by the Editor
June 18, 2019
It has been over a decade since the U.S. government takeover of Fannie Mae and Freddie Mac, the two government-sponsored enterprises (GSEs) that dominate the U.S. secondary mortgage finance market. In the meantime, government gridlock has made it difficult to reach a consensus on what to do with the GSEs. One approach which has been proposed is to treat the GSEs as public utilities where the federal government would provide an explicit guarantee to backstop the credit risk of the mortgages acquired by the GSEs. Given the huge losses imposed on the American taxpayer as a result of the government bailout of the GSEs, it should be clear that it is unwise for the government to guarantee the risk underlying the U.S. mortgage finance market. Applying a regulated utility model to the GSEs is not appropriate and will lead to economic inefficiencies and likely another taxpayer bailout.
Summary of the “Utility” Model for GSE Regulation
There have been many proposals to treat the GSEs as public utilities. For example, the Federal Housing Finance Agency (FHFA), the main regulator and conservator for the GSEs, circulated such a proposal in 2018. While the FHFA has since changed its leadership and approach to GSE reform, this “Utility Proposal” is a good example of the structures suggested to regulate the GSEs as utilities. The core of the Utility Proposal is to reconstitute Fannie and Freddie from entities in conservatorship into privately owned “utilities” with regulated pricing to intended to produce a “fair return” to shareholders. The other key aspects of the Utility Proposal include:
- Fannie and Freddie would be privatized (the Utility Proposal calls them “secondary market entities” or “SMEs”) and would be allowed to raise private capital. The Utility Proposal expects there would be additional competitors joining the secondary mortgage finance market over time, but cautions that having too many SMEs could be counterproductive by resulting in a “race to the bottom” in terms of underwriting standards.
- The SMEs would be regulated and would have minimum capital and liquidity requirements.
- The SMEs would issue mortgage-backed securities (MBS) covered by an explicit government guarantee. The FHFA, as their regulator, would collect fees paid by the SMEs in exchange for the government guarantee and use the proceeds to create a mortgage insurance fund that would cover mortgage losses in excess of the private capital held by the SMEs, similar to how the FDIC’s insurance fund covers losses on insured bank deposits. The cost of the government guarantee would be passed along to borrowers as part of the cost of mortgages.
- The SMEs would issue a single type of MBS under the Common Securitization Platform (CSP) developed by Fannie and Freddie. The objective of the CSP is to standardize the structure of MBS and aggregate and distribute mortgage data to achieve improved liquidity, pricing and execution in the MBS market.
- The SMEs would maintain the “cash window” which could be utilized by smaller lenders to sell their mortgages.
- The SMEs should have nationwide operations so they don’t focus solely on the best markets or leave some markets underserved.
- The Utility Proposal calls for an approach “comparable” to existing affordable housing requirements, including duty-to-serve obligations and funding for a housing trust fund.
Challenges with Applying a “Utility” Model to Mortgage Finance
The heart of the Utility Proposal is to provide a government guarantee to backstop the credit risk on a large amount of the mortgage debt issued in the U.S. The substantial amount of losses shifted to the American taxpayers during the recent financial crisis is evidence that this plan is extremely dangerous. In order to mitigate this risk, the idea is to regulate the newly privatized Fannie and Freddie (along with any other new entrants) as “utilities”. It is possible the FHFA hoped that the use of the utility characterization will evoke soothing feelings of stability as observers analogize to the relatively predictable world of electric utilities, water utilities and the like. However, there are several problems with applying a “utility” model to the secondary mortgage finance market.
The public utility framework with regulated rates of return is an inappropriate model for the mortgage finance market. The optimal scenario for creating a regulated public utility is when a “natural monopoly” exists, meaning it would be prohibitively costly and economically wasteful for two or more entrants to develop duplicative infrastructure. Some common examples of natural monopolies are electrical power systems and water systems. This dynamic does not exist in the American secondary mortgage finance market. There are no structural features in this market that would preclude multiple providers. Of course, some upfront investment would be required for new entrants and scale would improve efficiency, but not to a materially different degree than in other types of businesses. Indeed, the Utility Proposal anticipates additional entrants into the secondary mortgage finance market.
