Deep Dive Episode 36 – What Should the FHFA's 2019 Agenda Be?

[Music and Narration]

 

Operator:  This is Free Lunch, the podcast of The Federalist Society's Regulatory Transparency Project. All expressions of opinion on this podcast are those of the speakers. 

 

Devon Westhill:  Good afternoon, and welcome to the 35th episode of The Federalist Society Free Lunch Podcast for the Regulatory Transparency Project. Join our conversation about where government regulation might be improved by visiting the RTP website at regproject.org, R-E-GProject.org. You can find RTP Facebook, Twitter, and LinkedIn, as well as subscribing to our biweekly newsletter at our website. My name is Devon Westhill. I'm the Director of the RTP and the host of the Free Lunch Podcast.

 

In this episode, we'll discuss what the Federal Housing Finance Agency's agenda should be in the new year as Acting Director Joseph Otting takes office, and as the nomination of Mark Calabria to be the next director progresses. Our examination today will cover questions such as what are the key issues and projects for the FHFA going forward, what can and what should it do to lead reform of Fannie Mae and Freddie Mac, and what authority does the agency have to unilaterally enact potential agenda items?

 

I'm very pleased to announce that we have two distinguished guests joining us today to discuss these issues. Alex Pollock, Distinguished Senior Fellow at the R Street institute, will interview Ed DeMarco, President of the Housing Policy Council. Before joining the R Street Institute, Alex was a Resident Fellow at the American Enterprise Institute from 2004 to 2015, and President and Chief Executive Officer of the Federal Home Loan Bank of Chicago from 1991 to 2004. He's the author of Boom and Bust, and more recently, Finance and Philosophy, as well as numerous articles. Alex's work focuses on financial policy issues, financial cycles, risk and uncertainty, housing finance and banking systems, and the interactions of these issues with politics. Alex is the Director of CME Group, Ascendium Education Group, and the Great Books Foundation, and a past president of International Union for Housing Finance. He's a graduate of Williams College, University of Chicago, and Princeton.

 

Prior to heading to Housing Policy Council, Ed was a Senior Fellow in Residence at the Milken Institute’s Center for Financial Markets. From 2009 to 2014, Ed was acting director of the FHFA, where he served as the Conservator for Fannie and Freddie and Regulator of those companies and the Federal Home Loan Banks. He was named HousingWire Magazine’s Person of the Year in 2012 for his impact on housing finance. Ed was Chief Operating Officer and Senior Deputy Director of the FHFA and its predecessor agency from 2006 to 2009. Ed earned his B.A. in Economics from the University of Notre Dame and a Ph.D. in Economics from the University of Maryland.

 

In just a minute, I'm going to turn the floor over to Alex, who, as I mentioned, will be interviewing Ed. Before I do, I want to remind everyone that The Federalist Society takes no position on particular legal or public policy initiatives, and therefore, all expressions of opinion on Free Lunch Podcast are those of our featured speakers. Also, as usual, our speakers are going to take questions after their remarks, so please be prepared with any questions you might have prior to the start of our Q&A period.

 

Okay, Alex and Ed, thanks a lot. I really appreciate you guys joining us today for our Free Lunch Podcast. Alex, I'm going to go ahead and give you the mic at this time.

 

Alex Pollock:  Thanks, Devon. And many thanks to The Federalist Society for hosting this most timely and important discussion. It's a real pleasure, in particular, to be here with Ed DeMarco. Nobody has a better understanding of the Federal Housing Finance Agency and its housing finance domain than he does.

 

As a reminder, the Federal Housing Finance Agency came out of an act of Congress in 2008 as the housing finance crisis was upon us. People had tried for years to get control of Fannie and Freddie through regulation. It was -- it turned out to be too late, and very soon, the FHFA found itself conservator of the failed Fannie and Freddie, which it remains to this day. In particular, the director of the FHFA is the conservator. It's important to remember that this is an agency which has a director, not a board, so it's a powerful individual position. The director has a five-year term, so it can span administrations, as the most recent director, Mel Watt's term did, which just ended on January 6th. So a new acting director, Mr. Otting, is coming in, as Devon said, and we have Mark Calabria nominated, so the Trump administration will now have its own leadership in this agency.

 

A final note is that when the FHFA was created, it combined regulation of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. And with that, we'll get to Ed's views on all this. And Ed, starting at the highest level, what do you think the biggest issues facing the FHFA in 2019 are under its new leadership?

