Never underestimate the ability of Congress to address a problem through symbolic action. Over the weekend, Sens. Tim Johnson, D-S.D., and Mike Crapo, R-Idaho, introduced a bill, the Housing Finance Reform and Taxpayer Protection Act of 2014, to phase out secondary mortgage lending corporations Fannie Mae and Freddie Mac over a five-year period and replace them with a new insurance-based system. The 442-page draft bill builds on a plan unveiled last June by Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va. Like its predecessor, this bill rests on the faulty premise that the main problem is these companies’ continued existence. Lawmakers instead should allow them to operate, but without a federal lifeline. Significantly, the new bill makes no mention of the junior preferred and common Fannie Mae and Freddie Mac shareholders whose earnings are being seized in perpetuity by the U.S. Treasury.
Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”) are secondary mortgage lenders. Their main job is to promote residential mortgage market liquidity. In other words, they don’t make loans. Instead, they buy them from banks and other primary lenders, and then retain them as investments or, as in almost all cases, eventually bundle them into marketable pools of bonds known as “mortgage-backed securities” (MBS). As a supplementary activity, the companies issue corporate bonds to raise money for MBS purchases. Fannie Mae and Freddie Mac in effect connect mortgage markets with capital markets. By maximizing the efficiency of capital, they can reduce home mortgage interest rates by anywhere from 20 to 50 basis points (i.e., two-tenths to one-half of a percentage point) and expand opportunities for homeownership. And banks, having unloaded unloaded long-term loans for cash, are in a better position to make more home loans.
Congress chartered Fannie Mae and Freddie Mac, respectively, in 1968 and 1970 as “Government-Sponsored Enterprises,” or GSEs (in Fannie Mae’s case, this was a re-chartering – it had been set up as a government agency back in 1938). These would be full-fledged corporations, but with a unique public mission. This arrangement has been a two-edged sword. On the one hand, the companies have certain advantages over market competitors, including a line of credit with the U.S. Treasury and exemption from state and local taxation. On the other hand, they operate under strict and growing scrutiny from Congress and the executive branch. For the last five and a half years, the “Government” part of that term has asserted itself with a vengeance.
It was July 2008. The overleveraging of the mortgage market, which had been building for more than a half-decade, now was threatening the nation’s financial markets. House prices, having begun to drop the previous year, now were plummeting in many local areas. And mortgage delinquencies and defaults were beginning to rise. The Washington, D.C.-based Fannie Mae and the McLean, Va.-based Freddie Mac, though for years highly profitable, were ill-prepared for the worst. Bear Stearns, a large portion of whose portfolio consisted of mortgage bonds, already had collapsed earlier in the year. Congress, at the urging of the Bush administration, quickly passed the Housing and Economic Recovery Act. The measure created a new agency, the Federal Housing Finance Agency (FHFA), to replace the existing HUD-based regulator of Fannie Mae and Freddie Mac. FHFA would impose stricter risk-based capital standards and otherwise do everything possible to prevent massive GSE defaults on mortgage bonds.
The law would prove to be a stopgap measure. By September 2008, a worldwide credit collapse became a possibility. Merrill Lynch, Lehman Brothers and American International Group (AIG) each were folding. Early that month, FHFA, advised and fully supported by the U.S. Treasury Department and the Federal Reserve System, took over Fannie Mae and Freddie Mac, placing them under conservatorship. It was official: Fannie Mae and Freddie Mac, whose combined asset portfolio had reached about $5 trillion, were wards of the federal government. The new arrangement wasn’t receivership, which virtually would have assured liquidation. But it was much stronger medicine than regulation. In the words of FHFA, the purpose of conservatorship is “to preserve and conserve each Enterprise’s assets and property and restore the Enterprises to a sound financial condition so they can continue to fulfill their statutory mission of promoting liquidity and efficiency in the nation’s housing finance markets.” In more practical terms, FHFA now could dictate company business practices.
