House under construction

Housing Perspectives

Research, trends, and perspective from the Harvard Joint Center for Housing Studies

To Senator Toomey: The Process of Exiting GSE Conservatorship Is Not So Simple

On Thursday, January 13, the Senate Banking Committee held a nomination hearing for Sandra Thompson, now Acting Director, to be the permanent Director of the Federal Housing Finance Agency (FHFA), the regulator of Freddie Mac and Fannie Mae, the two government-sponsored enterprises (GSEs). At that hearing, Senator Pat Toomey (R-PA), the Ranking Member, emphasized one specific concern in his questioning: since his reading of the legislation establishing the FHFA made it clear to him that Thompson, as head of the agency, had the sole power to end the conservatorships of the GSEs, why would she not simply do so as quickly as possible? He and some other Republican members went so far as to refer to it as a “statutory requirement.”

The nature of such hearings requires very short answers, often well under a minute. Acting Director Thompson responded within that constraint, referencing the need to work with Treasury and also Congress on such an exit. Sen. Toomey did not appear satisfied.

In my seven years as CEO of Freddie Mac, I found there was a reality one had to accept: almost everything in housing finance, and especially with respect to the GSEs, is exceptionally complicated and sometimes downright obscure. I have therefore developed a short history of key conservatorship-related events that fully explains—without the ultra-short time limit of Congressional hearings—the process by which the GSEs can exit conservatorship, including who has the authority to do what. The punchline is that the FHFA alone does not at this time have the unconstrained legal ability to end the conservatorships; at a minimum, Treasury will also have to agree, and possibly even Congress as well.

The Conservatorships Begin: 2008

In July 2008, Congress passed legislation to create the FHFA out of several other regulatory organizations, and in doing so, authorized it to put the GSEs into (and later exit) conservatorship. Conservatorship is a rarely-used regulatory status in which the conservator (in this case, the FHFA itself) takes full operational control of the company being “conserved.” Conservatorship was used infrequently, almost always with small banks, which typically exited conservatorship by being sold off.

Soon afterwards, in September, as market confidence in the GSEs’ ability to meet over $4 trillion of obligations eroded, the FHFA put the companies into conservatorship. This was, of course, at the height of the 2008 financial crisis. The policy objective by the Bush administration and the Federal Reserve was to restore full market confidence in the GSEs since anything less would have made the severe global financial market downturn then underway even worse. This was rather different from the historic examples of conservatorship utilized for small banks.

However, when passing the legislation to establish the FHFA, Congress did not give it the power or resources to financially support the GSEs as needed to restore market confidence in them. Instead, Treasury had to provide that support, and did so via an agreement with the FHFA known as the Preferred Stock Purchase Agreement (PSPA). The PSPA put a large dollar amount of monies at risk ahead of creditors, and quickly restored market confidence in the two companies. In the agreement, which is a legally binding contract, the FHFA commits that it will not authorize the companies to exit conservatorship without first obtaining the approval of Treasury. Such a requirement was reasonable on the part of Treasury, as it naturally would want a say in what happened to companies into which it expected to invest billions of dollars. This was all done under a Republican Treasury Secretary, Henry Paulson.

The Unsuccessful Effort to Replace the GSEs: 2009–2018

Reflecting a consensus across almost the entire political spectrum, Treasury repeatedly stated it would not approve an exit that has the GSEs going back to the pre-conservatorship status quo, since the failure of the two companies made clear that significant structural reforms were required. Since the GSEs were established by Congress in laws (known as the charters of the GSEs) that specify how they had been structured pre-conservatorship, a universal view emerged that such changes needed to be made, unsurprisingly, via new legislation by Congress. Over the years, this viewpoint was expressed by Treasury secretaries of both parties, especially Messrs. Geithner and Mnuchin.

So, through about 2018, the sequence of “who has the authority to take the GSEs out of conservatorship” looks like a daisy chain. To start, FHFA has legal authority from its founding documents to end conservatorship, as cited by Senator Toomey. However, the PSPA gives Treasury veto power over the FHFA making such a declaration. Then Treasury adopted the uncontroversial view that Congress first has to pass legislation to make the structural changes required to avoid a return to the unacceptable pre-conservatorship status quo. Thus, at the end of the daisy chain sat Congress in charge. The FHFA’s hands were thoroughly tied.

