Two high ranking officials testifying before congress this week made it clear that, when it comes to the future of Freddie Mac and Fannie Mae, the Departments of Treasury and Housing and Urban Development are reading from the same play book,

Federal Housing Finance Agency Acting Director Edward J DeMarco and Assistant Treasury Secretary Michael Barr spoke before a House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises.  It was clear from the prepared remarks of each that the Administration feels it is essential that the government continue to support the housing industry, but it is not a given that that support will include government guarantees or that any guarantees would be in the same form they are today.

Each testimony recounted the history of the two government sponsored enterprises (Enterprises or GSEs), with DeMarco also devoting some of his testimony to the background of the Federal Home Loan Banks and their current situation and recounted some of the accomplishments since the GSEs were placed in conservatorship in August 2008, including a recap of the their loss mitigation activities and efforts to recoup losses through repurchase demands. 

In this context, DeMarco made several remarks that might signal some interesting enforcement activities. First, he said that, given the extent of the loss mitigation options available to borrowers he was supportive of Enterprise efforts to discourage borrowers from strategically defaulting on their mortgages. 

He also made it clear that the Enterprises were expected to enforce lender compliance with their contractual obligations, including outstanding repurchase requests.  At the end of the second quarter, Fannie and Freddie had a combined 11.1 billion in outstanding repurchase requests, one-third of which have been outstanding for over than 90 days.  DeMarco said if discussions between the Enterprises and their lenders do not yield reasonable outcomes soon, "FHFA may look to its supervisory and conservatorship authorities provided under statute to resolve the situation."

DeMarco also referenced the 64 subpoenas issued by FHFA in July for records and information regarding Enterprise losses on private label MBS.  The subpoenas had been issued because the GSEs had difficulty obtaining the requested information.  As the information is received, he said, "FHFA will determine whether private-label MBS issuers and others are liable to the Enterprises for certain losses they have suffered on private-label MBS and, when appropriate, will seek to recover these losses.   

Both men noted the recently published finding that the biggest losses to the Enterprises have come from their single-family credit guarantee business rather than from their owned portfolios.  Of the $226 billion in losses since the end of 2007, $166 billion or 73 percent was attributable to the guarantee business.  $148 billion of this was borne by the tax payers while $78 billion came from the Enterprises' stockholders.  The Enterprises are now pricing the guarantee to a level sufficient to cover model lifetime estimated costs, including a return on economic capital at a rate commensurate with the interest rate on Treasury-held senior preferred stock.  One exception is pricing of Home Affordable Refinance Program (HARP) loans which does not cover anticipated costs.  However, those loans are improving credit risk and have improved pricing relative to the existing Enterprise loans they replace.

DeMarco said that the future design of the housing finance system should give consideration to targeting subsidies to specific groups that lawmakers determine warrant that benefit.  He cited as examples the FHA and Veterans administration guarantees that reflect policymaker's judgment as to the public benefits from targeting certain borrowers.  "It is reasonable to question whether all conventional mortgages warrant a government guarantee," he said. 

While recent calls for some form of explicit federal insurance have certain merit and some attractive features, the potential costs and risks of that framework have not been fully explored.  "To put it simply, replacing the Enterprises' 'implicit' guarantee with an explicit one does not resolve all the shortcoming and inherent conflicts in that model, and it may produce its own problems." 

Such an explicit guarantee presumes that the market either cannot evaluate and price the tail risk of mortgage default, at least not at an acceptable cost, or cannot manage that amount of risk on its own.  "But we might ask whether there is reason to believe that the government will do better?  If the government backstop is underpriced, taxpayers eventually may foot the bill again."

Second, he said, if the government provides explicit credit support for the vast majority of mortgages, it would likely want a say about the allocation or pricing of mortgage credit for particular groups or geographic areas which has the potential to distort pricing of risk and risks further taxpayer involvement and costs. 

Third, explicit credit support for the majority of mortgages coupled with the tax deductibility of mortgage interest, would further direct the nation's investment dollars toward housing.  Lawmakers must weigh such incentives against the alternative uses of funds.

Barr and DeMarco each stressed the necessity for a smooth and gradual transition into a post-conservatorship era and highlighted the progress already made in upgrading the risk in the Enterprises portfolios.  DeMarco said that in conservatorship the Enterprises must continue to focus on their core business activities, loss mitigation, and remediation of internal weaknesses, and not introduce new products. 

The FHFA acting director said he is frequently asked how much more money the Enterprises might require under the Preferred Stock Purchase Agreement with Treasury.  In April he said $400 billion and, because Fannie and Freddie each use different models to predict future losses, he will hold to that projection.  However, work is underway to develop projections that are comparable between the two and when this is completed it may be that under less severe stress scenarios those projected losses could be lower. 

Barr said that HUD and Treasury working together had laid out goals for a new stable and well-functioning housing market that would achieve the following objectives.

• Mortgage credit would be widely available and distributed in an efficient manner to a wide range of borrowers even when markets are under stress.
• Both ownership and rental affordable housing options should be available for low-and moderate-income households.
• Consumers should have access to mortgage products that are easily understood and effective consumer protection to keep unfair, abusive, or deceptive practices out of the market.
• Credit and interest rate risk should be distributed in an efficient and transparent manner that minimizes risk to the broader economic system and does not generate excess volatility. It should not contribute to systemic risk or overly increase interconnectedness from the failure of any one institution.

Any system that achieves these goals should be characterized by:

1. An alignment of incentives among issuers, originators, brokers, ratings agencies and insurers to guarantee long-term viability rather than short term gains.
2. Any government support should earn an appropriate return for taxpayers to ensure that private sector gains do not come at the expense of public losses.  If government support is provided, the role and risks must be clear and transparent.
3. A strong regulatory regime should ensure capital adequacy though the system, enforce strict underwriting standards, and protect borrowers from unfair and deceptive practices.
4. Standardization of products to improve transparency and efficiency while leaving room for innovations to develop new and beneficial products.
5. Support for affordable single and multifamily housing.
6. Diversified investor base and sources of funding.
7. Accurate and transparent pricing.
8. Continued secondary market liquidity to lower borrowing costs, stabilize the market and support the goal of diversified sources of funding.
9. Any institutions with government support should be provided with clear goals and objectives that are not commingled with general mandates.

Barr noted that the GSEs and government are currently playing an outsized role in the housing finance system; a situation that is neither sustainable nor desirable.  "After reform, the GSEs will not exist in the same form as they did in the past.  Private gains will no longer be subsidized by public losses, capital and underwriting standards will be appropriate, consumer protections will be strengthened, and excessive risk-taking will be restrained."