As the two continue to produce strongrnearnings, Merrill Lynch says, “the bag taxpayers are holding isrnquickly filling up with cash,” and that could eventually persuaderntaxpayers to change their outlook on the fate of the GSEs. </p

Looking back at the housing crisis, thernauthors say they see what needs to be done:</p<ul<li

Price credit risk fairly tornaccount for long-term losses; </p</li<li

Manage risk carefully, especiallyrnwhen home prices are rising;</p</li<li

Hold appropriate capital to managerneconomic downturns smoothly;</p</li<li

Recognize that a governmentrnguarantee must be explicit and that, even without such a guarantee,rngovernment will be the ultimate backstop. </p</li</ul

The failures of the GSEs in the abovernareas were not theirs alone and the private sector did not prove anyrnmore able to handle the risk nor did they have the capital to do so. “The implicit government backing had some benefits and somerndrawbacks, but in our view it is a relatively easy fix that does notrnrequire an entirely new model of mortgage finance.” The first twornitems on its list have already been essentially accomplished thernpaper says, it only remains to capitalize the agencies and recognizernthe explicit government backing.</p

According to the authors, GSE earningsrnare strong, their business model looks sound, and return on therntaxpayers investment is around the corner. Over the course of 2014rnpayments to the government will likely exceed the taxpayersrninvestment and over the following few years taxpayers could benefitrnnot just from the credit channel but from increased net governmentrnrevenues. This comes at the cost of increased credit risk, somethingrnthe taxpayers would probably face anyway, even if the model werernprivatized.</p

One of the problems of the old GSErnmodel was their funding of rapidly growing portfolios funded by thinrncapital levels. This posed a large liquidity risk and requiredrnaccess to rolling over maturing debt, not possible in the summer ofrn2008. Because of the implicit guarantee the GSEs had enjoyedrnfavorable debt funding giving them a strong incentive to focus onrnthis non-mission critical but highly profitable business. Byrncontrast the insurance side of the business generated the bulk of thernlosses ($173 billion from 2008 through 2013) and contributed least tornrevenues over the years. </p

As GSE portfolios wind down the GSEsrnare becoming monoline insurance companies. They have tightenedrncredit risk standards while mitigating losses on the rapidlyrnshrinking pre-2008 book of business. While profits will taper,rncapital requirements will not be as intense and government backingrnlikely will not be applied to non-core functions. “This is veryrnimportant reform that is already underway and will take about fivernmore years to complete.”</p

The authors ask if large-scale reformrnis in the best interests of taxpayers and answer that as the GSEsrnproduce strong results and provide the backdrop for industry recoveryrn”a complete overhaul of the mortgage finance model becomesrnincreasingly difficult to justify” Completely eliminating the GSEsrnand replacing them is complex and risky. The infrastructurerncurrently in place is substantial while the size and efficiency ofrnthe agency credit market is unparalleled and may be difficult tornimprove upon. With “the required principles in place forrnsuccessful mortgage securitization…small improvements may provernmore beneficial than large changes.'</p

The questions that remain in the viewrnof the authors are the issues of the government guarantee andrnownership/capitalization. The first as they see it is not an option;rnprivate markets cannot be asked to provide crisis backstops and thernvalue of the nation’s housing stock cannot be allowed to go into freernfall. The government can own the enterprise or sell part or all tornprivate investors while maintaining oversight and receivingrncompensation for the backstop. The taxpayers’ investment should bernrecouped within a year and then a portion of future earnings can bernused to develop and maintain a backstop fund. New machinery andrninfrastructure is not required for this. Private capital, junior torntaxpayer capital, can be layered in because the enterprises arernprofitable and well run. The government footprint can continue to berndebated as credit standards and fees an be adjusted to modify it asrndesired.</p

The authors conclude that, inrnretrospect the recent crises provided an extreme test of the system,rnand while some obvious changes are needed the key reforms are alreadyrnunderway. Reid’s comments may lead to growing support for smallrntweaks rather than a full overhaul of the existing system.

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