 

Ed DeMarco:  Yeah, well, thank you, Alex. And hello, everybody. It's a pleasure to be here. So with a change in leadership at FHFA -- and frankly, we're probably looking at two changes in leadership, one with Controller Otting as the acting director now and then, presumably and hopefully, Mark Calabria to be confirmed by the Senate in short order to be the permanent director. When you come into any federal agency, but particularly one like this with this authority not just as regulator but also as conservator, seems to me as though that first year has three broad sort of categories of priorities and focus for a new director.

 

The first, obviously, is just administrative and management. You need to get a handle on the agency and the companies you regulate. You need to get to know people, find out what the status of things are administratively within FHFA, but also, not just as regulator, but as conservator of Fannie and Freddie, to get to know the companies, their senior management, and get some control over the firm. It's a different thing at FHFA. You're not just the regulator, but as conservator, you stand in the shoes of the board and management. So even though there are boards and there is management, ultimately, the conservator's responsible. And so getting some sense of that and how one wants to manage and exercise that responsibility is itself a learning process.

 

Second area is you are still very much a safety and soundness regulator, and so understanding and assessing and drawing your own conclusions about risks, and risk management, and where that all stands is clearly going to be a top priority for someone coming in as the new head of this agency. You have to understand the individual and idiosyncratic risks of the entities you regulate, not just Fannie and Freddie, but also the 11 home loan banks. You've got to understand and learn and get comfortable with the risk and risk management processes and the supervision process at FHFA, and also got to think about the system and the systemic risk, because I'm sure we'll come back to it, Alex, but there's plenty of systemic risk in this structure.

 

And then finally, there's what does one convey, not just to your regulated entities, but to Congress, the administration, and the public about sort of the direction and purpose you intend to have as regulator and conservator at FHFA? It's very interesting. We think about Director Watt having just stepped down. A few months after he took over, he gave a major speech in which he said, "Look, we're going to have a change in focus from the prior regime. We are going to focus on managing the present. We're not going to be focused on future legislation or future state. We're just going to focus on where we are today." And I would anticipate that a new FHFA director needs to give some kind of articulation to the public about what to expect in terms of how that director views their role and where they want to take this responsibility as conservator. So that's a lot right there to undertake, and manage, and get working on in the first year. And I haven't even gotten into any detail stuff, but I think that's a good starting point, a point of departure for a new director.

 

Alex Pollock:  A good start, indeed, Ed. And you touched on this, but let's be a little specific about it. How much authority does the director of the FHFA have on his own, especially including the powers as conservator of Fannie and Freddie? And what can or could the director and conservator do without any action of Congress?

 

Ed DeMarco:  Right. So as I said, the conservator -- the statutory authority of the conservator is to stand in the shoes of management and the board of directors. So ultimately, the conservator's responsible for the management and direction of these companies, which is far greater responsibility, or different responsibility, I should say, than being a safety and soundness regulator. And so by being conservator, even though there's a CEO at each company and there's a board of directors, that CEO and that board reports to the conservator. All major decisions and direction are the responsibility of that conservator. So that's one thing, just in terms of the operation of companies with $2-3 trillion worth of securities outstanding. That is a big responsibility right there.

 

Alex Pollock:  Each. That's $2-3 trillion each.

 

Ed DeMarco:  Yeah. Thank you, Alex. And then – but it goes beyond that, right? The authority is not just to exercise it as the conservator, but as conservator, you're responsible for the conserving and preserving of the assets of the company, but you also have a broader responsibility and the statutory language gives the conservator a broad expanse in terms of what is in the interest of the conservator. And that conservator gets to decide a lot of things in terms of what they think serves the interest of the conservator and advances the overall interests and public purposes that Congress has given not just Fannie and Freddie, but has given FHFA.

 

Alex Pollock:  Thinking about all that, how forward-leaning do you think the director of the FHFA should be about moving toward a bigger and broader reform of the housing finance system?

 

Ed DeMarco:  My personal view is that the FHFA director should view themselves as a partner working with the administration and with Congress in discussing, analyzing, contributing sound analytics and data to the reform process. And I think that there's certainly within the authorities that I describe for the FHFA director, there's certainly an opportunity for an FHFA director to say, "I am going to undertake my responsibilities and create a forward path that assists and facilitates the development of the future of the housing finance system." And so should they go in that direction? I believe that's what Mark Calabria is certainly well situated to able to do is to say, "Look, there's been a lot of progress."

