How Dodd-Frank is a big obstacle to closing down Fannie and Freddie

On Friday, Treasury Secretary Geithner said that the Obama administration is preparing to move forward with closing Fannie Mae and Freddie Mac and bringing back a robust private housing market. Ironically, the secretary’s statement was made almost one year to the day after the administration released its white paper on reform of the housing market. Since then, there has been virtual silence on the administration’s plans, while the private housing market has continued to grow weaker. Many banks, large and small, are abandoning the mortgage business, and MetLife had to close down its own large mortgage business when it couldn’t find a buyer.

One of the options in the administration’s white paper was a fully private market; in response, I and my AEI colleagues Alex Pollock and Ed Pinto circulated our own white paper in March 2011 in the belief that a deal between the administration and House Republicans that produces a wholly free housing finance market was possible. Although House subcommittees have considered some important legislation that moves toward reviving the private market, it is unlikely that anything will get through this Congress without the administration’s support.

Accordingly, we welcome the Treasury secretary’s renewed interest, but it is important for him and the administration to understand that it will be extremely difficult to close down Fannie and Freddie without amending the Dodd-Frank Act in significant ways. Among them, and by no means all, are the following impediments to the return of a robust private market:

· Although Fannie and Freddie might be privatized or otherwise eliminated over time, a robust private market cannot develop as long as FHA is able to insure mortgages up to $729,500 and remains exempt from the 5 percent risk retention requirement in Dodd-Frank. No matter what standards are ultimately adopted for the Qualified Residential Mortgage, FHA will always be able to out-compete private securitizers as long as it does not have to bear this additional cost and is able to insure most mortgages issued in the United States.

· In addition, the 5 percent retention requirement strongly favors the biggest banks, which alone have balance sheets large enough to hold the retention amount and still carry on an active securitization business. This would be bad enough as a competitive matter, but given the fact that many of the large banks are now substantially reducing their mortgage financing activity, the continued application of the risk retention requirement will prevent the growth of any private sector substitutes for the GSEs or FHA.

· The Volcker rule, which has already drawn opposition in many other quarters, is also an impediment to the development of a private securitization market. That market depends heavily on the ability of lenders to hedge their interest rate risks while they are assembling a pool of mortgages for securitization. The Volcker rule applies to any firm that is affiliated with an insured bank, and prohibits proprietary trading, which is very difficult to distinguish from hedging transactions. Until there is a safe harbor for hedging transactions, the risks of running afoul of the Volcker rule may prevent many bank-affiliated securitizers from entering the private housing finance market.

It is good news that the administration is now willing to go forward with GSE reform, but if it is serious about privatizing or eliminating Fannie and Freddie it will have to propose some serious reforms in Dodd-Frank at the same time.

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