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From Banking and Finance Law Daily, March 24, 2015

NY Fed staff report says GSE conservatorship has not produced housing finance reform

By Colleen M. Svelnis, J.D.

The Federal Reserve Bank of New York has issued a staff report evaluating the measures taken by the U.S. government to rescue Fannie Mae and Freddie Mac in 2008. The report, authored by W. Scott Frame, Andreas Fuster, Joseph Tracy, and James Vickery, outlines the business model of the Government Sponsored Enterprises and their role in the housing finance system. The staff report concludes that the decision to take Fannie Mae and Freddie Mac into conservatorship and invest public funds did achieve the short-term goals of stabilizing mortgage markets and promoting financial stability during the financial crisis. However, the report says that conservatorship led to tensions between maximizing the firms’ value and achieving broader macroeconomic objectives. Additionally, the authors conclude that it has so far failed to produce reform of the U.S. housing finance system.

Background. Fannie Mae and Freddie Mac were established to enhance the liquidity and stability of the U.S. secondary mortgage market and promote access to mortgage credit, particularly among low- and moderate-income households and neighborhoods. During the financial crisis in 2008, Fannie Mae and Freddie Mac were placed into conservatorship under the Federal Housing Finance Agency in an effort to conserve their value. At the same time, the Treasury Department entered into preferred stock purchase agreements with each institution. Under these agreements, U.S. taxpayers ultimately injected $187.5 billion into Fannie Mae and Freddie Mac.

Conservatorship v. receivership. The federal government had the choice between receivership or conservatorship. The report proposes several reasons why the conservatorship was preferable to receivership:

  1. In the summer of 2008, there was significant uncertainty about the housing market and future losses at Fannie Mae and Freddie Mac and a receivership might not have solved the immediate problem.

  2. The business model of the Enterprises had been the subject of intense debate in the years leading up to their failure receivership would have reorganized and released the two firms. The authors state that the thinking was that conservatorship would force Congress to address the problems of this business model, or else face the long-term prospect of government control of the U.S. housing finance system.

  3. Receivership raised an operational concern relating to the treatment of derivatives as “qualified financial contracts.” Receivership would have created greater uncertainty about business continuity and derivatives counterparty actions.

  4. Conservatorship still allowed for the receivership option to be chosen in the future, if a subsequent administration felt that it was a better course of action.

Elements of optimal intervention. The report states that an optimal intervention response to Fannie Mae and Freddie Mac’s financial distress would have included the following five objectives:

  1. Fannie Mae and Freddie Mac would be enabled to continue their core securitization and guarantee functions as going concerns, thereby maintaining conforming mortgage credit supply.

  2. The two firms would continue to honor their agency debt and mortgage-backed securities obligations, given the amount and widely held nature of these securities, especially in leveraged financial institutions, and the potential for financial instability in case of default on these obligations.

  3. The value of the common and preferred equity in the two firms would be extinguished, reflecting their insolvent financial position.

  4. The two firms would be managed in a way that would provide flexibility to take into account macroeconomic objectives, rather than just maximizing the private value of their assets.

  5. The structure of the rescue would prompt long-term reform and set in motion the transition to a better system within a reasonable period of time.

According to the report, the conservatorship structure largely accomplished the first three objectives, relating to short run financial stability and credit supply, but was arguably less successful on the fourth objective of aligning the activities of Fannie Mae and Freddie Mac with broader macroeconomic objectives during the Great Recession.

Conclusion. The staff report concludes that actions taken to support Fannie Mae and Freddie Mac were successful in the short term because it achieved the goals of supporting the housing market and removing the two firms as an immediate source of systemic risk to the financial system. However, the report also determined that the conservatorships have not yet achieved the goal of reforming the system of residential mortgage finance. The uncertainty over the government’s future role in residential mortgage finance has caused delay, which the authors say raises the likelihood that serious reform will be judged as too difficult to accomplish, and raises the risk that the conservatorships are ended by returning Fannie Mae and Freddie Mac to private status with only minor changes to their charters. The report says that it would be a “missed opportunity to put U.S. residential mortgage finance on a more stable long-term footing” if Fannie Mae and Freddie Mac are not wound down.

Companies: Fannie Mae; Freddie Mac

MainStory: TopStory FinancialStability GovernmentSponsoredEnterprises OversightInvestigations Mortgages

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