 

Let me frame it this way. There's been a lot of progress legislatively in narrowing the scope of potential outcomes in housing finance reform legislation. So within that sort of defined range of outcomes, there's a number of, I would call it administrative preparation that FHFA can do to help move the conservatorships and the market down the road that makes legislating easier and also makes the transition process, once we have legislation from the GSE/conservatorship state to the future state, it makes that transition easier, less risky, and will not take as much time. So I think that there's a lot of constructive work the FHFA director can do that supports and facilitates the development of a post-conservatorship secondary mortgage market.

 

Alex Pollock:   And we should add, remind everybody while we're at it, that the U.S. residential mortgage market in general, the whole market, is the biggest credit market in the world, except for sovereign debt. So it's certainly something we all need to be thinking about. You mentioned the Congress. It seems really easy to imagine, yet again, that nothing will come out of the Congress, especially with divided partisan control of House and Senate. People have been saying for years, Ed, that Fannie and Freddie conservatorship just can't go on. We can't have the status quo forever. But could the status quo simply persist, and if it did, what would be wrong with that?

 

Ed DeMarco:  Well, since it's persisted for over 10 years, it certainly can continue to persist. But folks need to understand how has it been successful in being able to do that? How can two companies that essentially failed in 2008 still be operating? Well, they're operating because the American taxpayer is continuing to stand behind them and provide the capital backing, the credit risk guarantees these companies make each day. So there remains a considerable amount of taxpayer exposure that allows these companies to operate, and that more direct management of the companies that the conservator does all contributes to why these things have been able to function for 10 years in conservatorship. But it is not without risk, and it is not likely something that certainly something that should on forever. And the interesting thing about it is that there's broad consensus about wanting to step the government, the taxpayer involvement in this market, back. But we just haven't been able to make more progress on it.

 

      The other part of your question, Alex, I think is important to understand is that the risk characteristic of conservatorship has not been static. And in fact, over the last several years, and the housing policy council has been making this argument and making this point, is that in fact, while it looks like this is all operating really well, the systemic risk in this system has actually been growing. And I think that that's something we should all be very concerned about because the creation of the conservatorships themselves in 2008 was a result of the systemic risk in the GSE model.

 

But if you look at what's happened over the last several years, in particular in conservatorship, is we're actually concentrating more and more activity, risk assessment, risk management, more and more of this market is done based on the business decisions of Fannie and Freddie operating in conservatorships. So the systemic risk has actually been growing, and I think both in terms of thinking about the soundness of our financial markets as well as taxpayer exposures, that's something for us to be very concerned about. And it's a key reason why we need to keep the focus on driving towards an ultimate legislative outcome.

 

Alex Pollock:  You know, I very much agree with that. But we'll see if anything happens or [if] our status quo keeps persisting, even though it shouldn't. Thinking of the systemic risk which you just brought up, something very interesting in the history of Fannie and Freddie is that their failure came from credit risk, but nobody predicted that credit risk would be their weak spot. People agonized for at least a decade over interest rate risk, and then credit risk came in from the blind side. And one of the things you worked on in your time at the FHFA was credit risk, in particular, and the risk transfer transactions where one gets a mortgage credit risk out of Fannie and Freddie and into the hands of private investors. And there've been a goodly number of these transactions. Is this a fundamental strategy you think should continue? And so far, what would you say are the successes or the shortcomings of the credit risk transfer efforts to date?

 

Ed DeMarco:  Sure. So I think absolutely it's something that should continue. I would say the biggest success has been simply the demonstration that there is ample private capital out there that is willing to undertake the management and oversight of mortgage credit risk. The downside of kind of where we are at the moment with it is that still so much of the intermediation of it, the pricing of it, the structuring of it is all controlled by Fannie and Freddie. It's not truly evolved into a full and open market yet, but important steps have been made. Alex, if I may, it might be good for me to sort of step back and explain this a little bit to those that don't follow it all the time.

 

Alex Pollock:  I think that would be a great idea.

