GSE Reform

It’s been a couple years since I worked at one of the GSEs so I’m interested in all the talk of reform. My guess is that there is a zero percent chance that Geithner is going to call for an end to the GSEs.

There are two basic problems with reforming the GSEs and two additional political problems. The big problem, of course, is convincing the market that any reformed GSEs are, in fact, operating without government support. But, setting that aside, the business problems are:

1) The GSEs have never had a business model that is capable of making money absent relatively overt federal guarantees. In good times the GSEs still needed subsidized borrowing costs to make money. Now, when the risk premium required for a monoline mortgage insurer is many times higher than it used to be, the GSEs require even more explicit government support. If this support goes away, the GSEs fail instantly. What idiot would lend to a truly independent monoline mortgage insurer? No one unless the rates were incredibly high, at which point the GSEs have no way of earning a spread between borrowing costs and mortgage rates.

2) The only business model that was more thoroughly destroyed by the financial crisis than the investment banking business model, was the monoline mortgage insurance business model (e.g.). A scaled-down version of the GSEs would be a monoline mortgage insurer. No one wants to own a monoline mortgage insurer absent government support.

The political problems are:

1) No one besides the GSEs is buying mortgages right now. If the GSEs stop buying mortgages, mortgage rates will increase significantly. I got a 30-year mortgage 6 months ago at 4.75%. Only an entity that is being heavily subsidized by the government is willing to take on a mortgage loan at that rate in the current environment. If GSE subsidies go away right now, mortgage rates increase and home prices fall. (I think it would have been possible to get rid of the GSEs in 2005 without dramatically effecting mortgage rates, but there is no way that getting rid of the GSEs’ subsidies will not raise rates now).

2) At this point, the GSEs have to borrow more money from Treasury every quarter just to pay interest and dividends on debt and preferred stock that the GSEs issued to the Treasury. The interest and dividends on these instruments is so high that even if the GSEs return to pre-crisis levels of profitability, they won’t be able to pay back Treasury – ever. So, any serious plan to restructure the GSEs would require Treasury to take massive losses on these "investments." Politically, this means that the Democrats would have to acknowledge a huge loss of taxpayer dollars to help companies that they provided political cover for for years. Given what we’ve seen in health care, they may be this politically-unaware, but I doubt it.

I’ve heard several suggestions that they are considering giving the GSE’s an ownership structure similar to the FHLBs. Obviously, I don’t think this will work. Such a structure would not solve either of the business problems and it wouldn’t solve the first political problem. It could solve the second, if the Treasury is willing to acknowledge the loss. I also don’t see how GSEs owned by federally-insured banks would ever be perceived by the market as operating without effective federal guarantees.

The only option that I think is feasible is letting the GSEs muddle along until the mortgage market picks back up. At that time, the government could slowly wind them down and quietly acknowledge the losses. This is also what is de facto happening.

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