But this particular conservatorship also came with a federal bailout. Over the next few years, the U.S. Treasury provided the corporations with a combined nearly $188 billion in cash draws with which to pay bondholders. Of that sum, $117 billion went to Fannie Mae and $71 billion went to Freddie Mac. The bailout carried serious strings that felt more like rope. The Treasury Department would acquire senior preferred stock with a mandate for the companies to forward dividends set at 10 percent. And it would acquire warrants to purchase 79.9 percent of all outstanding common stock at effectively zero dollars. Conservatorship at least would a temporary measure. That was the arrangement anyway.
Then, during 2011-12, something unexpected happened amid the rising tide of foreclosures: The housing market rebounded. The Standard & Poor’s/Case-Shiller Home Price Index, a highly respected indicator of month-to-month house price changes in major metropolitan markets, was registering substantial hikes. Profits in the mortgage industry, including Fannie Mae/Freddie Mac, likewise surged. The Great Recession, for all the hardship it created, was for the most part contained within the real estate, financial and insurance sectors. With the worst of the downturn behind, the opportunities for GSE profits grew. The U.S. Treasury Department, supported by the FHFA, saw an opportunity to speed up collection of Fannie Mae and Freddie Mac debt. In August 2012, the department issued a “sweep amendment” superseding the 10 percent dividend rule. Now each company, for all intents and purposes, had to hand over all profits to the government. It amounted to arbitrary confiscation. Any number of Fannie Mae and Freddie Mac investors, including those whose money in a New York-based hedge fund, Perry Capital LLC, filed suit against the Treasury Department the following year, accusing the government of an illegal taking.
Fannie Mae and Freddie Mac now were federal cash cows. And they were producing lots of milk. By the close of 2013, the companies had repaid the U.S. Treasury about $185 billion of their combined $187.5 billion in bailout loans. Projected payments scheduled for the end of this month will put this debt repayment at $202.9 billion – in other words, about $15 billion more than what they owe. Continuing the conservatorship beyond the repayment at this point would amount to a legalized heist. And it’s a haul that only will grow over the years. Earlier this month the White House Office of Management and Budget estimated that the two companies would send another $180 billion in combined profits over the next 10 years. That’s money whose rightful owners, the companies and shareholders, will never see in lieu of court rulings overturning the sweep rule.
Ted Olson, the Bush-era Solicitor General who serves as the attorney representing shareholders in Perry Capital, also sees the sweep rule as legalized theft. In an article for the Wall Street Journal last July (“Treasury’s Fannie Mae Heist”), he wrote: “The government’s scheme to wipe out these investors is bad policy and a plain violation of the law that respects private, investment-backed expectations and our constitutional protection of property rights.” But restoring autonomy – or something like it – to these two companies has found little favor in the Obama administration or in Congress. The tide of anti-Wall Street populism still runs high. Lawmakers have focused not on weaning Fannie Mae and Freddie Mac from federal control, but on abolishing then altogether. The theme appears to be: Out of sight, out of mind.
With the issue being how rather than whether to repeal Fannie Mae/Freddie Mac, certain lawmakers believe they have the answer. Last June, Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va., introduced the Housing Finance Reform and Taxpayer Protection Act (S.1217) to phase out these companies over five years in favor of a system in which: 1) private insurers would cover at least the first 10 percent of losses on a specific pool of mortgage bonds; and 2) a new fund, known as Federal Mortgage Insurance Corporation (FMIC), financed by premiums charged to securities issuers, would cover losses beyond that. The bipartisan bill also would abolish FHFA and continue the promotion of affordable housing goals through a new Market Access Fund. Fannie Mae and Freddie Mac might wind up as history, but their functions would be well and alive.
Only weeks later, in July, Rep. Jeb Hensarling, R-Tex., chairman of the House Financial Services Committee, followed suit with his own bill, the Protecting American Taxpayers and Homeowners Act, or PATH (H.R. 2767). Like the Corker-Warner measure, this one would phase out Fannie Mae and Freddie Mac over a half-decade and replace the companies with a new system of mortgage purchase and securitization. But unlike that bill, PATH would not provide government guarantees for the secondary mortgage market. Instead, it would back loans insured by the Federal Housing Administration, limiting such loans to 115 percent of area median home prices and raising minimum down payment on FHA loans to repeat buyers from 3.5 percent to 5 percent.