 

Ed DeMarco:  Yeah. So I think it's sort of readily understood that in any given mortgage loan, there's two basic kinds of risks. There's the credit risk, the risk that the borrower doesn't make their payment, and then there's the interest rate risk, or market risk. That is, particularly with a 30-year, fixed-rate mortgage, that you've got this long-term fixed interest rate on an earning asset, and yet, the market interest rates move all around. And that's what you were talking about in your question with interest rate risk. Who bears that? And if interest rates start to go way up, and your funding costs go up, but you're still only earning 4 percent on that mortgage, that's a problem. That was the definition of the savings and loan crisis in the '80s. Or, vice versa, interest rates go down, everybody refinances, and you had put on a bunch of liability to match a long-term asset, and suddenly the asset disappears because of refinancing.

 

The interesting thing about interest rate risk is that in the securitization structure, as long as Fannie and Freddie are not holding their own MBS, that interest rate risk is being held by private capital. It's being sold into the market, and that risk is being managed by private capital. Fannie and Freddie are the ones -- traditionally, they retained all of the credit risk themselves. They made a guarantee to the investors, as a borrower defaulted, that Fannie and Freddie would make good on repaying the principle. And so they concentrated all that credit risk on their balance sheets. That was a systemic risk, and that, as you noted, led to the failure. So what the credit risk transfer activity of the last five or six years has been is FHFA, as conservator, directed Fannie and Freddie to start selling off some of this risk.

 

Or to put it another way, to risk share with private capital this loss exposure. So that has been getting done since 2013 as that market's continued to develop. I think it's very important for the new FHFA director to come in and ensure the continued development of that because fundamentally, what housing finance reform is about is it's about creating a truly private, competitive market in mortgage credit risk. We're creating a set of mortgage credit assets for the market to be able to acquire, and trade, and hold. So credit risk transfer is a very important development in helping to create that market, and I certainly look forward to the new FHFA director wanting to continue to move things in that direction. It both helps build the market and it helps to de-risk the taxpayer.

 

Alex Pollock:  And as we look forward in a longer run, if you were thinking of an optimal state, what do you think the pattern of mortgage credit risk bearing should look like in some long run future? Where would it reside?

 

Ed DeMarco:  Yeah, so interesting. You noted earlier, Alex, that in between Fannie and Freddie, we're talking about $5 trillion in mortgage security. So that means there's $5 trillion in mortgage principle or mortgage credit risk out there to be managed. Even in this town, $5 trillion is a lot of money. And so the answer to your question is that there shouldn't be one answer. I think that if one is going to attract private capital to invest in manage support, $5 trillion worth of mortgage credit risk, we need to have multiple channels. We need to have multiple ways in which this gets done. We need to have multiple types of investors participating in this. So think about mortgage REITs, institutional money managers, anyone that's interested in a credit related asset; certainly, banks themselves, commercial banks and savings institutions putting their own capital at risk; mortgage insurance companies, reinsurance companies. We need all of these sources of private capital so that we've got multiple different perspectives and multiple eyes on this so that we have multiple channels. What that does is it helps to spread the risk --

 

Alex Pollock:  And that creates pricing. That's a market pricing you're implying. Excuse me.

 

Ed DeMarco:  No. Exactly right. It's all about creating that market. Yep.

 

Alex Pollock:  And all of that would be a very different view indeed from the former theory, I'll say the old-fashioned GSE theory, which was the thing to do was concentrate all the mortgage credit risk in the country on the banks of the Potomac, as they used to say.

 

Ed DeMarco:  Exactly. Exactly.

 

Alex Pollock:  It seems to me this is a hugely important area, just as you say. Let me --

 

Ed DeMarco:  -- Right. Alex, I just want to add one other thing about that. So some folks had a sense that since Fannie and Freddie were holding all this, they were holding mortgage credit risk across the entire country, and so they had a natural diversification. Real estate was thought, well, it's a local thing, so if a local area or a region has a problem, it doesn't matter. There really is no credit risk because you're nationally diversified. And in some of the recessions we saw, like in the 1990s, they tended to be more regional—the oil patch, New England, California. But then in 2008, we were reminded, hey, this can happen nationwide, and that diversification didn't matter when you had a nationwide problem.

 

Alex Pollock:  That's for sure. Let me switch to a particular element which will be of interest to people, I think, and that is one of the key elements in all of the Fannie and Freddie debates is the famous, or notorious, depending on your point of view, Third Amendment to the Senior Preferred Stock Purchase Agreements, the origin of the so-called profit sweep where Fannie and Freddie's profits all go as a dividend to the Treasury. Presumably, the new FHFA director as conservator and the Treasury could agree to change that agreement. Should they, and what are your thoughts on that, on the future of the Third Amendment?

