GSE Reform Resurfaces: Challenges and Implications

Introduction

Following President Trump's election in November, discussions surrounding the potential reform of the government-sponsored enterprises (GSEs) have resurfaced. Although not a primary focus of his campaign, the privatization of Fannie Mae and Freddie Mac could have significant implications for investors, taxpayers, and the broader housing market. As of December 2024, Fannie Mae and Freddie Mac collectively guarantee $6.6 trillion in Agency Mortgage-Backed Securities (MBS), or 50% of all outstanding U.S. mortgage debt. Ginnie Mae mortgages, which carry the full faith and credit guaranty of the U.S. Government, make up another $2.5 billion or 20%. During Trump's first term, various GSE reform proposals were discussed among stakeholders, but no legislation advanced, and the issue remained dormant during Biden's presidency. The new administration, along with active equity investors and reform advocates, is now reigniting these discussions, suggesting a possible push to end the GSEs' conservatorship.

Background of Conservatorship

In response to the Global Financial Crisis, the U.S. Treasury placed Fannie Mae and Freddie Mac into conservatorship in September 2008. This action was intended to stabilize the mortgage market and restore confidence in the government-sponsored enterprises (GSEs). Since the start of the conservatorship, the Treasury has injected approximately $190 billion in capital into the GSEs, from a total commitment of up to $446 billion. In exchange, the Treasury received warrants to purchase up to 79.9% of common stock and approximately $190 billion in senior preferred shares with a 10% dividend rate. The senior preferred shares have generated $300 billion in dividends for the Treasury. However, the preferred stock agreement was recently modified to allow the GSEs to retain capital instead of making dividend payments. To compensate taxpayers for the forgone dividends, the liquidation preferences for the senior preferred shares are being increased by the amount of capital retained. As of the third quarter of 2024, the Treasury's liquidation preference for the senior preferred shares stands at $340 billion. As a result of retaining capital, Fannie Mae and Freddie Mac increased their combined net worth to $147 billion as of the third quarter of 2024. Despite this steady growth, the GSEs remain well below the minimum regulatory capital framework requirements set by the Federal Housing Finance Agency (FHFA) in 2020. Under the risk-based capital requirements, the GSEs must maintain minimum regulatory capital levels, including a tier 1 capital ratio of at least 2.5% of their adjusted total assets. As of September 30, 2024, Fannie Mae's capital requirement is $187 billion, while Freddie Mac's is $141 billion, resulting in a combined total requirement of $328 billion.

Path to Privatization

The path to GSE privatization is complex, with three major obstacles standing in the way:

1. Regulatory Capital Requirement Shortfall: The first major hurdle is addressing the current regulatory capital shortfall of $181 billion, which includes the $328 billion capital requirement offset by $147 billion of retained earnings. Assuming Fannie Mae and Freddie Mac's combined earnings of $25 billion per year, it would take approximately seven years to build capital organically. An Initial Public Offering (IPO) may accelerate the capital raise, but logistical and legislative hurdles could complicate the process.
2. Treasury's Liquidation Preference: The second challenge involves addressing the $340 billion liquidation preference for the Treasury's senior preferred shares. Due to recent amendments to the preferred stock purchase agreement, this liability will continue to increase, obstructing the path to privatization. However, if the Treasury were willing to forgive their preferred stake, the GSEs could proceed with privatization. Nonetheless, the feasibility and willingness to write off $340 billion owed to taxpayers may not be viable in the current political climate.
3. Implicit Guarantee Status: The final challenge involves addressing the status of the implicit guarantee in the context of privatization. Currently, investors in Fannie Mae and Freddie Mac securities benefit from the conservatorship, as they can rely on the remaining $256 billion in untapped financial commitments and a 2011 Treasury white paper that pledged support for all GSE obligations, including mortgage-backed securities (MBS) and debt. Ending the conservatorship would create uncertainty about this guarantee. While investors and rating agencies might view the proposed capital plan positively, it is difficult to envision agency debentures and MBS maintaining their current credit status in this scenario, particularly during a market downturn. The GSEs could also seek an explicit guarantee, similar to Ginnie Mae, but this would likely require an act of Congress and a fee paid to the Treasury for assuming the risk, which could increase costs for underlying borrowers.

Potential MBS Market Implications

Privatizing Fannie Mae and Freddie Mac raises many concerns, three of which are:

1. Impact on Mortgage Rates: The potential widening of mortgage spreads and the resulting increase in primary mortgage rates could negatively impact both investors and consumers. Uncertainty around government support after privatization might lead to higher and more volatile borrowing costs, worsening the current challenges in housing affordability.
2. Disruptions to the Mortgage To-Be-Announced (TBA) Market: A fully functioning forward settlement market is essential for the mortgage industry, as it allows mortgage originators to manage risk at the time of a rate lock. In 2024, the TBA market had an average daily trading volume of $290 billion, making it one of the most liquid and transparent financial markets globally. Any disruptions to the TBA market could have significant ripple effects on housing finance.
3. Ginnie Mae Market Share: Decisions about the guarantee could have a significant impact on the issuance of Ginnie Mae-guaranteed mortgages. If the creditworthiness of the GSEs is seen as weaker, leading to wider spreads and higher primary rates, there might be a shift in MBS issuance towards Ginnie Mae, potentially increasing the risk borne by taxpayers. Policymakers need to carefully consider these potential outcomes against the advantages of reducing government involvement in the mortgage market.

Conclusion

The privatization of Fannie Mae and Freddie Mac is a complex issue with significant risks and uncertain benefits. In the coming months, we may learn more about the President Trump’s willingness to pursue this path. However, the journey is filled with challenges, such as the need for substantial capital, legislative obstacles, and potential market disruptions. Any perceived decline in the credit quality of GSE-backed mortgage-backed securities (MBS) could pose serious problems for financial markets, housing markets, and consumers. Policymakers must carefully balance the desire to reduce government involvement with the need to maintain stability in the housing finance system. Ultimately, any move toward privatization will require meticulous planning and coordination among government branches to mitigate risks and ensure a smooth transition. Given these complexities, we believe there is a low probability of a resolution in the near term, but a narrow path remains if the Administration chooses to pursue it. The most likely scenario is maintaining the status quo, with Fannie Mae and Freddie Mac continuing to build capital through retained earnings, as this approach has proven effective in sustaining a stable mortgage market.

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