The long quest to re-privatize Fannie Mae and Freddie Mac — the huge federal mortgage-securitization groups that support the U.S. secondary market with mortgage-backed securities — is pushing ahead. “While it seems as though nothing is happening, much is happening,” says Wharton real estate professor Susan Wachter. In this Knowledge at Wharton interview, she explains where developments are heading and the new securities now attracting private investors for the first time since 2008. The interview highlights issues from her new paper — Next Steps in the Housing Finance Reform Saga — written for the Penn Wharton Public Policiy Initiative.

An edited transcript of the conversation follows:

The Push to Re-privatize Fannie Mae and Freddie Mac — Key Milestones.

Fannie and Freddie have been around for a very long time. They’ve operated as private entities — shareholder entities — with an implicit guarantee but specifically without an explicit government guarantee so that they were not, in fact, federally owned organizations or controlled organizations. But as of September 7, 2008, they came under government control. But with the crisis in the overall housing market with the demise of Lehman, it was clear that Fannie and Freddie were illiquid, insolvent and required a government intervention to prevent their meltdown, which of course would have brought down the entire housing market.

At the time, the housing market was in free fall. But this would have clearly, without support of Fannie and Freddie, taken a Great Recession and made it into Great Depression 2.0. The intervention was necessary. At that point, Fannie, Freddie became regulated entities and controlled by the Federal Housing Finance Agency (FHFA), which is a separate, independent entity. And Fannie and Freddie are now under conservatorship directed by FHFA.

Clearly keeping FHFA in the oversight position forever, with Fannie and Freddie in a conservatorship — what that means is that the taxpayer is … totally on the line for all losses…. Having basically a nationalized housing finance system is not something that’s viable for the long run for the United States.

So, alternatives must be considered and are being considered. But they range from one side of the spectrum to the other side of the spectrum. And getting to consensus has been problematic.

Areas of Congressional Agreement

The dialogue has evolved on this. There are broad areas of agreement; not perhaps a 100%, but among many parties, across the political spectrum, agreement has come about on some very important aspects of how to reform Fannie and Freddie.

First, the need for a 30-year fixed-rate mortgage going forward. That this is an instrument that provides protections to home owners and [there is some consensus] that there is a need for this mortgage product in the United States.

Second is the need for a liquid mortgage-backed securitization market to support the 30-year fixed-rate mortgage.

Third is the need for private capital to be in first-loss position so that the taxpayer is not on the hook but, in fact, private capital, appropriately so, takes the risk and evaluates what the risk is, and charges appropriately for the risk in mortgage rates and in mortgage insurance rates. This is the private market’s role of setting up incentives and taking on losses appropriately.

An [additional] key is that when there is a catastrophe, that’s the role for the government — to be there for a catastrophic risk occurrence. And there is consensus that that’s the appropriate role for the government — the only appropriate role — to step in.

In addition to this — to hopefully insure a more stable market going forward — there is a consensus on the need for transparency, for a platform for standardization of mortgage-backed securities — mortgage terms — and a publicly available set of characteristics of the mortgages and the mortgage-backed securitization. [In other words, we need] some sort of utility that would be able to verify mortgage terms over time and put into place standards for mortgages and mortgage-backed securitization.

And finally, there is some agreement for some role for affordable housing. So, the combination of factors that there is agreement on is pretty substantial at this point. But the implementation of how do we get there is where there’s a great deal of disagreement.

“Clearly keeping FHFA in the oversight position forever, with Fannie and Freddie in a conservatorship — what that means is that the taxpayer is … totally on the line for all losses….”

Proposed Solutions

There are two major proposals that have gotten some support.

The first is the Protecting of the American Tax Payer and Homeowner Act, which was introduced by Rep. Jeb Hansarling (R-Texas) in the House in 2013. And that did come out of the House Committee on Financial Services. It hasn’t made it any farther than that.

