The Federal Housing Finance Agency (FHFA) recently announced and sought public comment on a proposed “living will” rule to apply to the two government-sponsored enterprises (GSEs), Freddie Mac and Fannie Mae, which it regulates. The two companies together provide the financing on almost one-half of the $11 trillion of single-family mortgages in America.

Such a living will, more officially known as a “resolution plan,” is defined by the Federal Reserve to be a “strategy for rapid and orderly resolution in the event of material financial distress or failure,” where “resolution” means the partial or full wind-down of a bank or other financial institution until the impacts of the financial distress or failure are materially eliminated. Colloquially, such a plan is sometimes compared to a “prepackaged bankruptcy,” meaning a contingency plan for how a financial institution will sell off assets or be liquidated in a manner that does not generate chaotic aftershocks elsewhere in the financial system.

Only the largest banks, known as systemically important, are required to have living wills. That’s because banks of such size will have potentially hundreds of operating subsidiaries, including in foreign countries under different legal regimes and using different currencies. For these banks, having liquidity and capital pre-positioned in the right operating subsidiaries and the right currency can make all the difference between a relatively orderly resolution and one that spreads financial distress. By their nature, then, living wills are mostly highly technical documents – they are about details and specifics rather than some financial vision or policy.

For the GSEs, though, a living will has relatively little value versus what it does for systemically important banks. There are three key reasons for this difference:

1. The structure of a GSE, compared to that of a large bank, is ultra-simple: a GSE operates almost entirely via one legal entity, in one country, and in one currency, so the need for a detailed living will is substantially less;
2. Because about 90 percent of GSE assets are financed by pass-through mortgage-backed securities, a GSE in a living will situation faces liquidity risks that are dramatically reduced compared to those faced by a bank; and
3. In some future GSE distress situation, when policymakers consider the health of the economy and homeownership, receivership will likely prove to be an unattractive policy alternative compared to other options the government could deploy, so its likelihood of occurring is, in practice, minimal.

Nevertheless, a proposed rule has been issued by the FHFA, and the effort needed for the GSEs to meet its requirements would be a major undertaking, lasting several years and, I estimate, generating thousands of pages of submissions. In trying to understand why the GSEs are expected to undertake such enormous effort, despite the fact that a living will has relatively little value for them, I reviewed the FHFA’s proposal in depth. The result is my new paper “The FHFA’s Proposed GSE 'Living Will' Rule: Fatally Flawed and Unusually Vague.”

In reviewing the proposed rule, I quickly discovered how it is twice-over fatally flawed. At its heart are two core design features that are provably wrong: 1) a denial that the current government support agreement for the GSEs exists and can be relied upon, and 2) a requirement that the GSEs plan to continue operations in receivership without that support, despite its being necessary and integral to their business model. These errors subvert the entire rule: the flaws are truly fatal, and so the proposed rule needs a complete revision.

In addition, I found other major design features that are unusually and unacceptably vague, essentially calling for future judgments to be made by the FHFA without any substantial constraint on its views. This is an unusual blank check for a prudential regulator, empowering it to do whatever it wishes with almost no understanding by the public of what is intended (which the public would only find out in the months or years after the rule is approved).

Furthermore, much of the usual content of a living will is conspicuously absent from the proposal; it says little about the technical specifics of how the GSEs will sell off assets or be liquidated. The absence of these details is indicative of how much the proposed rule is different from a conventional large-bank living will.

It is therefore difficult to understand FHFA’s objectives in issuing this rule, as it has so little in the way of specific wind-down or liquidation details. My conclusion is that the proposed rule seems to be a policy document rather than a technical one, reflecting FHFA Director Mark Calabria’s well-known objective to shrink the GSEs’ footprint (i.e. their range and volume of activities). It also seems to reflect his view that the GSEs should transform from being two giant companies, which enjoy special government support to enable their incredibly central role in American housing finance, into being simply two of a larger number of GSE-type companies (each much smaller than today’s GSEs) and which receive less, if any, special government support. Thus, the proposed living will rule can be regarded mainly as a vehicle to implement this free-market policy view.

In addition, some of what the rule calls for seems to run counter to congressional intent, as expressed in the legislation that established each GSE.

In my opinion, the living will rule proposal should undergo a major revamping through the comment-and-revision process. This process should eliminate the fatal flaws and clear up the vagueness that currently gives FHFA too much discretion to do whatever it wants. Furthermore, the rule should be scaled back so the implementation effort required matches its low regulatory value. The rule should also be revised into a technical document, as more typically required of large banks, rather than the vehicle for policy implementation that it is in its current form.

If a major revamping does not happen, given the rule’s deep shortcomings, it is likely to be replaced wholesale in the future, to something more akin to mainstream regulation and consistent with congressional intent. Such a change could take place upon the appearance of a President Biden-appointed FHFA director, who may well show up later this year. The rule’s potential for quick revision by a new director makes it, of course, reminiscent of the recently-approved and much-criticized capital rule, which I also predict will be quickly revised when a Biden-appointed FHFA director arrives.