Understanding of GSE’s implicit and explicit guarantee

According to Americanbanker, some lawmakers and other commenters have also called for any future government guarantee to be explicit and transparent — rather than Fannie and Freddie’s implicit guarantee — and apply only to the mortgage securities issued under a new system. First of all, here is my understanding of GSE’s guarantee; second of all, here are the comments from Americanbanker. I think to change GSE’s guarantee needs new legislation which may not be easy to pass.

GSE’s implicit and explicit guarantee

Implicit guarantee and government support[edit]

Originally, Fannie had an ‘explicit guarantee’ from the government; if it got in trouble, the government promised to bail it out. This changed in 1968. Ginnie Mae was split off from Fannie. Ginnie retained the explicit guarantee. Fannie, however, became a private corporation, chartered by Congress and with a direct line of credit to the US Treasury. It was its nature as a Government Sponsored Enterprise (GSE) that provided the ‘implied guarantee’ for their borrowing. The charter also limited their business activity to the mortgage market. In this regard, although they were a private company, they could not operate like a regular private company.

Fannie Mae received no direct government funding or backing; Fannie Mae securities carried no actual explicit government guarantee of being repaid. This was clearly stated in the law that authorizes GSEs, on the securities themselves, and in many public communications issued by Fannie Mae.^{[citation needed]} Neither the certificates nor payments of principal and interest on the certificates were explicitly guaranteed by the United States government. The certificates did not legally constitute a debt or obligation of the United States or any of its agencies or instrumentalities other than Fannie Mae. During the sub-prime era, every Fannie Mae prospectus read in bold, all-caps letters: “The certificates and payments of principal and interest on the certificates are not guaranteed by the United States, and do not constitute a debt or obligation of the United States or any of its agencies or instrumentalities other than Fannie Mae.” (Verbiage changed from all-caps to standard case for readability).^{[citation needed]}

However, the implied guarantee, as well as various special treatments given to Fannie by the government, greatly enhanced its success.

For example, the implied guarantee allowed Fannie Mae and Freddie Mac to save billions in borrowing costs, as their credit rating was very good. Estimates by the Congressional Budget Office and the Treasury Department put the figure at about $2 billion per year.^[68] Vernon L. Smith, 2002 Nobel Laureate in economics, has called FHLMC and FNMA “implicitly taxpayer-backed agencies”.^[69] The Economist has referred to “the implicit government guarantee”^[70] of FHLMC and FNMA. In testimony before the House and Senate Banking Committee in 2004, Alan Greenspan expressed the belief that Fannie Mae’s (weak) financial position was the result of markets believing that the U.S. Government would never allow Fannie Mae (or Freddie Mac) to fail.^[71]

Fannie Mae and Freddie Mac were allowed to hold less capital than normal financial institutions: e.g., they were allowed to sell mortgage-backed securities with only half as much capital backing them up as would be required of other financial institutions. Regulations exist through the FDIC Bank Holding Company Act that govern the solvency of financial institutions. The regulations require normal financial institutions to maintain a capital/asset ratio greater than or equal to 3%.^[72] The GSEs, Fannie Mae and Freddie Mac, are exempt from this capital/asset ratio requirement and can, and often do, maintain a capital/asset ratio less than 3%. The additional leverage allows for greater returns in good times, but put the companies at greater risk in bad times, such as during the subprime mortgage crisis. FNMA is not exempt from state and local taxes. In addition, FNMA and FHLMC are exempt from SEC filing requirements; they file SEC 10-K and 10-Q reports, but many other reports, such as certain reports regarding their REMIC mortgage securities, are not filed.

Lastly, money market funds have diversification requirements, so that not more than 5% of assets may be from the same issuer. That is, a worst-case default would drop a fund not more than five percent. However, these rules do not apply to Fannie and Freddie. It would not be unusual to find a fund that had the vast majority of its assets in Fannie and Freddie debt.^{[citation needed]}

In 1996, the Congressional Budget Office wrote “there have been no federal appropriations for cash payments or guarantee subsidies. But in the place of federal funds the government provides considerable unpriced benefits to the enterprises… Government-sponsored enterprises are costly to the government and taxpayers… the benefit is currently worth $6.5 billion annually.”.^[73]

Americanbanker news:

There is a body of opinion in Washington that the best way to move on from the conservatorships of Fannie Mae and Freddie Mac is to develop legislation to create a new housing finance system that retains a government backstop.

