For nearly five years, Fannie Mae and Freddie Mac have operated under federal conservatorship. A number of observers, including lawmakers on Capitol Hill, think that’s too long. What’s more, they want to pull the plug on the mortgage giants’ existence. On June 25, Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va., introduced a bill, the Housing Finance Reform and Taxpayer Protection Act of 2013 (S. 1217), that would replace these companies with a new insurance-based system. Supporters champion the legislation as a way to protect the public from future bailouts and promote more home mortgage lending.
Yet the measure may invite a rerun of the 2008 credit meltdown because it doesn’t challenge the prevailing assumption of homeownership as a right. An alternative bill, at least, introduced last Thursday by Rep. Jeb Hensarling, R-Tex., would reduce taxpayer exposure. Created by Congress, respectively, in 1938 and 1970, Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) for decades have operated as “Government-Sponsored Enterprises,” or GSEs – Fannie Mae was the first to be designated as such upon its re-chartering as a for-profit corporation in 1968. Their enterprise is creating mortgage market liquidity. Rather than originate loans, in other words, these companies purchase loans from banks, savings & loan associations and other private-sector lenders; package them into tranches of bonds known as “mortgage-backed securities”; and sell the securities to institutional investors such as banks, pension funds and equity funds. The bonds carry the advantage of an implicit federal guarantee (“too big to fail”). The firms also hold in portfolio, for investment purposes, a residual portion of the loans they buy.
Business has been brisk these past several years. In the months just prior to their seizure by the federal government in September 2008, the Washington, D.C.-based Fannie Mae and the McLean, Va.-based Freddie Mac had been buying a combined roughly 45 percent of all new residential mortgage originations, a figure in line with the share of the previous two decades, though way up from a mere 7 percent in 1980. That figure quickly climbed to around 70 percent in 2009, where it remained for a while before coming down to about 60 percent. As of March 31, the companies held a combined nearly $5 trillion in mortgages and mortgage-backed securities. This surge in market dominance is the result of federal policy. Congress, as part of the Housing and Economic Recovery Act (HERA), created the Federal Housing Finance Agency (FHFA) in July 2008 to place a tight leash on the two companies. Two months later, with the mortgage market collapsing, FHFA took over the companies and placed them under conservatorship. Insulated from failure, the Treasury Department over the next few years infused them with cash totaling roughly $188 billion, with about $117 billion going to Fannie Mae and $71 billion going to Freddie Mac. In return, the department acquired senior preferred stock and warrants totaling 79.9 percent of equity. The terms were strict. The companies had no option to buy back these shares in the future. And they had to forward all dividends, set at 10 percent, directly to the Treasury.
The reins would tighten further. Last August, the Treasury issued its so-called “sweep amendment.” This rule superseded the 10 percent dividend requirement in favor of a mandate for each GSE to give up all profits exceeding the ceiling of a special capital reserve fund initially set at $3 billion. The fund is set to fall by $600 million annually until its depletion in 2018. Any hope of independence for Fannie Mae and Freddie Mac now appears quashed. The two companies have to hand over most, and eventually all, of their profits to the U.S. Treasury in perpetuity. Fannie Mae especially is a federal cash cow. The company’s net worth by the close of First Quarter 2013 was $62.4 billion, which translated into a $59.4 billion windfall for the government. What we have, at this point, are Government-Sponsored Enterprises that even in the loosest sense can’t be called enterprises.
All that money pouring into federal coffers is making for barn-sized legal targets for frustrated Fannie Mae and Freddie Mac investors now that the housing market is back in full swing mode. Last Monday, a New York-based hedge fund, Perry Capital LLC, filed a challenge to the sweep rule in District of Columbia federal court alleging the Treasury Department’s amendment amounted to an unauthorized government purchase of new securities. The suit also cited FHFA as having reneged on its mission of conservatorship in allowing the Treasury Department to issue the rule. Theodore Olson, solicitor general under George W. Bush and now back at his old firm of Gibson, Dunn & Crutcher, is representing the plaintiffs. “If the government wanted to assume the powers of receivership, it could have chosen that course,” remarked Olson. “Instead it chose conservatorship, and with the ‘sweep amendment,’ it overreached.” The next day, two nonprofit housing organizations – the National Low Income Housing Coalition and the Right to the City Alliance – along with four individuals filed suit in Miami federal court claiming the Federal Housing Finance Agency had violated the law in November 2008 in suspending scheduled payments by Fannie Mae/Freddie Mac to the National Housing Trust Fund. The fund, which was created in July 2008 by the HERA legislation, calls for FHFA to extract 0.42 percent of the companies’ new business. In 2012, that represented a hefty $382 million. The lawsuit, filed by Charles Elsesser Jr., an attorney with Florida Legal Services Inc., is demanding that FHFA Acting Director Edward DeMarco resume contributions to the trust fund.
