In Multifamily Finance, Fannie and Freddie Are Still the Elephant in the Room

Willy Walker, who in his role as CEO of Walker & Dunlop leads the company that’s the biggest contributor to Fannie Mae multifamily mortgages and the third-biggest to Freddie Mac’s, knows all too well that conservatorship was never meant to be a permanent solution.

“We have to keep in mind the fact that Fannie Mae and Freddie Mac [were put] into conservatorship to prop up the global economic system,” rather than for reasons inherent to their own operations, Walker said. “The idea that anyone had any vision about what they would be in the future [is false].”

Fannie Mae and Freddie Mac don’t originate their own loans. Instead, they buy them from banks and other lenders, package them for sale in the commercial and residential mortgage-backed securities markets and make an implicit guarantee to investors in the case of defaults. Given how important the agencies’ operations are to multifamily markets, it’s no surprise Walker is frustrated with the lack of progress in reorganizing them.

“All the proposals [to reorganize the GSEs] are way too complicated,” he said, noting that only a few debt markets, such as the trade in U.S. Treasurys, are larger. “You can’t draft legislation that will allow you to get everyone around the table to agree if you are trying to wholly change [one of the] largest bond markets in the world.”

But efforts to cleave Fannie and Freddie from government control have faltered time and again—most recently late last month, when a bipartisan pair of senators, Tennessee’s Bob Corker and Virginia’s Mark Warner, who have worked together for at least five years on plans to reform the agencies, declared that their latest effort was dead for the time being.

Treasury Secretary Steven Mnuchin, for his part, hasn’t detailed his preferences for the shape of a reform of the government’s role in the housing finance market. He has said he will make the issue his priority after congressional elections in November, but his hesitancy to do so earlier likely doesn’t stem from optimism that a reconfigured Congress might be a more productive partner. After all, the FHFA’s conservatorship has persisted under federal governments of every composition—from 2009, when Democrats controlled both houses of Congress as well as the White House, to today, when Republicans have prevailed in each.

(Representatives for the Treasury Department and the FHFA did not respond to inquiries for this story.)

The inertia over what to do with the giant institutions might be less severe if the agencies weren’t so central to U.S. housing markets—or, if the government’s conservatorship had been less lucrative. Combined, the agencies provided about $1 trillion in liquidity to mortgage markets last year, financing millions of apartment units and even more single-family homes along the way. And since taking control of Fannie and Freddie in 2008, the government has earned back the $187 billion it spent bailing out the agencies, plus $80 billion more.

The avenue by which the government has accumulated those returns from its control of the agencies is itself controversial, and has attracted lawsuits from the minority owners of the companies’ common stock who argue they’ve been denied their fair share. The original conservatorship agreement, which coincided with a federal bailout of $187.5 billion, was meant to help the agencies preserve their operating capital, thereby ensuring they would be able to persist in their role of providing housing-market credit guarantees. It took the form of a federal purchase of the GSEs’ senior preferred stock, which would pay taxpayers back with a 10 percent dividend.

But in 2012, the government changed the rules, swapping out the steady trickle of dividends with a net-profit sweep that allowed the Treasury Department simply to appropriate Fannie’s and Freddie’s profits each quarter. At the time, Obama administration officials argued that the move was necessary to salvage the government’s stake in the face of likely future losses. Old memos uncovered by a lawsuit last summer, however, gave the lie to that argument, showing that the Treasury Department officials were internally optimistic, not pessimistic, about the agencies’ future when they implemented the profit sweep.

Whether that reorganization was implemented in good faith or bad, the hefty payouts from net-profit sweep aren’t the only glue that have held the agencies in conservatorship for a decade. Congressional politics have also made compromise an uphill battle. Democrats have been concerned that were the agencies separated from the FHFA, their commitment to lending on affordable housing might waver. Republicans, on the other hand, are concerned that taxpayers would be on the hook for another bailout if another liquidity crisis disrupted housing finance markets again.

Indeed, the persistently ambiguous nature of the government’s commitment to pay off investors in the agencies’ securities is one reason nearly everyone agrees the conservatorship should give way to a more permanent scheme. Spinning the agencies off on their own would almost certainly involve forcing the GSEs to maintain a higher level of capital relative to their market activities, bolstering their ability to withstand a credit crunch.

