Is Mel Watt Setting up Another Bailout?

COMMENTARY Housing

Is Mel Watt Setting up Another Bailout?

May 23rd, 2018 10 min read
COMMENTARY BY
Norbert J. Michel, Ph.D.

Director, Center for Data Analysis

Norbert Michel studies and writes about financial markets and monetary policy, including the reform of Fannie Mae and Freddie Mac.
The Senate Banking Committee should ask Mel Watt what he views is the best way to fix these problems. YURI GRIPAS/REUTERS/Newscom

Key Takeaways

Fannie Mae has been lobbying government officials despite the fact that former FHFA director James Lockhart banned Fannie and Freddie from “all political activities"

It would be great to see the banking committee members ask Mel Watt about these behind-the-scenes lobbying efforts, and even better if they bring up the following.

The legacy of the GSEs is crony capitalism, higher mortgage debt, higher home prices, taxpayer bailouts, and no appreciable expansion of homeownership.

On Wednesday, Mel Watt, the director of the Federal Housing Finance Agency (FHFA), will testify in a Senate hearing titled “Ten Years of Conservatorship: The Status of the Housing Finance System.”

Given that Fannie Mae’s and Freddie Mac’s spectacular failure led to the 2008 financial crisis, it might seem odd that these government-sponsored enterprises (GSEs) remain in government conservatorship. Yet Congress has done nothing substantive on housing finance reform in almost a full decade.

If anything, the status of the housing finance system is more dangerous now because Fannie Mae and Freddie Mac have become even more entrenched.

Just last week Bloomberg reported one of the worst kept secrets in all of Washington: Fannie Mae has been lobbying government officials despite the fact that former FHFA director James Lockhart banned Fannie and Freddie from “all political activities – including all lobbying.” (The story doesn’t really mention it, but everyone within shouting distance of the Capitol knows Freddie has been doing the same thing.) The report states:

For nearly a decade, a top U.S. housing regulator has restricted Fannie Mae and Freddie Mac from trying to influence the raging debate over whether they should live or die.

But despite those limits, a top Fannie Mae executive has done just that over the past few months, quietly meeting with people inside and outside President Donald Trump’s administration, according to people familiar with the matter.

Brian Brooks, Fannie’s general counsel, has a specific goal, the people said: Build a groundswell among housing-finance stakeholders that the best outcome for Fannie and Freddie is for Trump and their regulator to release the companies from government control. Brooks, who has ties to Treasury Secretary Steven Mnuchin, wants this done without the involvement of Congress, which has failed since the 2008 financial crisis to come up with a legislative fix for the mortgage giants.

There may not be an issue with more special interests trying to secure government backing, so Mr. Brooks should have little trouble creating his groundswell. Even Treasury has signaled it wants explicit government guarantees in the market, and the only reason the GSEs are still in conservatorship rather than completely shut down is that an army of special interests has consistently clobbered anyone in Congress who even whispers about shrinking the footprint of these two companies.

It would be great to see the banking committee members ask Mel Watt about these behind-the-scenes lobbying efforts, and even better if they bring up any of the following topics.

Unaffordable Housing. The supposed purpose of Fannie and Freddie is to make housing more affordable, but these enterprises fuel low-equity leverage that has helped home prices rise faster than incomeAmericans have more debt than ever, homes are more expensive than ever, and the homeownership rate is virtually the same as it was in the 1960s. How can Mel Watt make the case that Fannie and Freddie are helping average Americans?

The Latest Housing Boom. Nationally, home prices are now above their pre-crisis peak, and the rate of growth looks eerily similar to the run up to the crisis. According to Housingwire, home prices rose more in the first two months of 2018 than the start of any year since 2005. Despite rapid price growth, home sales have been steadily increasing. Housing booms cannot go on forever, so what is the FHFA doing to protect consumers and taxpayers from the inevitable?

Expansion of Multifamily Business. Growth in multifamily (rental housing for five or more families) mortgage debt, fueled by the GSEs’ expansion of their multifamily business, has far outpaced the growth of multifamily housing units. Freddie recently announced it had grown its multifamily guarantee portfolio by 30 percent from the prior year (to $213 billion), and Fannie grew its portfolio by more than 11 percent (to $281.3 billion). Providing extensive government guarantees for multifamily lending is corporate welfare and crony capitalism— profits are privatized but the losses are taken by the taxpayers. How can Mel Watt argue this expansion is good for taxpayers?

High DTI Loans. The 2010 Dodd-Frank Act required certain ability to repay standards for residential mortgages. Congress also directed the Consumer Financial Protection Bureau (CFPB) to develop a Qualified Mortgage rule, so that any such mortgage would automatically complywith the ability to repay standards. These are supposed to be safer mortgages, with features such as a maximum debt-to-income ratio (DTI) for the borrower of 43 percent. Nonetheless, the CFPB’s final rule included a temporary provision known as the patch. Under this provision, set to expire in 2021, mortgages for borrowers with DTI ratios in excess of 43 percent still count as qualified mortgages provided they are eligible for purchase by the GSEs (see page 6). Since this rule was finalized, the GSEs have started purchasing mortgages with DTIs as high as 50 percent. Privately, industry insiders insist that the FHFA directed the GSEs to raise the maximum DTI. Does Mel Watt believe high DTI loans are a good way to protect consumers?

