GSE reform: Three guiding principles

President Trump’s second term has brought GSE reform back into the spotlight. The administration recently announced that it is preparing an IPO of the GSEs for later this year. This development caught the market off guard–the general expectation was that an IPO would not occur until later in the administration (or beyond) to allow the GSEs time to build more capital. The full details of the IPO plan are not known, but it does appear that this issue has become a priority for the administration. 

Fannie Mae and Freddie Mac (the government sponsored enterprises[1] or GSEs) play a central role in the housing finance system. The enterprises together guarantee around $6.7 trillion of mortgage-backed securities (MBS), or around 70% of the agency MBS market which also includes bonds guaranteed by Ginnie Mae. On September 8, 2008, against the backdrop of falling home prices and rising delinquencies during the GFC, both enterprises were taken over by their regulator, the Federal Housing Finance Agency (FHFA), and placed into conservatorship.

Treasury entered into agreements with each enterprise to provide lines of credit in exchange for senior preferred stock as well as warrants to purchase 79.9% of the common stock. The expectation was that both enterprises would eventually be wound down and replaced via legislation. But all legislative efforts failed, and 17 years later, the enterprises remain under government control.

There are many unknowns regarding the future of Fannie Mae and Freddie Mac. Before the enterprises can be released from conservatorship, the administration needs to address numerous complex issues. For example, what is the appropriate level of capital that the enterprises should hold? How will Treasury’s equity stake be handled? And how much control will the government retain post-release? Any disruptions to the agency MBS market would have a negative impact on housing affordability and on the availability of credit.

Three guiding principles

Against this uncertain backdrop, it’s helpful to take stock of what we do know. Based on policymakers’ public statements, there are three guiding principles that we believe are likely to apply regardless of the path that the administration takes. 

1) The GSEs will retain some form of government guarantee. The absence of credit risk is a key reason that agency MBS investors are willing to assume prepayment risk and negative convexity. And domestic banks receive favorable capital treatment on their agency MBS holdings because of the government backstop. President Trump has publicly stated that the GSEs’ implicit guarantee will continue post-IPO. This may mean that the lines of credit with Treasury will remain in place, or perhaps there will be additional support.

2) Mortgage market liquidity and depth must be preserved. Treasury Secretary Bessent has stated that privatization must be accomplished without widening the spread between the primary rate and the risk-free rate. Primary mortgage rates are directly tied to pricing in the TBA market, which accounts for the bulk of secondary mortgage market trading. Mortgage spreads over the risk-free rate are a function of many factors including the macro backdrop and technicals as well as liquidity and perceived credit risk (see chart). To avoid increasing mortgage rates, the administration must work to avoid TBA market disruptions.

3) The government will likely retain significant control post-IPO. While legislative efforts at GSE reform have failed, many changes have been made through administrative means. The enterprises’ investment portfolios have shrunk; UMBS was launched; the credit risk transfer market was established; the structure of guarantee-fees was revamped; and prohibitions were placed on lobbying. Many of these reforms are now integral to the US housing finance system. To prevent their discontinuation after privatization, some level of government control will need to be maintained, at least until each reform is fully evaluated and codified, as needed. Indeed, FHFA Director Pulte has stated that the enterprises will likely remain in conservatorship post-IPO.

A pivotal moment

The Trump administration’s push to privatize Fannie Mae and Freddie Mac marks a pivotal moment in U.S. housing finance. As the administration works through the many dimensions of GSE reform, temporary market disruptions may be inevitable along the way. But we believe that policymakers’ public comments should reassure MBS investors that the administration will likely take a thoughtful and deliberate approach. 

Preserving the GSEs’ guarantees and ensuring liquidity in the TBA market will be critical in order to avoid exacerbating already stretched housing affordability. Given the importance of the MBS market to US housing and to the electorate, policymakers cannot afford to make a market-breaking error. Ultimately, success hinges on balancing innovation with stability–ensuring that privatization strengthens, rather than destabilizes, the housing system.

 
[1] The 11 Federal Home Loan Banks are also GSEs. Fannie Mae, Freddie Mac, and all of the FHLBs are regulated by FHFA.