 

Ed DeMarco:  Right. Well, you listeners should know that I signed the Third Amendment, so …

 

Alex Pollock:  [Laughter] I should have mentioned that.

 

Ed Demarco:  That's probably an appropriate disclosure. It was signed in 2012 between FHFA and the Treasury Department. What we are amending, what we were amending, what this is referencing is the capital support agreement the Treasury put in place with FHFA at the time the conservatorships were created. So this is the vehicle by which that taxpayer capital I described earlier is actually made available to Fannie and Freddie, and it's the vehicle that the investors in Fannie and Freddie MBS rely upon today when they purchase those mortgage-backed securities. That's the source of capital, backing those MBS.

 

So the Third Amendment is the third time that that original agreement was amended. The original agreement had certain terms for a fixed dividend, and it also had terms for a commitment fee to be paid to the Treasury to compensate it for the agreement and so forth, for the value of the agreement. The Third Amendment made some changes in the structuring of that to say, "Well, we were going to replace the sort of fixed dividend payment," which had at times resulted in Fannie and Freddie borrowing from Treasury in order to pay Treasury back. It replaced that with what is referred to as the net income sweep where the earnings of the companies are simply paid as dividend to the Treasury as compensation for the capital support being provided by Treasury.

 

It actually was -- there was an adjustment made by Director Watt and the Treasury Department to allow for some modest amount of capital retention by Fannie and Freddie that was done a year or two ago, but --

 

Alex Pollock:  It still rounds to zero.

 

Ed DeMarco:  Well, it still rounds to zero when you're talking about $5 trillion dollars of credit guarantee.

 

Alex Pollock:  Yeah.

 

Ed DeMarco:  So look, Alex, I think that other things that we've talked about are far more the priority for FHFA than worrying about the structure of that Third Amendment. I think getting a handle on the GSEs and helping to work towards the development of an infrastructure that is resilient to be able to bring these conservatorships to an end is really where the priority ought to be.

 

Alex Pollock:  So in short, in principle, there certainly could be a Fourth Amendment, but you'd recommend that we not have one. Is that right?

 

Ed DeMarco:  I'm not advocating for any change.

 

Alex Pollock:  Yeah. Yeah. Let's think about another important element in the housing finance domain which we haven't talked about and isn't under the direct regulation of the FHFA, but it certainly affects housing finance, and that's the Federal Housing Administration and what it does. How do you think the FHFA should take into account whatever is happening with the FHA in terms of developments and systemic risk in housing finance?

 

Ed DeMarco:  Right. So, the FHA is a government mortgage insurance program, so it competes with the private mortgage insurers that are out there. Loans that have private mortgage insurance are typically securitized through Fannie Mae and Freddie Mac. Loans with FHA government-backed mortgage insurance are securitized through Ginnie Mae. FHA obviously is created with a public mission. Fannie and Freddie have a public mission. Having some sense of where those traditional segments of the market cross over, I think, is something an FHFA director should be well aware of. Certainly, in thinking about the guarantee fee pricing and about underwriting standards to be aware of where FHA is is something to pay attention to because the tight-, for among other things, tightening or wherever the FHFA sets certain limits is going to expand or contract the market segment served by FHA.

 

But I would take it a step further, Alex. I think this is more than -- while it certainly ought to be on the radar of the FHFA director, it actually also ought to be very much on the radar of Congress and the administration to be thinking about how taxpayer backing of the mortgage market is -- where it is, and how it is expressed, and how much subsidy is there, and how much distortion or tilting of the market results from each of these various programs is something that I think our lawmakers and policymakers ought to be attentive to and make sure that this, we'll call it an adjustment of the market from what a pure market system would produce, is something that lawmakers and policymakers really ought to me mindful of.

 

Alex Pollock:  I couldn't agree more. We mentioned that the FHFA is not only the regulator and conservator of Fannie and Freddie, but it's also the regulator of the Federal Home Loan Banks, and the home loan banks themselves are a sizeable thing with combined assets of over $1 trillion dollars and active all over the country in housing finance. What are your thoughts on issues relative to the home loan banks that the FHFA might be thinking about in 2019 under new leadership?

 

Ed DeMarco:  All right. So I think that there's several. First, of course, is getting an assessment, the risk assessment of the traditional advances business of the home loan banks. But beyond that, there are two important issues there for the new director to consider. The first is there's been, at this point, long running debate about membership eligibility in the Federal Home Loan Bank system, and in particular, whether the FHFA should allow what are called captive insurance companies to be members, or frankly, broadening into other types of entrance. So that's one.