However, there can realistically be only muted hope that today’s Congress, nine years after the conservatorships started, will agree on a feasible strategy to unwind Fannie and Freddie and replace them with a viable alternative. Washington is too divided; the chances of a bipartisan bill are still in question.

Of course, Congress doesn’t need to act to end the conservatorships. The Housing and Economic Recovery Act of 2008 in fact empowered and delegated the Federal Housing Finance Agency with the legal authority and responsibility to bring Fannie and Freddie out of conservatorship — assuming they can be sufficiently capitalized — and reform their regulation. The law could not be any clearer about the FHFA’s authority to set the housing finance system on a proper footing without direction from Capitol Hill.

Regardless of whether Congress could act, some supporters of proposals to recast or eliminate the two government-sponsored enterprises — and yet retain government support for mortgage assets — don’t seem to fully consider the complexities of transitioning to a future without Fannie and Freddie. Whenever elaborate financial policy reforms are implemented, a variety of economic, political, market and regulatory forces all necessarily intertwine over time to determine whether a policy will be successful, or an unintentional failure. Unfortunately, policymakers have all too often failed to rely on a clear, fact-based analysis of the risks and bad incentives they may be cultivating over the longer term. History tells us that it often takes decades before the impact of such a financial stew ferments into intended or unintended consequences.

The savings and loan crisis of the late eighties and early nineties is a perfect example of how good intentions can produce dire unintended financial consequences many years later. Its seeds were sown in the 1960s, when consumer deposit interest rate caps for S&Ls were capped at 5.5% to favor the S&Ls over banks and therefore help spur mortgage lending. But the market did not cooperate — interest rates in the country generally increased to unprecedented levels, hitting double digits by the early 1980s.

Depositors naturally abandoned banks and thrifts in favor of money funds which were paying about 10%. In response to this massive disintermediation, the government eliminated Regulation Q’s interest rate caps in 1982. But S&Ls then had to pay double-digit interest rates to remain liquid, while their assets consisted of 30-year fixed-rate mortgages yielding about 7%. This created negative spreads that burned through their capital. The die was cast at that point through the implementation of half-baked public policies.

So what is an example in some of the current GSE proposals of ideas that may have unintended consequences? Well, the capital base underlying a reformed housing finance system, for one. Large amounts of capital will undoubtedly be needed in a non-conservatorship future. This is particularly true since 100% of the profits that Fannie and Freddie have been earning over the last few years have been “swept” into the U.S. Treasury, and government policy has set Fannie and Freddie on a flight path to reach zero capital by Jan. 1, 2018.

In a recent speech, Federal Reserve Board Gov. Jerome Powell discussed GSE reform and sounded supportive of suggestions that Congress overhaul the system, although he did not endorse any one of the many GSE plans being floated. Powell mentioned the importance of capital, but he did not discuss the complex factors that will impact attracting that capital. Remember, Fannie and Freddie were never placed in receivership; they still have equity and debt holders whose ownership and contractual rights continue to be economically and legally extant. Any solution therefore requires that they be at the negotiation table.

Put another way, if their rights are eviscerated by whatever solution is forged, it will not only produce a volcano of litigation (which has already begun) similar to the “goodwill” cases brought by purchasers of failed S&Ls, it will impact negatively on the market’s willingness to provide the future capital that Fannie and Freddie (or their descendants) will need, as well as the cost of that capital.

Powell, some lawmakers and other commenters have also called for any future government guarantee to be explicit and transparent — rather than Fannie and Freddie’s implicit guarantee — and apply only to the mortgage securities issued under a new system.

Guaranteeing mortgage security instruments could also change the risk profile for taxpayers. As the last crisis proved, relying on deposit insurance in a widespread financial crisis to resolve failing banks can be more costly than guaranteeing the banks (as carried out by the Troubled Asset Relief Program.)

While returning Fannie and Freddie to the ranks of the private sector does require rigorous analysis, it is an admission of defeat to keep them in conservatorship. The FHFA has the full authority to end the conservatorships, and implement positive and attainable reforms. The only missing ingredient now is the will of the government.