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Senate Banking Committee Hearing on Fannie Mae and Freddie Mac SIFI Designation

Senate Banking Committee

“Should Fannie Mae and Freddie Mac be Designated as Systemically Important Financial Institutions?”

Tuesday, June 25, 2019

 

Key Topics & Takeaways

  • Recapitalization and Release: Wachter said it is for the markets to determine and the capitalization of Fannie Mae and Freddie Mac is important with a structure that promotes stability with a line of credit. Holtz-Eakin said if Fannie Mae and Freddie Mac are well capitalized and supervised, it would essentially be the same as an implicit guarantee. He said recapture and release for GSEs would be fantastic if no risk is involved, but a lot of legislative reform is required for the administration to use this tool.
  • Systemic Risks and SIFI Designation: Holtz-Eakin said Fannie Mae and Freddie Mac are systemically important and dominate the leveraged real estate and guarantor markets, which are the riskiest types of systemic activity. Wachter said both institutions cannot fail due to conservatorship and recommended the SIFMU designation. Wachter also said the credit risk transfer market already helps set prices and the To-Be-Announced (TBA) market helps set the interest rate. Wachter said stable GSEs help better serve many underserved communities and that diversification is important in the housing system. Holtz-Eakin said the stabilization of the GSE market would allow them to serve out their mission and cause more reliable performance of the GSEs. Pollock said better capitalized and managed systems with oversight better position the performance of GSEs.
  • Guarantors: Wachter said risks would increase because a multi-guarantor system would cause a race to the bottom, which would cause the erosion of standards and prices. She said the multi-guarantor system would provide competition only for the short run. Pollock said the multi-guarantor model is dangerous as the FHFA is neither empowered nor able to be the sole systemic risk regulator for Fannie Mae and Freddie Mac. He said the goal should be to position the FSOC and the Fed to work together to designate and regulate systemically important institutions. Holtz-Eakin said the key with multi-guarantors is to know how much capital is required to be held to control the debt to the leverage ratio.

Witnesses

Opening Statements

Chairman Mike Crapo (R-Idaho)

In his opening statement, Crapo focused on the state of the housing finance system, specifically on concerns about Fannie Mae and Freddie Mac dominating the mortgage market and leaving taxpayers on the hook in the event of a downturn. He agreed with a past statement from Federal Housing Finance Agency (FHFA) Director Mark Calabria that “the time to repair the roof is not during the downpour, but while the sun is shining,” and added his “strong” preference for comprehensive legislation. Crapo said in analyzing the Trump administration’s options, he believes Fannie Mae and Freddie Mac are too big to fail and pose a systemic risk with collective assets of $5.48 trillion and a leverage ratio of nearly 1000-to-1. He said that under Dodd-Frank Title I Section 120 authority, the Financial Stability Oversight Council (FSOC) can and should designate Fannie Mae and Freddie Mac as systemically important financial institutions (SIFIs) in order for the Federal Reserve (Fed) to have oversight over them and to enhance their prudential standards. Crapo said if they are designated as SIFIs, the government should consider whether this would result in increased capital levels, how the Fed and FHFA would coordinate their efforts, the impact on the broader mortgage market, and if this would put the housing finance system on durable footing.

Ranking Member Sherrod Brown (D-Ohio)

In his opening statement, Brown expressed how essential the ownership of a home is for many Americans and the need to address long term stability and affordability in the housing system. He said that Fannie Mae was chartered by Congress to address accessibility and affordability, and said Congress reaffirmed accountability and affordability through the passage of the Housing and Economic Recovery Act. Brown said he believes Fannie Mae and Freddie Mac should be designated as SIFIs and that it is important to distinguish whether pre-crisis, current, or future Fannie Mae and Freddie Mac are at the core of the discussion. He said previous witnesses have said Congress should protect access to the 30-year fixed rate mortgage, provide a catastrophic government guarantee, structure loan guarantors like public utilities to provide a regulated rate of return, serve broad national markets for lenders of all sizes and types, maintain the duty to serve, maintain affordable housing goals and metrics, expand investment in affordable housing, and maintain the Government-Sponsored Enterprise (GSE) multifamily business model.