 

And then the second is what can the FHFA contribute, even as technical expertise, to the administration and Congress; considering housing finance reform, to think about what is the role of the Federal Home Loan Bank system as a source of liquidity and as a channel for housing finance in a post-conservatorship system? So those are two areas really warranting attention by FHFA. If you like, I could go through the membership one a little bit more because it creates an interesting -- I think it's an interesting dilemma, if you will, of how to think about the statutory requirements.

 

Alex Pollock:  If you go way back in the role, in the history of home loan banks, you find a lot of people who thought that only savings and loans should ever be members and participants of the home loan banks. We've come a long way since then.

 

Ed DeMarco:  Yes. If we go back to -- we have. I mean, banks were not members until -- that's a relatively recent development. But insurance companies -- so this is where this captive insurance issue arises. As you well know, Alex, insurance companies have been eligible for home loan bank membership since the creation of the system in 1932. The reason was because in 1932, insurance companies, particularly life insurance companies, were major holders of mortgages. And so to give them a way to create some liquidity with their mortgage assets was part of what was being done there.

 

But now, today, we see this question about well, any entity can create a captive insurance company. And if I create a captive insurance company, well, is it an insurance company and should I get access to the home loan bank system as a result of having this captive? Well, here's the interesting question. Yes, insurance companies are eligible for membership, but no, in the sense that Congress created the home loan banks and gave it a narrowed and specific membership class because it wanted to keep them as cooperative, focused on entities engaged in housing finance. And so that's not necessarily the case if you have any captive insurance company come in. So this is a regulatory issue that the new director will have to wrestle with, and I think, ultimately, it becomes an issue for the Congress to wrestle with as well.

 

Alex Pollock:  And while we're thinking about that issue, should they have bigger thoughts about potential expansions of home loan banks, or should they be constrained to their historical roles?

 

Ed DeMarco:  Well, I think that the home loan banks seem to be doing pretty well with their historical roles as liquidity providers, and that seems an ample role for them. But they also, for over 20 years with work that you started, have also become a conduit to the securitization market that is relied upon by community banks and creates a potential -- well, not just potential any more, but an actual alternative channel to Fannie and Freddie directly and to Ginnie Mae. The home loan banks are Ginnie Mae issuers, and they also aggregate and securitize mortgages on behalf of their members through Fannie Mae. And when you look at some of the legislative proposals like the Hensarling-Delaney bill that was just introduced this fall, several proposals have specific authorization for the home loan banks to continue to develop in this way as a channel for securitizing mortgages.

 

Alex Pollock:  Thank you, Ed, for remembering my role in that. You and I used to have some really good discussions in our respective former roles in those days. I think we've covered --

 

Ed DeMarco:  Back in the day we both had a lot more -- yeah, go ahead, Alex. Yeah.

 

Alex Pollock:  [Laughter] Perhaps more hair, as I think you were going to say, but not less wisdom. But not more wisdom, sorry. We've covered a lot of ground in all this. Are there any concluding thoughts you have to wrap this up that you'd like to -- points you want to emphasize?

 

Ed DeMarco:  Just that I would say two things. One, certainly I believe, housing policy council believes, I think the industry believes that we -- housing finance reform remains an important priority. This needs to get done. There is too much risk rebuilding in this system we've got. And two, I'm looking forward to the new leadership at FHFA, and hopefully, I believe that that new leadership will come in and want to help contribute to Congress getting that job done.

 

Alex Pollock:  Thank you very much, Ed. And Devon, I think we're ready for questions from the participants.

 

Devon Westhill:  Well, fantastic. I also thank Ed, and I thank you also, Alex. It was a fantastic interview. But as we mentioned in the beginning, as Alex just said, we're going to go to audience questions now. In a moment, everyone on the call is going to hear a prompt indicating that the floor mode has been turned on. After that, to request the floor, enter star and then pound on your telephone keypad. I'm going to open the floor now.

 

Okay. The floor request mode is on. So when we get to your request, you'll hear a prompt. Please, please, thereafter, state your name and affiliation, and then ask your question. We'll answer questions in the order in which they're received. Again, to ask a question, what you need to do is enter star and then pound on your telephone keypad. We'll go ahead and get to the first question now.