While it’s hard to work up too much sympathy for the GSEs, who brought much of this upon themselves via often reckless expansion and extensive campaign contributions, it’s even harder to sympathize with the plaintiffs. The National Low Income Housing Coalition and the Right to the City Alliance embody the sorts of hard-Left nonprofit activists whose misguided advocacy set the stage for the credit meltdown. Required “contributions” by Fannie Mae and Freddie Mac to the trust fund constitute legalized extortion. Another lawsuit is challenging the federal conservatorship itself. A month ago, a Seattle-based lender, Washington Federal, along with the Austin (Tex.) Police Retirement System, filed suit in the U.S. Court of Federal Claims seeking $41 billion in damages from the U.S. Treasury as compensation for suspending dividend payments to shareholders. The government takeover, reads the suit, “destroyed the value of Fannie Mae and Freddie Mac’s common and preferred stock” and “trampled the private ownership rights” of investors. The complaint also claims that “the government bullied and coerced the companies’ board of directors” until Fannie and Freddie agreed to conservatorship.
One wonders why the plaintiffs waited nearly five years to take this action. Perhaps, like the plaintiffs in the Florida case, they were waiting until the money was right. During the past year it certainly has been. The Standard & Poor’s/Case Shiller Home Price Index of single-family detached dwellings for 20 U.S. metro areas showed a 12.1 percent increase in the 12-month period ending April 2013. That was the highest year-over-year gain in seven years. The March-to-April 2013 monthly gain alone was 2.5 percent. Not surprisingly, profits at the GSEs are way up. After losing a combined $253 billion during 2008-11, Fannie Mae and Freddie Mac realized a $28.2 billion gain in 2012. Fannie Mae’s net income of $17.2 billion last year actually was more than that of Berkshire Hathaway, General Electric or Walmart. Last month Fannie Mae and Freddie Mac sent a combined $66.3 billion in dividend payments to the Treasury (with most of the money representing Fannie Mae tax credit paper gains). This constituted slightly over half of the $131.6 billion in dividends forwarded to the government thus far.
These companies have become valuable – too valuable, in fact, for the Obama administration to let go. Under the guise of “conservatorship,” the administration is milking their profits in order to balance the federal budget. Notwithstanding their no-win situation, Fannie Mae and Freddie Mac have few sympathizers in the nation’s capital. Congress, across the political spectrum, is virtually unanimous in their view that the companies need to be terminated and replaced with a presumably “fresh” approach. Then-Treasury Secretary Timothy Geithner in February 2011 expressed a widespread sentiment during a speech before the Brookings Institution: “We need to wind down Fannie and Freddie and substantially reduce the government’s footprint in the housing market.” This, however, has proven easier said than done. First, “reform” has a multiplicity of meanings. Would-be reformers remain too far apart to arrive at a compromise with broad appeal. Second, even if Congress does phase out the two companies in favor of a more efficient arrangement – which is what the Corker-Warner legislation proposes to do – it may set the stage for another version of 2008 if it doesn’t prevent easy money from being made available to large numbers of borderline and unqualified borrowers. To understand the probable effects of the Corker-Warner bill, it’s necessary to know what’s in it. The measure would phase out Fannie Mae, Freddie Mac and the Federal Housing Finance Agency over a five-year period and replace them with a new independent agency, Federal Mortgage Insurance Corporation (FMIC). With an initial authorization period of eight years, FMIC would regulate and backstop the secondary mortgage market in a manner roughly analogous to Federal Deposit Insurance Corporation backing of bank accounts. Among its key functions:
Purchase loans from banks and other mortgage originators. Approve participation of brokers of mortgage-backed securities who in turn would issue the securities to investors. Guarantee the securities against all losses, with investors absorbing the first 10 percent. Continue the promotion of affordable housing goals via a Market Access Fund.
A press release by Senator Corker’s office describes the goal of the legislation this way: “to strengthen America’s housing finance system by replacing government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac with a privately capitalized system that preserves market liquidity and protects taxpayers from future economic downturns.” To build support, Senators Corker and Warner have attracted six co-sponsors, three Democrats and three Republicans, who sit on the Senate Banking, Housing and Urban Affairs Committee: Democrats Jon Tester (Mont.), Heidi Heitkamp (N.D.) and Kay Hagan (N.C.); and Republicans Mike Johanns (Neb.), Dean Heller (Nev.) and Jerry Moran (Kan.). The bill is getting a boost from outside sources as well. Former Senator Majority leader George Mitchell (D-Maine), former Senator Christopher Bond (R-Mo.) and former HUD Secretaries Mel Martinez and Henry Cisneros, co-chairs of the Bipartisan Policy Center’s Housing Commission, opined:
We are pleased that the Corker-Warner legislation incorporates many of the elements of the housing finance reform plan proposed earlier this year by the Bipartisan Policy Center’s Housing Commission. The BPC Plan is the product of 16 months of collaboration among 21 citizens drawn from diverse political and professional backgrounds. Like our plan, a key objective of the legislation is to create a new system that encourages private capital to play a far greater role in bearing mortgage-credit risk.