Testimony

Alex J. Pollock, Distinguished Senior Fellow, R Street Institute

In his testimony, Pollock commented that Fannie Mae and Freddie Mac are systemically important due to their control of half of the U.S. housing credit risk sector, assets of nearly $5.5 trillion, high leverage ratio, and history of systemic risk. He said that credit risk is the most common source of credit collapses and both institutions are giant credit risk takers. Pollock referenced former Treasury Secretary Henry Paulson’s prediction that a default of Fannie Mae and Freddie Mac would exacerbate a financial crisis and pass on the credit loss to the Fed. He said that “without question” both institutions are too big to fail, are systemically important, and should be designated as SIFIs. Pollock said this is based on factors such as their size, leverage, substitutability, interconnectedness, maturity mismatch, existing regulations, and liquidity risk. He added that for some individuals, both Fannie Mae and Freddie Mac meet the criteria for institution and activity risks for a SIFI designation. Pollock recommended to not delay a designation because of a conservatorship of Fannie Mae and Freddie Mac. He said the Fed should become an additional regulator for oversight of Fannie Mae and Freddie Mac, in coordination with the rest of the financial system.

Dr. Douglas Holtz-Eakin, President, American Action Forum

In his testimony, Holtz-Eakin said given the increase in housing finance reform discussions and the eventual exit of the GSEs from conservatorship, SIFI designation for Fannie Mae and Freddie Mac is the only solution. He said the core activity of both institutions has historically been real estate leveraged lending, which is risky to the financial system. Holtz-Eakin said both dominate this market, as they buy 48 percent of these loans at origination, and are responsible for 61 percent of mortgage-backed securities (MBS). He said there is no question about a SIFI designation with the enormous leverage and interconnectedness of Fannie Mae and Freddie Mac. Holtz-Eakin said that some individuals argue that the Fed would face a conflict of interest for setting rates on monetary policy and regulating the housing market. He said that if this is the case, it is imperative that the FHFA create an alternative regime to insulate the threat of GSEs on the housing market like the requirement of SIFIs holding more capital. Holtz-Eakin said as the FHFA finalizes capital requirement rules for GSEs, it is an opportunity for the agency to display to the FSOC their interest in insulating the threat of GSEs. He added that GSE stress tests should look like those of large banks and should be de-risked.

The Honorable Susan M. Wachter, Sussman Professor of Real Estate and Professor of Finance, The Wharton School of the University of Pennsylvania

In her testimony, Wachter said the structure and oversight of the housing finance system will be instrumental to avoid a repeat of the 2008 crisis, and there is a need for system-wide oversight of the mortgage market. Wachter suggested that Fannie Mae and Freddie Mac should be designated as systemically important financial market utilities (SIFMU). She said Dodd-Frank Section 204 grants the FSOC the ability to designate financial market utilities that are likely to become systemically important, and that Dodd-Frank Section 803 clarifies SIFMUs based on their likelihood to disrupt liquidity and credit, which could spread among financial markets. Wachter said GSEs are important to the structural foundation of the secondary mortgage market and for the characterizations to be considerations for a SIFMU designation as they include aggregate exposure, the aggregate value of transactions, relations, and interdependence, and address the concern for market disruption in the case of failure. Wachter said taxpayers are at risk with a lack of equity in a private capital model and that recapture and release proposals would enable GSEs to raise capital, reduce risk, and end the need for conservatorship. She said increasing the number of GSEs could lead to weaker underwriting standards and competition for pricing, which could be negative for GSE credit. Wachter said a SIFMU designation and oversight by FHFA and other agencies would maintain GSE functions and provide market stability.