 

Bob Davis:  Hello, this is Bob Davis. I'm at the American Bankers Association. I'd like to ask Ed for his thoughts on the recent FHFA proposal to establish capital rules for the enterprises while they're in conservatorship.

 

Ed DeMarco:  Thanks, Bob. Yeah, so for the audience, the FHFA put out an interesting notice of proposed rulemaking this summer proposing to establish capital standards for Fannie Mae and Freddie Mac. Well, you might think, well, don't they have that? Well, essentially, since they went into conservatorship six weeks after FHFA was created, they went into conservatorship, they ran out of capital, and so the capital has been provided by taxpayers. They've not been operating with a regulatory capital requirement per se, except what was inherited from the prior regime. So FHFA put out this rule to say, well, okay, once they come out of conservatorship, assuming they come out of conservatorship as the GSEs that they were 10 years ago, what would we say should be the regulatory capital framework? So HPC commented on that.

 

I think this is something for the new FHFA director to have to really look at and decide where they want to go with this. But I think they key point I'd like to make about that capital proposal is that it perpetuated a condition that we had pre-conservatorship. And that condition pre-conservatorship is that Fannie and Freddie operated with regulatory capital requirements on their mortgage exposure that was substantially materially less than other regulated financial institutions, certainly banks and savings and loans. And so when you have a dramatic imbalance in regulatory capital requirements, one would expect that the risk and the business activity itself is going to migrate to where the capital is lowest. And so we think it's really important, not just in terms of this rule, but in terms of how the FHFA director thinks about an implied capital allocation and cost of capital allocation to Fannie and Freddie today to think about capital measures that are comparable to what the market would actually require and what the regulatory standard is for other regulated financial institutions.

 

And certainly, we see Fannie and Freddie demonstrably being hugely systemically important and being, let's call them SIFIs, a systemically important financial institution. Every other SIFI out there has a substantial capital requirement, even more than non-SIFIs. One has to wonder why Fannie and Freddie are not held to a comparable standard.

 

Alex Pollock:  Ed, I think, if I could jump in there, I think that is a great point. And thanks for the great question, Bob. One of the biggest failures of the previous regime, as you point out, Ed, was that it allowed Fannie and Freddie to run on a super leveraged basis and allow everybody else to arbitrage a capital regime and put risk into the government. And that's presumably one of the key things that needs to be fixed, just as you say.

 

Devon Westhill:  Thank you for that question.

 

Alex Pollock:  We can go to the next question, Devon.

 

Devon Westhill:  Yeah, sure. And thank you, Alex. And if I saw another question, we would certainly go to that, Alex. But we presently only have the question from Bob, so I'll make another request for any questions that the audience might have. And then if I don't see anything, I'll toss it to you, Alex, in case you have any questions.

 

Alex Pollock:  Okay.

 

Devon Westhill:  Or else we'll end early. So again, I want to let everyone know that if you'd like to ask a question, just hit star and then pound on your telephone keypad. We'll get to you. I see someone who wants to get their question in before the end, so we'll go to that person now. Please remember to state your name and your affiliation.

 

Wayne Abernathy:  Hello, this is Wayne Abernathy. Really appreciate this excellent discussion, Ed and Alex, very important as well as very informative. I want to get back to this conservatorship point that you began with. And I think is very interesting, and I think it's important for people to understand. So the director of FHA, currently, he stands in the position as conservator for the two GSEs, for Fannie and Freddie. And in that conservatorship responsibility, his responsibility is to preserve value at the companies. As I understand, that's the role of a conservator. But he is also an FHA director, where I believe he has responsibility to protect the taxpayer. And I think, Ed, as you pointed out, that as time has gone by in the 10 years since the conservatorship has gone into effect, there's been an increase in risk and concentration of risk at the GSEs. Which of those two responsibilities of the FHFA director predominates, being the conservator to preserve value at the companies or to protect the taxpayer from losses?

 

Ed DeMarco:  Wayne, I think that there's a path for the conservator not to find those things in conflict. I mean, I, frankly, when I was running it, I did not find that to be a point of conflict. It was saying, "Look, I've got things that I've got to optimize, and these things ought to actually be working together. I protect taxpayers by making sure that the companies are operating in a prudential manner so that we are imputing an appropriate amount of capital, a cost of capital, so that the guarantee fee the insurance company we charge on the mortgage guarantees is appropriate." We raised the g-fees several times while I was acting director, and that was all to not just to protect taxpayers, but also to run that as a prudent business model.