Frank Keating, a member of that commission who had served as HUD general counsel under President George H.W. Bush and who now is president of the American Bankers Association, also praises the measure. He calls it “a positive first step in what is certain to be a long process toward creating a sustainable, rational and limited role for the federal government in supporting and regulating a mortgage market that is appropriately and predominantly filled by the private sector.” David Stevens, president of the Mortgage Bankers Association, calls the Corker-Warner bill “a thoughtful and comprehensive approach to…restructure the secondary mortgage market in a way that provides sufficient liquidity to the market so that lenders can offer a full range of sustainable mortgage credit to qualified borrowers through all market conditions.” And Mark Zandi, chief economist with Moody’s Analytics, lauds the bill as “a very serious effort to fix our broken mortgage finance system.”
Such rhetoric bears a striking resemblance to the rhetoric surrounding the new Senate immigration bill: An allegedly “broken” system, desperately in need of reinvention as the nation flails about in confusion and agony, gets a Fresh Start. But like the immigration bill, the Fannie Mae/Freddie Mac legislation represents a change more in form than in substance. The players would have different names, but the game would remain the same. And the game is high-volume mortgage lending with little regard for consequences. John Ligon, senior policy analyst with The Heritage Foundation, recognizes as much. “These are the same kinds of policies that undermined the U.S. housing finance system and stable homeownership over the past two decades,” he argues. “In the years before the 2008 housing crisis, there was little concern among private investors about the underlying strength of the mortgages that backed MBSs, because Fannie and Freddie assumed these risks with the implicit guarantee of the federal government. Corker-Warner would simply replace the names of the entities with the full faith and credit of the U.S. government.” Peter Wallison, senior fellow at the American Enterprise Institute and a prominent critic of easy mortgage credit, also sees little in the way of substantive change. Writing in the Wall Street Journal early this month, he painted a grim scenario:
A major feature of Corker-Warner is the requirement that the private sector share the insurance risk with the new FMIC. The bill specifies that a private risk-sharer like a bond insurer must take the first losses, no less than 10% on any securitized pool of mortgages. This is intended to protect the FMIC against losses, though it works only if the quality of the mortgages remains high. But as with Fannie and Freddie, the quality of the mortgages will be the weak link. Realtors, home builders and community activists all want as many homebuyers as possible. They are not concerned with fuddy-duddy obstacles like down payments, solid credit scores or low debt-to-income ratios. These interest groups and Congress will press the FMIC to lower its underwriting standards so that more and more loans can be insured. The private bond insurer or other risk-sharer will understand the downside potential of low-quality loans and will charge for the additional risk. That cost will be incorporated into the mortgage, increasing the monthly payment and making the cost of mortgages too high for many potential borrowers. The result? Congress or the administration or both will pressure the FMIC to lower its insurance fees so that the maximum number of people will be able to buy homes. Recall that the Federal Housing Administration required 20% down payments when it was born in 1934. It now requires a 3% down payment – and a government bailout. The scheme envisioned in Corker-Warner will work for a while, as long as housing prices keep climbing, and with more and more people entering the homeownership sweepstakes, they will. As housing prices get higher, housing will look like good investments, which will bring in more investors and drive prices still higher. Eventually, it will all come apart, as it did in 2008.
Wallison argues that investors won’t get burned in the next meltdown because they are fully insured. It will be homeowners, at least those persuaded to buy homes they couldn’t afford, who will bear the brunt of sharp price declines. And in the end, taxpayers may be required to cover shortfalls in the FMIC insurance fund if increases in premiums are insufficient in closing the gap. The fundamental issue, then, is the preponderance of “low-quality mortgages”; i.e., mortgages least likely to be paid back on time, if at all. It’s an issue lawmakers understandably don’t want to address. Because if they did, they would be forced to question the shibboleths that homeownership is for everyone, and related, that racial/ethnic disparities in ownership rates result almost exclusively from illegal lender discrimination.
