The Wall Street Journal last week described Bill Pulte’s recent mortgage-fraud allegations as ill-advised “political lawfare.” Thus it is, but it’s also an unfortunate distraction from a high-priority decision within Mr. Pulte’s legal remit: ending the GSEs’ conservatorship. If FHFA and the Administration do not tread carefully, they will do a lot of damage not just to the mortgage market, but also to the President’s mid-term hopes and long-term legacy.
The GSEs matter this much not just because a liquid, affordable mortgage market matters so much. It’s also because the GSEs issue $7.7 trillion in debt obligations, or almost a third of Treasury’s $29 trillion. The type of federal backstop afforded to the GSEs or assumed by markets determines how much Fannie and Freddie must pay to attract investors. How much the agencies pay also affects how much Treasury must pay to do the same. Because Treasury obligations float the U.S. Government’s boat, the cost of agency debt matters even more.
As we noted in a FedFin report last week, the GSEs federal guarantee comes in four flavors: explicit, “effective,” implicit, and none to speak of. Privateers refer the last flavor, but markets will assume the GSEs still enjoy an implicit guarantee no matter what anyone says, so the real flavors on offer are only the first three.
Because the GSEs are in conservatorship, they now have what FHFA has long called the “effective” guarantee – i.e., they are almost as good as full-faith-and-credit USG obligations, but not quite that good. The market thus prices in a spread of around fifteen basis points on like-kind maturities to reflect the tinge of added risk differentiating an effective guarantee from an explicit one.
This little bit of an edge may seem negligible, but it matters a lot to the U.S. Treasury, especially now that it must fund the $3.4 trillion of added deficit cost CBO estimates. GSE obligations are now priced off Treasury debt but do not compete directly against it. Even if CBO is wrong and the deficit doesn’t explode, adding about $8 trillion of explicitly-guaranteed GSE bonds competing with the USG pile will quickly balloon total issuance to $40 billion, if not more. Investors will demand higher returns from Treasury and all the USG and agency debt will surely crowd out private capital which will in turn be forced to charge even more to raise needed debt and equity. This is a negative feedback loop with profoundly destructive implications for U.S. growth no matter what the Fed may choose or even be told to do.
Pressuring the Fed and issuing Treasury obligations at the short-end of the yield curve might reduce overall federal-funding costs, but growing global doubts about the dollar could offset or even overwhelm any reductions. Ending the GSEs’ conservatorship ends the effective guarantee, forcing a reckoning in which Treasury will vigorously oppose giving Fannie and Freddie a costly, explicit backstop. This brings us back to an implicit guarantee. Here, the impact gets even trickier.
The GSEs’ cost of funds would surely rocket up without the effective guarantee, adding more to the cost of mortgages. How much more is a subject of debate, but it’s for sure more and more makes mortgages even less affordable.
The end of the conservatorship also has direct and immediate impact on banks and thus on who makes mortgage loans. Current rules stipulate that the favorable treatment of GSE debt under the liquidity standards ends without the conservatorship, as does the discounted capital charges against Fannie and Freddie assets. Banks will either hold less GSE assets or demand a good deal more to do so. Either way, that affects mortgage pricing.
That’s not all. Loans originated for the GSEs would also immediately lose their exemption from Dodd-Frank’s requirement for “skin in the game” for the assets they sell – i.e., they must retain a portion of the risk sold on to others in hopes of aligning issuer incentives with those of investors. Banks could do this if they want to; nonbank mortgage originators, not so much.
Nonbanks currently originate approximately two thirds of all agency loans but lack the capital resources to take on a risk-retention portfolio. Nonbanks would quickly switch to selling as much as they can to Ginnie Mae, which would still have an exemption along with an explicit guarantee. They’ll also need to figure out if they can turn into banks or otherwise come close to retaining the origination volume necessary for franchise viability. Any way you look at it, the mortgage market changes – a lot.
Mr. Pulte on Thursday waxed rhapsodic about the hundreds of billions the Treasury might garner when Mr. Trump decides the time is right to issue an IPO. The bigger, the better, or so he also said.
If the federal government were a business, then this might be true. But the federal government of course isn’t a business. It’s the repository of public resources entrusted to elected officials to ensure the public good. Making this happen in a GSE privatization is no easy matter.