 

But the conservator -- it's an interesting set of responsibilities in the statute. It's to preserve and conserve the companies, but it also gives the FHFA director latitude in understanding what that means and how it gets achieved. And so I think protecting taxpayers is -- in this sense, it's like saying, well, I'm there to protect shareholders. The taxpayers are the shareholders, and so I think that the conservator should be able to accomplish both of those, not as viewing them in conflict, but as viewing them as working together.

 

Wayne Abernathy:  Thank you. I appreciate that and appreciate the items you're pointing at as some of the things that the director can do. And again, excellent discussion, very much appreciate you being here on the call today.

 

Devon Westhill:  Wonderful. Thanks, Wayne. Thanks, Ed. Seeing no other questions and getting pretty close to the end of our time here, I know, Ed, you're going to have to leave. You've got a hard stop here pretty soon. I want to toss it back to you, Alex, to allow you to ask any final questions or perhaps give you and Ed an opportunity to say any final words to our audience.

 

Alex Pollock:  My final word, before I give Ed the final final word, is that I had an old boss whose saying was, "Don't get tired." And when it comes to housing finance reform, we have to not get tired. Or else, as discussed previously, the status quo with its, as I think Ed rightly said, serious systemic risk issues will, indeed, keep on going and we'll have Fannie and Freddie basically as government mortgage banks operating in ways that suck the risk into the government. Of course, it's part of that. Don't get tired. As we talked about, it's really important to keep working on this risk transfer to try to distribute the credit risk of this huge mortgage market around among many private participants, including, as I always like to say, those who originate the mortgages and who are in a position to be best aligned in their incentives with sound credit. But Ed, let's give you the final final word.

 

Ed DeMarco:  All right. Well, thank you, Alex. I certainly agree with all that. And I think as my final word, there's one area that, as I think back on this conversation, that we've not touched on. So let me touch on it as the wrap up. And that is to get legislation done, one needs not just to deal with these market structure and prudential regulation type issues, but one also needs to deal with some critical public policy questions about housing, housing finance, and the government's role in housing and housing policy. And for us to ultimately be successful in achieving housing finance reform legislation, we're also going to need to give some careful thought and consideration to housing policy; in particular, what generally goes under the banner of affordable housing.

 

But I hope in that construct that not only do we take those questions seriously, but that we try to bring some fresh ideas and thinking to it, because we should not approach affordable housing or promoting the opportunity for home ownership to be code for how can we bend the underwriting or subsidizing the cost to credit to get people into mortgages that they may not be able to afford. But in fact, how can we constructively use the power of markets and the opportunity of home ownership to create a more sustainable mortgage lending opportunity for folks that want to become home owners and want to avail themselves of the potential to build wealth over a working life as home owners.

 

But one's got to be focused on the sustainability. And, frankly, I think there's a lot that private capital can contribute here. One of the downsides of having everything concentrated in Fannie and Freddie is that I think we end up with less market innovation than we otherwise would get. And I think that market innovation could unleash the power of markets and private capital to create those kinds of sustainable opportunities. And I hope that we legislate in a fashion that allows markets to be able to bring that kind of constructive sustainable opportunity to families.

 

Devon Westhill:  Well, thank you so much for those final remarks, fellas. I really appreciate you being here. I think this has been a really enlightening conversation—timely, as Alex said in the very beginning. And also as Alex said, talking to our audience here, don't get tired. Don't get tired of the Free Lunch Podcast because, in fact, we have another that we will convene on Thursday this week. It is on "Fintech Licensing and the OCC Charter" with Brian Knight from the Mercatus Center and Margaret Liu of the Conference of State Bank Supervisors. I hope that you will join us on Thursday as well for our next episode of the Free Lunch Podcast.

 

And on behalf of The Federalist Society's Regulatory Transparency Project, I want to thank our audience for joining us on this podcast episode today. And until we meet again on Thursday, so long, everyone. Goodbye.

 

Operator:  On behalf of The Federalist Society's Regulatory Transparency Project, thanks for tuning in to Free Lunch. As always, you can subscribe on iTunes and Google Play to get new episodes of Free Lunch when they're published. Also visit our website at regproject.org. That's R-E-GProject.org. There, we regularly upload content in addition to our podcasts such as short videos and papers. And you can join the discussion by sharing your story of how regulation has personally affected you. Until next time, remember, there's no such thing as a free lunch.

 

      This has been a FedSoc audio production.