Question & Answer

Systemic Risks and SIFI Designation

Sens. Bob Menendez (D-N.J.), Crapo and Brown asked about risks posed by Fannie Mae and Freddie Mac, the use of SIFI designation, and regulator control for the rate of return to determine prices. Holtz-Eakin said both are systemically important and dominate the leveraged real estate and guarantor markets, which are the riskiest types of systemic activity. He said historically both institutions have helped large MBS portfolios, have high leverage ratios and their interconnectedness enhance their exposure to risk. Wachter said both institutions cannot fail due to conservatorship and recommended the SIFMU designation. She recommended against doubling up on regulations for GSEs. Wachter also said the credit risk transfer market already helps set prices and the To-Be-Announced (TBA) market helps set the interest rate.

Sens. Tim Scott (R-S.C.), Menendez, and Brown asked how SIFI designations would affect accessibility and affordability for the housing system and GSEs across different regions. Wachter said the reduction of systemic risk would lead to more affordable credit and that credit risk transfers market help fairly price mortgages and credit rates. Wachter said stable GSEs help better serve many underserved communities and that diversification is important in the housing system. Holtz-Eakin said the stabilization of the GSE market would allow them to serve out their mission and cause more reliable performance of the GSEs. Pollock said better capitalized and managed systems with oversight better position the performance of GSEs. He added that there is a need for as much competition as possible, since Fannie Mae and Freddie Mac dominate the market and dictate prices and innovation. Pollock also said that FHFA and Ginnie Mae make up a large part of the MBS market, which is another reason to take a systematic overview approach to address the problem.

Utility Model

Sens. Mark Warner (D-Va.), Crapo and Brown asked about the use of the utility model. Holtz-Eakin said Fannie Mae and Freddie Mac currently patch MBS issues, which is a utility inside of their systems, but said how genuine competition can be generated in MBS generation needs to be addressed. He said there is a need for comprehensive legislative reform. Pollock said there are many different models with pros and cons, but if large amounts of credit risk continue to be generated, he believes SIFI designation is the only solution to address Fannie Mae and Freddie Mac. Wachter said the utility model will help FHFA stabilize long term access to capital and the market. She cautioned against a model with too many utilities as she said competition can harm rates and standards.

Title I vs Title VIII

Sens. Crapo and Warner asked about Dodd Frank Title I vs VIII. Pollock and Holtz-Eakin said they prefer Title I due to concerns over Fannie Mae and Freddie Mac being highly leveraged and to address capital requirements. Pollock said there is the possibility to make both SIFI and SIFMU designations work. Wachter said the mandate for sufficient capital requirements already exist under the FHFA mandate and because GSEs are financial utilities, Title VIII is the best solution for oversight.

Recapitalization and Release

Mark Warner (D-Va.) asked about the effect on rates of recapitalization and release without a government guarantee. Wachter said it is for the markets to determine and the capitalization of Fannie Mae and Freddie Mac is important with a structure that promotes stability with a line of credit. Holtz-Eakin said if Fannie Mae and Freddie Mac are well capitalized and supervised, it would essentially be the same as an implicit guarantee. He said recapitalization and release for GSEs would be fantastic if no risk is involved, but a lot of legislative reform is required for the administration to use this tool.

Guarantors

Sens. Jerry Moran (R-Kan.) and Brown asked about the multi-guarantor system and risks involved. Wachter said risks would increase because a multi-guarantor system would cause a race to the bottom, which would cause the erosion of standards and prices. She said the multi-guarantor system would provide competition only for the short run. Pollock said the multi-guarantor model is dangerous as the FHFA is neither empowered nor able to be the sole systemic risk regulator for Fannie Mae and Freddie Mac. He said the goal should be to position the FSOC and the Fed to work together to designate and regulate systemically important institutions. Holtz-Eakin said the key with multi-guarantors is to know how much capital is required to be held to control the debt to the leverage ratio.

For more information on this hearing, please click here.