Freddie Offering Lines of Credit. Freddie Mac recently announced that it is going to provide lines of credit to non-bank mortgage companies to assist with their mortgage servicing operations. Allowing Freddie (or Fannie) to provide such loans – historically provided by commercial banks – effectively puts the federal government in direct competition with private banks. Freddie’s charter does not include an explicit prohibition against this type of lending, but it does include one against direct lending to fund mortgages. The whole point was to keep Freddie squarely in the secondary market, and these credit lines blur the distinction. Freddie’s CEO insists that they are not trying to undercut the private market, but officials with the Mortgage Bankers Association—typically defenders of the GSEs—don’t seem to be buying it. Can Mel Watt explain how Freddie’s expansion into providing direct loans is appropriate?

Arch/Imagine. Freddie Mac and Arch Capital recently announced a pilot program for a new form of risksharing that would boost investors’ “appetite for low down payment mortgages.” Under this program (called Integrated Mortgage Insurance, or, IMAGIN) Freddie “selects insurance at the loan level and appears to effectively control both pricing and coverage determinations.” While IMAGIN may sound lovely, it appears to be an end run around the mortgage insurance companies that currently provide – as required in Freddie’s charter – mortgage insurance for loans with less than a 20 percent down payment. Not only does Freddie have a long tumultuous history with the mortgage insurance industry, but it recently helped craft a new set of capital requirements [Private Mortgage Insurer Eligibility Requirements (PMIERs)] that all mortgage insurance companies must meet to be approved to insure GSE loans. It is not at all clear that Arch has to follow these capital standards. (For an interesting diversion, check out the largest beneficial owners of Arch Capital Group; see page 26 of the proxy statement.) Can Mel Watt explain (A) why more information on IMAGIN has not been made public; and, (B) why Freddie should be allowed to implement a program that blurs the lines between the secondary and primary mortgage markets?

Credit Risk Transfers. In 2013, under FHFA Acting Director Ed DeMarco, Freddie Mac completed the first of several deals designed to transfer credit risk from the GSEs to the private sector. DeMarco viewed these deals as a step toward contracting the GSEs, but it seems more likely they will do the opposite. Basically, CRTs are structured debt securities, whereby the GSEs borrow money and pay the debt back in a manner tied to the performance of underlying mortgages. In theory, if too many people stop paying back their mortgages, the people who lent to the GSEs lose money. But there’s a catch: These CRTs are structured so that credit losses on the mortgages are measured net of any payouts from private mortgage insurance companies. In other words, these CRT securities don’t lose money unless the private mortgage insurers – which are required to insure all mortgages with less than a 20 percent downpayment for the GSEs – don’t make their payments. These deals amount to buying a second car insurance policy, just in case your insurance company goes bankrupt and can’t pay claims. It appears that these CRTs have U.S. Treasury-like safety even though they are paying junk bond like returns, so it is hardly surprising that money managers and Wall Street traders love these things. Does Mel Watt feel it is appropriate for the GSEs to issue these types of securities while in conservatorship?

Initially, the FHFA acted like a federal conservator should: It tried to protect taxpayers and shrink the GSEs’ footprint. Now, under Mel Watt’s stewardship, the GSEs are expanding their role, the FHFA seems to be doing all it can to justify its own existence, and it is difficult to argue that taxpayers are any safer than they were in 2008.

The army of special interests angling for goodies from the government has effectively stopped Congress from acting, but these folks should take a closer look. Fannie and Freddie are demonstrating the expected outcome from mixing private firms with government protection.

At first, everyone loves the government-sponsored firms because they can get great deals and tons of business. Eventually, though, the government-sponsored firms crowd out the private sector, growing larger and more powerful than ever. At some point, these entities morph into something that was never intended, and that is why even the special interests that originally served as partners ultimately lose.

The mono-line mortgage insurance companies, for instance, are now realizing that the GSEs could easily become giant government-backed mortgage insurers, thus cutting them out. And what will the Independent Community Bankers of America tell their members now that commercial banks are competing with Freddie to make loans?

Wall Street appears happy to go along with pretty much any version of government backing for securities, but those guarantees always come with strings. The strings might not be so terrible when times are good, but when things go wrong it is only a question of which Wall Street group loses. Just ask Lehman.

Of course, while this political game plays out in Washington, D.C., average Americans lose. The private sector cannot compete with government-backed financing, so there are fewer opportunities across the nation for people to earn money by solving financial problems. Why start a bank or a mortgage company now?

The legacy of the GSEs, as it would be with any such private-public partnership, is crony capitalism, higher mortgage debt, higher home prices, taxpayer bailouts, and no appreciable expansion of homeownership. The Senate Banking Committee should ask Mel Watt what he views is the best way to fix these problems.

This piece originally appeared in Forbes https://www.forbes.com/sites/norbertmichel/2018/05/22/is-mel-watt-setting-up-another-bailout/#56669d7a1572