Sen. Corker expressed the general feeling among lawmakers when he stated last June: “I just don’t see any appetite in Congress for Fannie and Freddie ever being returned to the private market.” Yet not everyone agreed on how to do this. Republicans generally were opposed to creating a new federal mortgage insurance agency. And Democrats believed that the new insurance-based system, which deliberately would resemble FDIC, would give too much of a role to bond issuers and fall short in subsidizing low- and moderate-income housing.
Over the ensuing months, the Senate Banking, Housing and Urban Affairs Committee went about fleshing out the details of the Corker-Warner bill. Last Tuesday, Senators Tim Johnson, D-S.D., and Mike Crapo, R-Idaho, respectively, the chairman and Ranking Republican of that committee, released a summary of a new bill that fleshed out the details of its Corker-Warner predecessor. And over this weekend, they formally introduced it. Like its predecessor, the Johnson-Crapo bill would have private capital take the first 10 percent of losses on mortgage-backed securities, with a “loss-sharing” provision would expose the public to covering losses beyond the initial tier. It also would create an MBS issuer-paid, self-financing insurance fund ostensibly to promote housing affordability. The bill also incorporates a Hensarling bill feature in raising the down payment for FHA-insured repeat buyers from 3.5 percent to 5 percent.
Passage of the Johnson-Crapo bill by both houses isn’t likely, especially in this, an election year. Rep. Hensarling is especially vocal in his opposition. “We now have a virtual government monopoly over our mortgage market. This is not healthy,” he said in a critical response to the new Senate plan. “My fear is that if you leave a permanent government guarantee in the secondary mortgage market, you kind of put Fannie and Freddie in the witness protection program, given them a new name [and] reconstructive surgery, and unleash them on an unsuspecting public.” At the other end of the spectrum, Sen. Elizabeth Warren, D-Mass., stated last October in Washington, D.C. at the 100th convention of the American Bankers Association: “We need [Fannie Mae and Freddie Mac] reform, but it must be targeted reform that preserves the good things about the pre-crisis system.” In her speech, she called for maintenance of a large government presence in housing credit markets, strong regulation, an increase in loan modifications on behalf of distressed borrowers, and an assurance that smaller lenders have a place in the market. Financial community observers believe the chances for action this year are slim. “I’m skeptical that the Majority Leader (i.e., Sen. Harry Reid, D-Nev.) wants to put vulnerable Democrats in the awkward position of taking tough votes on the housing finance system,” said Brian Gardner, senior vice president at the Manhattan-based investment banking firm of Keefe, Bruyette and Woods. Investors generally are nonplussed as well. Last Tuesday, the day of the introduction of the bill outline, the respective share prices for Fannie Mae and Freddie Mac dropped 31 percent and 27 percent.
There is a good reason to be skeptical of the new bill. Not only does it not take taxpayers off the hook, it may make them more liable. This is because the measure, rather than discourage high-risk lending, shifts the burden to other parties. Peter Wallison, a senior fellow at the American Enterprise Institute, last June explained the likely, and grim, scenario of the Corker-Warner bill – which is to say, the Johnson-Crapo bill:
We should recognize by now that insurance funds run by the government are not insurance in any meaningful sense. The government does not effectively price for risk; it prices to confer political benefits…Even in the unprecedented event that the FMIC actually prices for risks, there will come a time when the Government Mortgage Complex – the Realtors, homebuilders and community activists – will call upon Congress to stop accumulating money in the fund. It’s a tax, they will say, on the people who are trying to buy homes, and the fund is certainly large enough for any future catastrophe. Congress, of course, will relent, as they did when they capped the bank insurance fund at the behest of the banking industry many years ago. After all, why impose a needless tax on homeowners? When the catastrophe actually occurs, the mortgage insurance fund – like the bank insurance fund – will be found to be inadequate and the taxpayers will once again be called upon to fill in the hole.
