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56 | TH E M R EP O RT O R I G I NAT I O N S E R V I C I N G DATA G O V E R N M E N T S E C O N DA R Y M A R K E T THE LATEST GOVERNMENT conservatorship," Layton said. "It also called for regulation akin to how states regulate electric and other utilities (which includes setting prices charged to the public). Today, this utility-style GSE reform is the only major idea still around with broad support. Interestingly though, it did not emanate from any of the sources of earlier big and bold proposals, but out of the careful, years-long work of reforming the GSEs inside conservatorship by the FHFA, with Treasury also playing an important role." Legislative vs. Administrative Paths to GSE reform: Where Do They stand? I deas for reform obviously require new legislation to be passed, but when it became clear that there was a shift from replacing to GSEs to reforming them through what became known as an "administrative path." Layton said that this approach bypasses the need for congressional legislation because the changes necessary for the GSEs to exit this oversight could be made by the FHFA through regulation, plus the Treasury could modify the existing contract by which the enterprises gets funding through them. "Right now, in fact, the consensus in Washington is that any legislation about GSE reform will not happen for many years at a minimum," Layton said. "Given how well the GSEs are working in conservatorship, there is no pressure on Republicans or Democrats in Congress—who have very different ideas about what should be done with the GSEs—to force compromise on a reform plan. That means the administrative path is the only realistic option available right now." What Two Key GSE Reform Activities Are Quietly Underway Right Now? A ccording to Layton, the most important GSE reform activity now underway is that the two enterprises are retaining all their earnings to build capital, an extremely important fact that many people gloss over. This makes the GSEs more financially stable, mean- ing they do not have to ask the treasury for additional cash injections, which are ultimately funded by taxpayers. The second reform activity is FHFA Acting Director Sandra L. Thompson making changes to Calabria-era regulatory minimum capital requirements which called for an "unnecessarily high level" of capital. The limited scope of the revisions that have been implemented are designed to eliminate a "perverse incentive" for the GSEs to take on high risk mortgages and an equally perverse disincentive to lay off mortgage credit risk. "Unfortunately, those are the only two important GSE reform activities underway right now," Layton concluded. What Should We Watch for to See if Additional GSE Reform Activities Get Underway? L ayton sees three areas where additional government action is needed to facilitate a conser- vatorship exit. These changes are major undertakings which will take a lot time to imple- ment (Layton estimates years, not months). They are: The existing regulatory mini- mum capital rule must be revised downward. This means largely adopting the underlying economics of how capital is required for risk in the banking system, but then applying it to the particulars of the GSEs, which are very much not banks, where the current capital rule treats them too much as though they are. Too high a regulatory capital requirement would directly translate into a privatized GSE having too high a cost of capi- tal. As the largest component of guarantee fee pricing is the cost of capital, that would directly lead to inordinately high guarantee fee pricing by the two companies. Such a revised capital requirement would take at least a year, maybe even closer to two, to develop and implement. The FHFA must build the proper legal and operational infrastruc- ture for utility-style regulation of the GSEs after they would have exited conservatorship. This is a heavy lift for the agency, assuming it duplicates the well- established state-level utility regu- latory regime rather than trying to create something de novo. This would include establishing wholly new activities such as holding public hearings when the GSEs request pricing changes, examin- ing all operating expenses to see which ones might be ineligible (e.g. unduly lavish customer en- tertainment), doing financial and economic studies to determine the required rate of return for inves- tors (about which hearings would also be held), and so on. These things are second nature to state- level public utility commissions, but far afield from what financial regulators like the FHFA do. Ultra-complex mechanics need to be developed and imple- mented for each GSE to restruc- ture the ownership of its equity. That ownership is currently distorted by Treasury holding all of the senior preferred stock (with over $200 billion outstand- ing) as well as warrants on 79.9% of the common stock, both of which sit beside the historic (i.e. pre-conservatorship) common and junior preferred shares, which are still owned by public market investors. (Such public market investors have few rights during conservatorship, but its ending would return those rights—such as the ability to elect the Board of Directors—to them.) A conserva- torship exit requires that this eq- uity ownership structure become undistorted and conventional, and free from conservatorship-related legal uncertainties. Treasury, more than the FHFA, is key to this happening, and the complex- ity, especially in such immense size and for two companies at the same time, is unprecedented. (Included in this undertaking would be establishing a fee for the GSEs to overtly pay Treasury for its support.) "Right now, in fact, the consensus in Washington is that any legislation about GSE reform will not happen for many years at a minimum." —Don Layton, Senior Industry Fellow for the Joint Center for Housing Studies, Harvard University,

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