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Finally, a Fix for Fannie and Freddie

In my recent blog post on the 10th anniversary of Dodd-Frank, I lamented that while “this supposed ‘financial reform’ has caused harmful and sometimes disastrous effects for consumers, investors, entrepreneurs,” it “barely touched” the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, which “played a significant role in fomenting the crisis.”

I added, however, that there was at least now some hope of reform of Fannie and Freddie. The Federal Housing Finance Agency (FHFA), under the leadership of Director Mark Calabria, has proposed a regulatory capital framework that would move the GSEs out of the government-run conservatorship they were placed into at the dawn of the 2008 financial crisis when the government found them to be nearly insolvent. As I wrote in recent comments to the agency on behalf of the Competitive Enterprise Institute, the proposed capital framework would also shrink the GSEs’ “footprints to create a more competitive marketplace in housing finance, and reduce their risk to taxpayers and the economy as a whole.”

On September 25, the Financial Stability Oversight Council (FSOC), which is given the power by Dodd-Frank to designate a financial firm as a “systemically important financial institution” (SIFI), at last warned about the true risks the GSEs pose. The FSOC issued a statement warning that “any distress” to the GSEs “could pose a risk to financial stability, if risks are not properly mitigated.”

The FSOC added that the proposed FHFA capital rule could mitigate these risks: “The proposed rule would increase the quality and quantity of capital that the Enterprises would be required to hold. Significant high-quality capital would mitigate risks to financial stability by making it more likely that the Enterprises will be able to perform their countercyclical function and maintain market confidence as viable going concerns through the economic cycle.”

My comments to the FHFA also largely praise the capital rule, while noting that it was only a first step in moving toward a free and competitive housing finance market. Pointing out CEI founder Fred Smith’s prescient warnings about the GSE’s dangers—in 2000, he warned that a bailout of the GSEs could cost $200 billion, almost predicting on the nose what the 2008 rescue would cost taxpayers—I noted that “Smith and CEI scholars have called for the GSEs to be wound down or stripped of government guarantees, arguing that housing doesn’t need to be propped up by the government any more than any other economic sector.”

I added, however, that Smith also “proposed short-term reforms to reduce their footprint in the housing market and their risk to taxpayers.” One of these was strong capital requirements similar to what the FHFA is now proposing.

While generally agreeing with the proposed capital requirements, I suggested that the rules be modified to allow the GSEs to rely slightly more on credit risk transfer securities (CRTs) to build their capital. I noted that “from 2013 to 2018, CRTs have transferred $102 billion in risks of losses from the GSEs to private-sector investors.”

I also noted the insights of the late Christopher Culp, one of the world’s most respected experts on derivatives who served as senior fellow at CEI and as an adjunct professor of finance at the University of Chicago, that financial innovation can reduce overall risk.  Culp observed that “people have feared what they don’t understand, and financial instruments are no exception.” Yet, by “helping market participants manage their risk profiles,” these instruments create “a stronger and more resilient financial system.”

I concluded the comments by praising the FHFA for taking this vital first step for GSE reform. “For more than a decade after the financial crisis, Fannie and Freddie were the two elephants in the room that no one wanted to tame, and conservatorship only saw the elephants grow even larger with less accountability to shareholders, taxpayers, and policymakers. While there is room for improvement in the Framework, the FHFA deserves kudos for moving forward to reduce risks to the taxpayer and the economy and to create a more competitive market for housing finance.”