Will GSE Reform Proposal Be a Tough Sell for Investors?

On Tuesday, a new version of a white paper authored by several noted housing policy experts for the Urban Institute titled "A More Promising Road to GSE Reform: Governance and Capital" expanded on the capital and governance issues raised by the authors' original proposal in March to replace the GSEs with a corporation, the National Mortgage Reinsurance Corporation (NMRC).

The NMRC would essentially perform the same functions as the GSEs with the main difference being the NMRC would transfer all non-catastrophic debt risk on the securities it issues to a broad range of private entities.

The authors of the paper, one of which, Gene Sperling, was hired last month as Democratic presidential nominee Hillary Clinton’s top economic adviser, have estimated that private investors will have to put up an estimated $125 billion to capitalize the NRMC—the equivalent of about 2.5 percent of the mortgages the company guarantees, assuming it would guarantee about $5 trillion worth of mortgages.

Urban Institute senior fellow Jim Parrott, another of the white paper's authors who has advised Clinton on housing policy, told DS News that “We don’t think the current system is so flawed as to warrant that radical an overhaul,” and that “We’re really trying to change only what really needs it, maintaining the rest. In our view that means taking the infrastructure that lenders and borrowers have come to rely on over the years and putting it onto a firmer foundation, so that it no longer rests on a Too Big to Fail duopoly.”

Will investors be reluctant to put money into the venture, given the fact that the government is keeping all of Fannie Mae’s and Freddie Mac’s profits and has been since August 2012? At that time, the bailout agreement was amended to require all GSE profits to be swept into Treasury quarterly instead of 10 percent yearly as was the original agreement.

The sweeping of GSE profits into Treasury, or the Net Worth Sweep as it has been termed, has prompted nearly two dozen lawsuits from GSE investors who claim the sweep is illegal. Some of those suits are still pending.

Two of those lawsuits were filed by one of the GSEs’ largest shareholders, New York-based hedge fund Pershing Square Capital Management, in 2014. Pershing Square CEO Bill Ackman indicated that he believes it may be difficult for the NMRC to convince private investors to put up money. According to Bloomberg, Ackman said last year, “If the government’s allowed to take 100 percent of the profits forever, no one’s going to put a dollar of capital in a rescue situation and it’s going to cause people to really question whether they’re willing to put a dollar of capital into any financial institution.”

The paper co-authored by Parrott and Sperling (along with Lewis Ranieri, Mark Zandi, and Barry Zigas),  lists a number of possibilities to make NMRC shares more attractive to investors:

• Creating a mandate for the NMRC to “manag[e] the company in a fashion that does not expose either taxpayers or fixed-dividend security holders to undue risk.” So looking after their interests is embedded in their charter.
• Giving investors representation on the board to help inform the company’s day-to-day decision-making.
• "To ensure investors in fixed-dividend securities that the NMRC is committed to prudent underwriting practices, the U.S. Treasury will purchase some portion of the NMRC’s initial issuance of these securities…. Future issuance of fixed-dividend securities would be sold to private sources of capital who would be pari passu with the Treasury on a claim basis.” In other words, the authors said, the investors and Treasury will be in it together.

Mark Zandi, Chief Economist with Moody's Analytics and another of the paper's co-authors, does not think the NMRC will have trouble attracting investors. Zandi stated, “The system will ultimately need $270 billion in capital, of which $160 billion will come from risk transfers and $110 billion from fixed dividend securities. Of course, this will be built up over time as the NMRC gets to scale.  In any given year, the NRMC will require between $25 and $30 billion in capital. Investor demand for risk transfers has been strong to date, and I think investor demand for the fixed dividend securities will also be strong. Investors will be attracted by the fact that NMRC is a permanent entity that will always need to raise capital, and be profitable enough to pay investors to continue to attract them. Investors in the fixed dividend securities will also be attracted since they will be parri passu with the U.S. Treasury’s investment in the securities.”

While Clinton has not spoken out directly on GSE reform, the hiring of Sperling as her top economic adviser indicates that she likely shares his views on housing policy. Sperling previously served as Director of the National Economic Council under Clinton’s husband and Obama and also served as Counselor to former Treasury Secretary Timothy Geithner.