Wallison also explains why the requirement for private investors assuming the first 10 percent of mortgage bond losses (to be issued by FMIC-registered firms), isn’t likely to prevent a bailout:
They (i.e., the bond issuers) have an interest, to be sure, but it’s an insurer’s interest; they will require compensation based on their views about the likelihood of default by the mortgages in the MBS pool. This cost will have to be included in the cost of the mortgage. Thus, the private loss-takers have no particular interest in making sure that the mortgages are of good quality – only that their compensation is commensurate with the risks in the pool they are presented with. A portfolio lender, on the other hand, operating in an environment in which the government is not setting low mortgage underwriting standards, has an interest in, and the ability, to set standards that will reduce the likelihood of default. That’s why a fully private market will generally produce high-quality prime mortgages.
The Johnson-Crapo proposal does not create a fully private market. It merely appears to do so. And this is why the end result of easy mortgage money under the new system will be the same as under the pre-2008 system : a surfeit of defaults and foreclosures among homebuyers who couldn’t afford the loans they took out. The U.S. Treasury, once again, will be pressed into service as a bailout agency.
So if the Johnson-Crapo bill simply pours old wine into a new bottle, as Wallison argues, why is the Senate going through the motions? The best explanation is that Fannie Mae and Freddie Mac make for convenient public scapegoats for the mortgage collapse of 2008. On the surface, this populism is highly justifiable. Each is a huge corporation, holding or guaranteeing a combined roughly $5 trillion in mortgage assets and buying a combined 60 percent of all new home loans. Each long had been considered to be “too big to fail” prior to their takeover. Each had received large Treasury bailouts to make sure they paid bondholders. Each had built an impressive Washington lobbying operation. And each about a decade ago were embroiled in an accounting scandal through which top executives had enriched themselves. No lawmaker in either party wants to convey the appearance of siding with these companies – or hedge funds such as Perry Capital investing heavily in them.
Yet while Fannie Mae and Freddie Mac have a good deal to answer for, their pending demise is not something to be welcomed. First, they were latecomers to the easy money game; they were followers, not leaders. It wasn’t until around 2006, at least three years into the mortgage boom, when they ramped up their purchases of high-risk loans. Second, and more importantly, those purchases were driven heavily by politics outside their control. For many years, and especially since the early Nineties, these corporations were aggressively pressured by the federal government and a multiplicity of allied community and civil-rights groups to create more opportunities for affordable housing. That many “underserved” borrowers could not afford the homes they bought was apparently of little concern. Fannie Mae and Freddie Mac, as corporate behemoths, presumably could cover borrower defaults. While management should be faulted for getting caught up in the enthusiasm of the housing boom, the fact remains they were hostage to the very Washington politics that had created and maintained their GSE status.
The real problem, as I have maintained repeatedly over the past year, is the illusion that homeownership in this country is a moral entitlement, and as a corollary, that one’s inability to buy a home represents a failure of the financial system to “reach” that person. As long as there is pressure from various interest groups to force banks and GSEs to loosen their risk standards in the name of greater affordability, these lenders will be forced to engage in practices whose losses would be passed onto the public. This tendency becomes especially dangerous when accompanied by mandates to achieve racial/ethnic “diversity,” which on a practical level means raising the percentages of loans going to blacks and Hispanics and/or to neighborhoods in which they predominate. The aggressive application of this affirmative action principle to the financial sector heavily drove the eventual high default and foreclosure rates.
Congress seems bent, one way or another, on phasing Fannie Mae and Freddie Mac out of existence. What lawmakers should be doing instead is developing a plan to fully privatize these companies, putting them on an even footing with competitors and would-be competitors in the secondary mortgage market. The federal government, as it is, has its own secondary market lender, Government National Mortgage Association (“Ginnie Mae”), part of the Department of Housing and Urban Development. What exactly is the point of retaining the federal conservatorship over Fannie Mae/Freddie Mac, which are set very soon to more than satisfy its debt to the U.S. Treasury? While these corporations should not continue to receive duopoly status, neither should they be subject to continued suffocating oversight. And surely their shareholders should not have to lose any sleep about the government hijacking their profits in perpetuity. The Johnson-Crapo plan changes the form of mortgage risk management, but in the end, very little of the content.