That proposal is basically to privatize Fannie and Freddie entirely, to withdraw support for Fannie and Freddie 100%. They would have no support implicit or explicit. There would be a common securitization platform, a utility that the proposal calls for. And the utility would support mortgage securitization standardization. It wouldn’t impose standardization, but it would make whatever mortgage backed security standards were being used transparent and call for the mortgage lenders and securitizers to abide by whatever standards were set out. But that’s as far as the government or a public would go — to set a utility to oversee the securitization platform that was put forth.

The second major proposal is by former Sen. Tim Johnson (D-South Dakota) and Sen. Mike Crapo (R-Idaho), and it received support across the political spectrum. However, it did not receive sufficient support to come out of the Senate Banking Committee in spring 2014. But it did go very far along in terms of getting consensus among many parties. There are still obviously points of major disagreement, which is why it did not come out of committee.

But to first go to the points of agreement that were embodied in this: First of all, there is a first loss capital [provision]; it puts private capital — in the first-loss position. This is very key; secondly, there was some provision for affordable housing; third, a platform for trading a single security that would have to be approved by a regulator — to be very much like the FDIC with the Federal Mortgage Insurance Corporation [FMIC], which would ensure mortgages that would be explicitly guaranteed by the federal government and … would then trade.

It would be insured by aggregators who would have to be approved also by FMIC. There would then be competition among the aggregators to provide mortgage-backed securities and also the corporations that provided the insurance for the mortgage backed securities would trade. And there would be private capital up front.

This proposal, if you go through the different positions of consensus that we discussed earlier, goes very far along in embodying those positions of consensus. And in fact, it was the run up to the Johnson-Crapo Act that I think brought about the sense of, OK, this is what we can agree on. So, that’s really where the state of the debate is at this moment.

In the Johnson-Crapo proposal the mortgage backed securities are insured explicitly by the federal government under the regulation of the new entity, the Federal Mortgage Insurance Corporation, similar to the way the FDIC provided insurance for demand deposits. And the borrower ultimately pays in mortgage rates for an insurance fee, which is then paid to the federal government to the entity that is overseeing — that’s the FMIC — which means, of course, that investors are not receiving — they must pay through the aggregators — the aggregators must pay up front an insurance fee to the federal government for the right to this explicit insurance in case of catastrophic risk.

“Where is that capital going to come from? Who’s volunteering to put up $500 billion worth of first-loss capital equity to take the losses in front of the government? What about all the other mortgages out there that could be issued and securitized without a tax?”

So, the ultimate [goal] is that the mortgage-backed securities that are trading have no risk to the investor … because these are fully guaranteed, explicitly by the federal government. In order for the aggregators to receive this insurance, to get the stamp of approval by the federal government, the eagle stamped on their mortgage backed securities to make them no credit risk, zero default risk to the investor, they must pay for insurance from the federal government. And also they must abide by standards set up by the FMIC as well.

What Is the Risk Premium?

There is one very large question — what should be the risk premium? And of course, there are similar questions over demand deposits. What should be the risk premium for FDIC? And will this risk premium be priced accurately over the cycle? These are all very large questions.

Then there are two other related questions which are: Will there be lenders who are issuing mortgage backed securities that do not have government insurance? Will those expand over the cycle because they will be competitively at an advantage since they do not have to pay the tax? And there is nothing in this legislation which prevents that.

What Will Implementation Look Like?

The implementation questions, of course, are key. One question of implementation which was perhaps one of the reasons why in the end Johnson-Crapo did not get out of committee, is: Where is the private capital to support that first loss position, which in the legislation is required to be 10%? The mortgage-backed securities market was last estimated at $5 trillion — [10% of that is] $500 billion. Where is that capital going to come from? Who’s volunteering to put up $500 billion worth of first loss capital equity to take the losses in front of the government? So, that’s one question.

A second question is what’s the guarantee fee? And of course, that will affect the profitability of the mortgages and the interest and willingness of private capital to come to the game.

