-year fixed-rate mortgages?  I doubt it.  As a result, the sum total impact of these changes is to make a secondary market with at least a USG backstop, if not direct guarantee, a critical element to any Administration that wants to keep thirty-year fixed-rate mortgages flowing – and Treasury clearly does. 

The odds of crafting a safe course to a TBA market through all these regulatory rapids are considerably higher via administrative fiat than yet another legislative round.  For proof, see not only Congress’s general inability to do more than delegate questions this complex.  Still not convinced?  Then, remember the fifteen years that have passed since Sen. Shelby first tried to redefine the GSEs followed by subsequent efforts by Sens. Corker and Warner, among others, to redefine Fannie and Freddie by law. 

Mr. Mnuchin clearly knows this – indeed, that’s what he’s saying quite directly.  What he’s not saying so far is what Treasury wants other than ending the conservatorships ASAP, reviving the role of private capital, and retaining thirty-year, “middle-class” mortgages.  Easier said than done.  Fortunately, Treasury is skilled not only in knowing its political needs and policy wants, but also how the new regulatory framework redefines what big banks can do to play the part Treasury seeks in a far more privatized mortgage market.  Who else wins?  What do new mortgages look like?  At how much taxpayer risk?  Does FHA just take over from the GSEs for much of the market?  Keep those cards and letters coming in to Treasury.