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The Moelis Plan – Putting The Cart Before The Horse
The team from Moelis has unveiled a new and somewhat improved version of their plan to return the Government Sponsored Enterprises to the shareholders. Before turning to the substance, much of which is quite good, it’s important to note up front that they have the interests of their clients, who are major shareholders in the GSEs, foremost in mind here. This is not a criticism of Moelis, which is doing what it is being paid to do, and admirably I must say, but something to keep in mind in understanding the effort, as some key features only make sense in that light.
What Moelis gets right:
1. It is important to appreciate what pushed the GSE’s into conservatorship in the first place. Moelis makes the point that it was not the core TBA guaranty book but rather the actions taken with the portfolios of both firms in purchasing lower quality and riskier PLS, subprime, and alt-a mortgage product. In leveraging their implicit federal backstop, they had an almost unlimited execution advantage in disrupting the non agency markets.
2. The principles set forth by Moelis appeal to most stakeholders. This includes a list of items including protecting the taxpayer, leveling the playing field permanently for all lenders regardless of size, and affirming the affordable lending regime that currently exists today. It references the joint trade association letter and endorses the calls made in that document to lock in many of the reforms that were made by policy under Director Watt and his team. Frankly much of that was initiated under then Acting Director DeMarco.
3. Moelis lays out a pro-forma outlook at the future financials and how the taxpayer might profit from their proposal. While I will leave the details of this to others with more expertise to debate, I will note that it is at the very least counterintuitive. Today all profits from both institutions go to the taxpayer, so it is difficult to imagine how the taxpayer would manage to reap greater returns by selling its position. I’m not saying it’s fair or good policy, but as a matter of taxpayer math, it’s hard to see why this is a positive.
4. Moelis goes to great lengths to diminish the GNMA operational model proposed by the recent discussion draft released from Congressman Hensarlings’ office. To this point I am in complete agreement about the understaffed, overwhelmed, undercapitalized aspects of GNMA today and the stark comparison to the capabilities of the GSE’s in their current form. There is simply no comparison and the false belief that GNMA can serve this role is far fetched at best. Moelis adds some key points that others have made in the past especially the value to small lenders that would be likely lost including access to a cash window and the ability to buy defaults out of pools. The GNMA model likely increases concentration risk on large banks, not the opposite.
What Moelis Gets Wrong:
1. The plan starts with recapitalization. In essence, they are putting fuel back into the tank of the car before it is fixed. This poses the very real risk that we never fix the car adequately before it’s entirely refueled and ready to drive off. This makes no sense at all as a matter of public policy, as it increases the odds that we skip reform altogether. But it makes a great deal of sense for shareholders, as it increases the odds that they recoup dramatically with or without reform. Assuming we should think of this from the perspective of the nation and not the shareholders, the focus here must be reform first. If we cannot get the structure and framework right, we sure as heck better not have them on the edge of release. Frankly, the housing system might be better off retaining the current structure than letting free market capitalism with a government backstop back out in the open before insuring that they are framed in with the appropriate policies and a commitment behind them and to the markets for safety and sustainability first.
2. While agreeing that an explicit federal backstop is needed, Moelis explains that this requires legislation. And, while recognizing that this would help MBS pricing and likewise lower interest rates for borrowers, it does not seem to make this a cornerstone event. In the absence of a congressionally authorized explicitly guaranty behind the MBS, investors in a forward looking global market will ultimately have to believe that the US Government will bail these entities out in the future just as they did a decade ago. Sovereigns would have to determine whether their institutions could trust this model and consider its risk weighting in the same manner as they do today. This could have meaningful impact to interest rates and consumer access to credit.
3. This leads to the next critical point. The plan leaves in place the duopoly model. Unless we end the system’s reliance on a TBTF duopoly we are simply not addressing the fundamental flaw in incentives that got us into so much trouble. You can do that by increasing the number of guarantors so that any one can fail, or collapsing them into one that is treated like a market utility. But you’ve got to do one or the other to have any real reform. The duopoly model would be the worst of all outcomes, resulting in too much risk and too little competition.
4. Moelis argues that the regulator can protect the level playing field, continue the affordable housing goals, and frame in the charter creep concerns. The reality is that the effectiveness of any regulator varies by regime and leadership. We have seen that stark contrast in other regulators just in the past two years. The confidence in relying on regulatory infrastructure that is subject to change versus the more concrete and permanent changes established by legislation are important decision points. With the view about getting this right before we march to recapitalize and monetize speculative shareholders, I continue to advocate that reform before recapitalization must be protected in this debate.
Conclusion:The conservatorship has lasted too long and ending it will take political will that thus far we just haven’t had. The alternative presented by Moelis is tantamount to giving up, putting Fannie and Freddie on a path to re-privatization. But it makes no sense from a matter of public policy, as even conservatorship is better than a return the system that has failed us already. Indeed, it only makes sense from the perspective of the shareholder. But surely the needs of the housing finance system must come first.
Let’s avoid putting the cart before the horse. Let’s continue to pursue legislation and unite around the need to establish an explicit guaranty, prohibit pricing for market share, establish more rational and effective affordable housing measures, frame in the permissible activities of the future entities, and implement a capital regime that will stand the test if time. Any other action at this point leave open the slippery slope back into the abyss that resulted in the bailout to begin with.