And a third question is, what about all the other mortgages out there that could be issued and securitized without a tax? Will they compete against the mortgages that do receive the explicit insurance?

And will that competition be pro-cyclical — that is, will these mortgages expand during the boom period of the cycle and then during the bust period they will be out there uninsured and potentially causing systemic risk? So that I think was one of the most important questions that was brought to the structure of Johnson and Crapo.

But a second important question was: Where is the role for affordable housing?

Both of those questions get back to an underlying aspect of the proposal, which is this single security, which is to be implemented, regulated, and overseen by the federal government since it would receive the federal government’s explicit backing. But who is in fact overseeing the single security? What are the characteristics of a single security? What is the risk? What are the terms? And do these vary among the insurers, the aggregators that are participating in this market and that are putting up the first-loss position? If so, do we actually have a liquid market for the mortgage backed securities that allow a 30-year fixed-rate mortgage?

Those were all questions which the legislation, as close as it got to coming out of the committee at that point, these questions were raised in terms of pretty much the fundamentals of the proposal, which go to the question, would in fact such a structure support the 30-year fixed-rate mortgage? Would such a structure be stable over the cycle? And third, would such a structure support affordable financing or, more simply, financing broadly available for those who qualify over the cycle?

Those were all questions which … still have to be addressed before a consensus can emerge.

Effects on Interest Rates

There is a real range of estimates on that. Some estimate that it will be de minimus. Some estimate that it will be several hundred basis points, which, of course, would make these non-competitive against securitizations that did not need to pay a 100, 200 basis point tax.

“Fannie and Freddie have instituted a new security…. Those are trading and they are in fact, bringing private capital in to take first-loss credit risk.…”

To my mind, the question is, how are they priced over the cycle? So, it’s not just a question of a static pricing. It’s the dynamic pricing and that, of course, depends on how risky the overall market becomes, which depends on the entry and the withdrawal of capital into this market from other sources. So, it’s a very difficult question to answer without answering that other question: What’s the structure of the mortgage-backed securitization market over the cycle?

Reform Fannie and Freddie?

Why not just reform Fannie and Freddie? The question is what do we mean by “reform”? There is some consensus on what we might mean by reform — no portfolio going forward and we’re moving in that direction in any case. And that’s where the riskiest loans were.

A second part of the consensus is that there should be transparency. In the mortgage-backed securities [market] there should be a common securitization platform to provide transparency so we can track what loans are in fact being securitized going forward. And that too is in place.

But then, the third component is really where there is a big question, which is: How do we get private capital into Fannie and Freddie to take the first loss, because there is consensus that there should be private capital at risk prior to the taxpayer? That’s a key point where there’s major disagreement.

And in part, there’s major disagreement because it hinges on the question: Who owns Fannie and Freddie? There are major lawsuits right now on who owns Fannie and Freddie that need to be resolved. And there may also need to be a Congressional weighing in on that question of who owns Fannie and Freddie, because Fannie and Freddie were originally chartered and still are chartered through Congress. These are federal national charters which are not state chartered but chartered by Congress. So, we will need Congress to weigh in on that.

However, there is movement as we speak in terms of that third component of bringing at-risk capital, private capital. Both Fannie and Freddie have instituted a new security just for that purpose — to bring private capital in front of the taxpayer. Those are trading and they are in fact, bringing private capital in to take first-loss credit risk and to price that credit risk — and to do so transparently. This is a new development and it’s increasing very rapidly.

So, in fact, while it seems as though nothing is happening, much is happening. These new instruments go by the name of STACR in the case of Freddie (Structured Agency Credit Risk – STACR — bonds) and Connecticut Avenue Securities, in case of Fannie.

They are very large at this point and they’re taking a major share of the credit risk of both entities, and of the new issues of both entities. So, this is a very good development because we do need not only regulators to oversee the risk of the mortgage market, we need a transparent way for private capital to price and reveal the pricing of the risk of the credit of the mortgages that are being issued, and either implicitly or explicitly being supported by the federal government.