For at least the last two decades, the mortgage industry has been subject to increasing pressure from federal regulators (including FHFA’s predecessor agency, HUD’s Office of Federal Housing Enterprise Oversight), the Clinton, Bush and Obama White Houses, and a host of nonprofit shakedown groups such as ACORN, National People’s Action, and Neighborhood Assistance Corporation of America, to step up lending to blacks and Hispanics, regardless of ability to pay. To them, if traditional underwriting standards result in higher loan application rejection rates for nonwhites, then banks ought to lower their standards. And blacks and Hispanics did account for a disproportionate share of low-quality mortgages. A 2008 study by the Federal Reserve Bank of San Francisco, for example, after examining data on nearly 240,000 mortgages in California underwritten during the years preceding the credit collapse, concluded that blacks, Hispanics, Asians and whites, even after controlling for borrower income and credit score, had respective foreclosure rates of 3.3 percent, 2.5 percent, 1.6 percent and 1.0 percent. Another 2008 report, conducted by the Federal Reserve Bank of Boston, revealed that foreclosures on subprime mortgages made to blacks and Hispanics in Massachusetts occurred at much higher rates than for whites who took out subprime mortgages during 1998-2006. And a 2004 report prepared for HUD by a California-based consultant revealed that black and Hispanic default rates on Nineties-era Federal Housing Administration (FHA) loans were more than twice the rate for whites. Study author Robert Cotterman noted: “Blacks, Hispanics, and those in judicial foreclosure states and underserved areas have higher conditional loss rates, other things the same.”
Such studies matter because Fannie Mae and Freddie Mac, and whatever federal agency that replaces them, are going to feel the pressure to buy high volumes of mortgages made to less than creditworthy borrowers. And that means that holders of mortgage-backed securities will have to bear a higher risk of not receiving their promised income stream. Such an outcome, if taken far enough, would trigger another and possibly even larger public bailout. Supporters of the Corker-Warner bill aren’t likely to bring this up scenario. They would prefer to alter the structure of the secondary mortgage market, but without insisting upon high standards of risk assessment. The Dodd-Frank banking reform legislation’s extensive affirmative action requirements, not to mention the Eric Holder-led U.S. Justice Department’s “settlements” of race-based lawsuits against mortgage lenders such as Wells Fargo, make the task of maintaining solvency that much more difficult.
Rep. Jeb Hensarling, R-Tex., chairman of the House Financial Services Committee, believes he has a better approach. Last Thursday, July 11, he unveiled a summary of an alternative bill called the Protecting American Taxpayers and Homeowners (PATH) Act. Like the Corker-Warner bill, the Hensarling measure would liquidate Fannie Mae and Freddie Mac within five years and replace them with a new securitization structure. Unlike the Corker-Warner bill, thankfully, PATH would not provide government guarantees for the secondary mortgage market. Instead, it would back Federal Housing Administration-insured loans, and limit such loans to 115 percent of area median home price. It also would raise minimum down payments on FHA loans for non-first-time buyers from 3.5 percent to 5 percent. Rep. Hensarling reportedly wants to hold a hearing on July 18. Inasmuch as the Hensarling approach minimizes taxpayer exposure to securities collapse, it does rest on the same assumption of the Senate bill: Fannie Mae and Freddie Mac must go. But is that a sound assumption? The truth is there isn’t anything an alternative entity will do that these two companies can’t do equally as well. What’s more, as per the Corker-Warner bill to force the FMIC to bear the first 10 percent of all losses, private mortgage insurers already take a first loss on all Fannie/Freddie loans with loan-to-value ratios in excess of 80 percent.
The problem isn’t the continued existence of Fannie Mae and Freddie Mac as financial conduits between banks on Main Street and brokerage houses on Wall Street. Providing liquidity is a key “middleman” function that expands the availability, and lowers the cost, of mortgage credit. The real problem is the companies’ continued existence as extensions of the federal government. A true reform bill wouldn’t abolish the two companies. It instead would: 1) allow them to operate as normal for-profit companies; and 2) deny them privileges that prevent other firms from competing with them.
The greatest challenge would be to resist political pressure, especially from “civil rights” leaders and their allies in Congress, to serve large numbers of high-risk borrowers. Neither the the Corker-Warner nor the Hensarling bills seek to produce such an outcome. Speaking about the prospects for privatization of Fannie Mae/Freddie Mac, Senator Corker stated last month, “It’s a lottery ticket at best…I just don’t see any appetite in Congress for Fannie and Freddie ever being returned to the private market.” Yet his bill faces an uphill climb because Republicans aren’t keen on creating yet another federal bureaucracy. A lobbyist noted three weeks prior to its introduction, there is “no way” many Republicans will vote for the creation of a new federal mortgage insurance agency even if Fannie and Freddie disappear. The best bill, then, is one that minimizes the federal “footprint,” to use former Treasury Secretary Geithner’s metaphor. That would be Rep. Hensarling’s House alternative.