As a result, advocates for a reorganization have zeroed in on options that they believe the executive branch could pull off singlehandedly—without congressional authorization.

“The FHFA director has wide latitude to change how the GSEs operate,” Mark Zandi, the chief economist at Moody’s Analytics and a leading housing-finance expert, said.

That most radical position—that the agencies should be increasingly hemmed in with a view toward eliminating them entirely—is advocated by researchers motivated, in part, by their view that the GSEs significantly contributed to the 2008 financial crisis in the first place. The most vocal proponents of banishing the government guarantee in the housing markets entirely, a think tank at the American Enterprise Institute (AEI) led by Peter Wallison and Edward Pinto, argue that by extending affordable credit to some marginal housing buyers who’d otherwise be shut out of housing markets, Fannie and Freddie’s role has been to accelerate the cost of low-income housing, contributing to a perpetual seller’s market that leads to constant instability: booms and busts.

Data from the Case-Schiller index of home prices, Pinto said, show that prices for entry-level homes are today rising far faster than either income levels or the prices of higher-tier houses, suggesting to him that Fannie’s and Freddie’s ability to extend guaranteed credit encourages marginal buyers to hunt for entry-level homes when they’d otherwise sit the market out. As a result, the price of the cheapest third of single-family homes rises much faster relative to income levels than more expensive houses, creating the potential for another rapid selloff similar to the one that helped precipitate the 2008 crisis.

The GSE’s “effort to make housing more affordable…actually makes housing more expensive, because you haven’t solved the supply-demand imbalance,” Pinto said. “Now, we’re [more than five years] into a seller’s market, and we’re getting the exact same response from the market” as before the financial crisis, with rising prices for low-tier housing.

The AEI researchers point to indicators they say represent the agencies’ contribution to sliding loan standards. The national mortgage risk index, a statistical indicator of underwriting quality calculated by the think tank, has deteriorated this decade. Cuts in mortgage-insurance premiums failed to attract as many new homebuyers as predicted, and were followed by further housing-price increases, Pinto said, implying that the government’s efforts to goad a buyer’s market were misdirected. In urban markets like New York and Los Angeles, according to AEI, supply is so tight that government-guaranteed leverage can’t help but create frothy prices. Beginning early next year, when Trump will have the chance to appoint a new director of the FHFA after the term of current head Mel Watt expires, the AEI researchers assert that the presidential administration could effectively sideline the agencies even without congressional action.

Zandi is skeptical that that’s a wise way forward.

“You need well-capitalized guarantors,” the economist said, casting doubt on the prospects for a market that excludes any government insurance. “[The industry] will always need a catastrophic backstop.”

And most industry insiders contest the notion that the GSEs do more harm than good.

Walker, for example, disputed the AEI’s notion that underwriting standards have slid, especially in apartment-building lending.

“On the multifamily side, that is a definitive no,” Walker said. “[The agencies] have not changed their underwriting standards since the crisis, period.”

“I think the system is working,” Zandi said. “Mortgages are being made, at low interest rates, to a broad set of households. None of the pipes are broken—all the water is flowing.”

David Brickman, who leads Freddie Mac’s multifamily business, pushed back against the notion that Fannie and Freddie crowd out private capital to the detriment of efficient mortgage markets.

“An important observation about the multifamily market is that it never became just a GSE-dominated space with GSE pricing,” he said. “Despite concerns that are raised, we still lose plenty of business to other private market participants.”

Brickman argued that by providing the same implicit guarantee to top-tier and affordable homes alike, the GSEs effectively subsidize needier borrowers, creating a housing market that works better for buyers who’d be shut out otherwise. And by virtue of offering a federal guarantee, the agencies draw huge sums of mortgage debt through the GSEs’ securitization factories, creating economies-of-scale efficiencies in the lending market that would be unachievable otherwise.

“While small changes in the GSEs’ support for multifamily might not have a significant effect, removing $140 billion in support is likely to significantly reduce stability and liquidity in the multifamily mortgage and property markets,” Brickman said.