Of course, Democrats and Republicans in Congress have markedly different ideas about what makes sense in the way of structural reform to the GSE system. Academics, think tanks, industry associations, and others proposed many ideas as well. All these ideas centered around replacing the GSEs with “something different.” An honest reckoning is that the proposals based upon these ideas, after broad public examination, flunked the dual tests of (i) being realistically implementable and workable and (ii) offering a transition that was not unduly risky. Naturally, ideological and economic interest groups were also pressing their differing viewpoints. In the end, no such proposal ever got close to being enacted by Congress.

The Alternative of “Administrative Reform” Emerges

In the absence of successful legislation to replace the GSEs, a new approach publicly emerged in 2018. It focused on an implementable and low transition-risk solution within the narrow band of keeping in place, rather than replacing, the GSEs in order to avoid the uncertainties associated with more dramatic changes. This solution would have the companies continue to operate on a day-to-day basis largely unchanged, allowing the mortgage market to continue working as it had for many years, and therefore keeping implementation risks and costs low. Importantly, this solution would also keep the GESs subject to the reforms instituted during conservatorship–which by that time were extensive and well-regarded. (Such reforms include things like tight investment portfolio caps, the extensive use of credit risk transfer transactions, etc.) Finally, they would be regulated like an electric utility, which includes price setting by the regulator. Although this approach quickly gained broad support, it was not a full consensus by any means.

By keeping the reformed GSEs in place, instead of replacing them, the need for legislation seemed unnecessary. This new approach became known as GSE reform “by the administrative path” or “using administrative means.” This meant it could be implemented solely through new and changed regulations by the FHFA plus amendments to the PSPA that together could, it was believed, deliver an acceptable level of GSE reform while not requiring any changes in legislation. Treasury, under Secretary Mnuchin, discussed such an approach publicly. Key members of Congress (including Senator Crapo, then Chairman of the Senate Banking Committee) even encouraged an administrative approach, given how unlikely it was that Congress would pass relevant legislation after having failed to do so during a decade of conservatorship.

It should be noted that there are legitimate concerns whether the administrative path can sustain a reformed GSE system indefinitely. For example, the PSPA was not designed for long-term support of the companies, as any funds Treasury provides, once used, are not replenishable to ensure the total available always stays at a confidence-retaining high level. Also, a future administration could change the relevant regulations and PSPA amendments, making market confidence more fragile. By contrast, legislative changes are viewed as more permanent. Then, in terms of the raw politics, if Congress doesn’t like what emerges from an administrative path, it can easily overcome partisanship to pass legislation stopping or even reversing it. (They already did something similar, earlier in the conservatorship.) Given all of this, Secretary Mnuchin continually pointed out his preference for a legislative solution, and indicated that any administrative path he might pursue should be seen as a way to get started, with Congress expected to take over at some point, presumably building upon whatever administrative path reform had been delivered and making it permanent.

Concluding Points

In short, a summary of the process required and who can do what at this time, is:

  • The Director of the FHFA, on her own, can only prepare the GSEs for eventual exit – nothing more.
  • The Director of the FHFA and the Secretary of the Treasury together could implement an exit from conservatorship via the administrative path that would fully include a large degree of reform of the GSEs (i.e. what has already been accomplished within conservatorship), and include utility-style regulation. This is not at all akin to having the GSEs return to the pre-conservatorship status quo. Congress would ideally follow up with legislation affirming the administrative path changes, making them permanent, although it is unclear if this is absolutely necessary.
  • If Congress can again successfully mobilize to undertake GSE reform that goes beyond what the administrative path can deliver (i.e. replacing the GSEs, rather than reforming them) then FHFA and Treasury can provide much-needed technical expertise to Congress to avoid unforced errors in a complex field. Of course, I am not aware of anyone who thinks this is likely to happen within the next few years, given that it hasn’t happened in the last decade-plus.

I have not included in this short explanation how many of the steps related to conservatorship exit are likely to take years to accomplish. Retaining capital to meet a reasonable minimum regulatory requirement will take at least three to five years. Resolving all the complex and intertwined issues of Treasury’s ownership position in the GSEs—necessary so they could eventually go back to private ownership with the taxpayer receiving full compensation for supporting the two companies—could take even longer to design and play out. And the FHFA developing a utility-style price regulation regime from scratch is a heavy lift as well.

So, conservatorship exit is not simple and will take many years to implement. And the FHFA cannot even come within a country mile of doing it solo.