Furthermore, the underlying mortgage business is quite different from businesses that are traditionally regulated as utilities. The delivery of electricity or water is a fairly predictable business segment while the mortgage market, on the other hand, can be quite volatile especially during asset bubbles or times of economic stress. Due to its operational characteristics, the secondary mortgage finance market does not seem well-suited for the application of a regulated utility model.
Given this lack of suitability, trying to force a regulated utility model on the secondary mortgage finance market would cause significant problems in practice. In the case of traditional public utilities, a key part of the regulator’s role is to determine the profit that shareholders are allowed to earn. At a high level, this involves the regulator setting an approved revenue amount for the utility that will generate a rate of return on investment. When implementing this model for the secondary mortgage finance market, regulators would face several key questions, including: what is the appropriate rate of return for investors, and how should the regulator determine the revenue level for the SMEs in order to generate those returns for investors?
A critical threshold question related to the “utility” model would arise in determining the targeted rate of return for investors. While traditional public utility regulators have decades of experience in determining appropriate levels for investor returns, this would be a new market segment for regulators with considerable room for error. Furthermore, there would be a lack of directly comparable risk/return data points available to regulators to help them determine an appropriate level of return. Given the size of the mortgage finance market, mistakes in setting the rate of return for investors could have serious repercussions.
In the case of the SMEs, determining the revenue level necessary for the targeted rate of return effectively means regulating the fees charged by the SMEs to provide a guarantee for the MBS that they issue. To do this job properly, the regulator would need to take into account fairly detailed considerations regarding the credit quality of different mortgage types. If the guarantee fee is too low for the related risk, losses will arise. Conversely, if the guarantee fee is too high, investors will earn returns in excess of expectations for a “fair” return. The difficulty of this job for the regulator would be magnified because the guarantee fee would need to be set in advance of any mortgage acquisition. At the inception of a mortgage, the regulator is unlikely to be able to accurately forecast and analyze the risk of potential credit losses on long-term mortgages (e.g., 30 years).
This process would be complicated further by the significant amount of political influence that would inevitably arise as a result of the government’s backstop combined with the continued imposition of public policy missions on the SMEs, such as affordable housing goals. Simply put, as long as the government is relying on the SMEs to deliver politically motivated housing benefits, we must expect government interference that will cause the SMEs to make non-economic decisions in operating their businesses.
History has demonstrated that government involvement in private markets inevitably results in unintended consequences. In this case, we can foresee problematic ways this situation could develop. Let’s say a recession occurs and the SMEs start realizing unexpected credit losses on the mortgages they have acquired and securitized. Would the government make the private investors whole by allowing increases in the guarantee fee charged to future borrowers? If this happens, private investors would be rewarded for failure and future borrowers would be penalized for losses arising from past borrowers. Alternatively, if the government reneged on its commitment to investors in the SME “utility” to provide a fair return on the mortgages previously acquired, that could throw the secondary mortgage finance market into confusion and disarray. The SMEs would likely reduce their acquisition of mortgages until the rules were clarified. Likewise, private capital would be hesitant to continue to invest in SMEs in light of such uncertainty. Such a reversal on the part of the regulator could create serious damage to a “utility” model. It is quite possible such circumstances would result in yet another bailout of the secondary mortgage finance providers.
Conclusion
The regulated utility model is not a good fit for the secondary mortgage finance market for a variety of reasons. The secondary mortgage finance market is not the type of natural monopoly that would typically require a regulated utility framework and the mortgage finance business, with its inherent volatility, is not well-suited to a regulated utility approach. Implementation of this plan would encounter serious practical challenges. In a utility model, the regulator would need to be able to accurately price in advance the long-term credit risk related to mortgage debt, a task that recent history has shown to be quite difficult. These challenges would be aggravated by inevitable government interference in SME business operations. As long as the government is relying on SMEs to achieve politically motivated social policy objectives, such as affordable housing goals, the SMEs will suffer from the consequences of non-economic decision making driven by government interference. Until these issues are resolved, it could be difficult for the SMEs to attract significant private capital at reasonable rates of return. It does not take much imagination to think of examples of how this dangerous combination of factors implicit in a “utility” model could end up saddling taxpayers with losses in the future.