But the agency’s purview to have any voice in the shape of its own makeover is slippery, and speaking to Commercial Observer, Brickman had to tread with care. One of the biggest differences characterizing the agencies’ post-crisis incarnations has been the FHFA’s restrictions on their ability to lobby Congress.

“Both Fannie and Freddie were exceedingly active in lobbying,” Walker said. “They did a huge amount of work to help people get elected to Congress.”

Under the FHFA, that kind of activity has largely fallen by the wayside. Shades of that history emerged this month when Bloomberg reported that Fannie Mae’s general counsel, Brian Brooks, had met with Trump administration officials to encourage them to pursue a path toward ending conservatorship on their own—without the need for congressional intervention. That course would contradict the preference of the director of the Federal Housing Finance Agency, Mel Watt, a former congressman who believes legislators should determine the agencies’ future.

In the meantime, enthusiasm has built since last summer for a plan to reform the agencies commissioned by Blackstone and hedge fund Paulson & Co., both of which are frequently listed among the GSEs’ largest shareholders. The plan, drawn up by Moelis & Company in its role as an adviser to the shareholders, calls on Fannie and Freddie to raise up to $180 billion in capital over four years, by retaining earnings and selling shares. Thereafter, the agencies could continue to guarantee 30-year fixed-rate mortgages under the watchful eye of the FHFA, which would set stricter capital standards to reduce the likelihood of another government bailout.

“We’ve proposed an extremely pragmatic plan,” said Landon Parsons, a senior adviser at Moelis who worked on the scheme. “Instead of recreating infrastructure that may or may not work, what we do is maintain the existing infrastructure but recognize [the need for] ongoing government support…Any government support should be explicit and should be paid for.”

The trouble, according to Zandi, is that during the steady economic expansion of the late 2010s, there’s been little impetus to shake up a system that has extended as-yet untested credit to residential borrowers and returned billions of dollars to taxpayers.

“The main sticking point is that the system works,” Zandi said. “You’re not happy with the pipes, but the water’s flowing. Do you really want to change the plumbing?”

Regardless of where the agencies go from here, a survey of multifamily lending players underscored how high the stakes would be for any major reorganization. Shlomi Ronen, the founder of a Los Angeles debt brokerage that often arranges agency financings, Dekel Capital, emphasized that Congress and the FHFA ought to implement any reforms with deliberation, forecasting that changes that aren’t well explained clearly in advance could startle the market.

“Anything that’s done ad hoc or very abruptly is going to create a lot of anxiety,” Ronen said. “That will impact pricing.”

Adverse reverberations, in turn, could be cataclysmic in Ronen’s home state, he explained. Sky-high land prices and zoning restraints already make it difficult enough to make the math work on affordable housing projects. Things could get immeasurably direr, he said, if the sector’s go-to financing source disappeared.

“In California, it’s very tough to find sites to build affordable housing,” Ronen said. “The availability of financing makes possible what would otherwise be totally impossible.”

Closer to commercial real estate finance’s center of gravity in New York City, on the other hand, the agencies play less of an all-encompassing role. Michael Gerstein, a managing partner at New York-area multifamily manager Global One Investments, said his firm has occasionally accessed Fannie Mae financing, but private capital from banks has been uber-competitive in his firm’s geographical aegis.

“I think we got involved with Fannie Mae for a small amount of time,” Gerstein recalled. “But when the market took a dive in 2009, [Fannie] also took a hit. We’ve developed relationships with some banks [instead]; that’s just where it took us.”

For many other major apartment building owners, however, the agencies remain indispensable. Jason Morgan, an executive who leads acquisitions for Morgan Properties, an owner of multifamily properties based in King of Prussia, Pa., said that agency-guaranteed mortgages are his firm’s go-to financing source.

“Most of our portfolio is financed through the agencies,” Morgan said. “They’re more innovative than other multifamily lenders. They have a huge commitment to the multifamily industry.”

Their absence would open up a gaping vacuum, especially in affordable housing, according to Morgan.

“There’s a huge affordability problem, and Fannie and Freddie do a great job of providing [liquidity],” Morgan said. But even for the behemoth institutions bestowed with the power to grant a government guarantee on mortgages, creating enough affordable dwellings for Americans to call home will remain a challenge, the acquisitions executive said. “Unfortunately, the problem is only going to continue.”