As a Democratic North Carolina congressman, Melvin Watt had a hand in creating the mortgage meltdown. Now he’s the new head of an agency charged with helping to reverse the meltdown. Irony is well and alive in Washington, D.C. Yesterday former Rep. Watt (in photo) was sworn in to a five-year term as director of the Federal Housing Finance Agency (FHFA), created in 2008 to oversee Fannie Mae and Freddie Mac. These two companies now hold or guarantee roughly $5 trillion in assets. The Democratic-majority Senate had confirmed Watt on December 10 by 57-41 following a failed effort in October to block a Republican filibuster. The approval followed a Senate vote on November 21 to lower the bar for invoking cloture (i.e., breaking a filibuster) on most presidential nominations from 60 votes to a simple majority.
To understand why Mel Watt is the wrong man to head FHFA, it would be helpful to review once more the sequence of events described by NLPC that led to his nomination. For the condition of Fannie Mae and Freddie Mac, which required an infusion of Treasury funds totaling nearly $190 billion, must be placed in the context of an unsustainable and federally-driven credit expansion. The roots of the problem lay in increasingly stringent government mandates to lower mortgage lending standards in hopes of expanding homeownership opportunities. Initially spurred by the housing reauthorization legislation of 1992, Congress and various regulatory agencies pressured mortgage lenders into devoting larger portions of their portfolios to high-risk loans; i.e., loans far more likely than normal to result in default and foreclosure. A network of nonprofit community and “civil rights” groups drove much of this pressure. Banks and other lenders, went the argument, were starving low- and moderate income households of mortgage loans, especially if these households were black or Hispanic. As a long-term strategy, this campaign was highly ill-advised, yet lucrative investment opportunities beckoned for the time being.
This is where the Washington, D.C.-based Federal National Mortgage Association (“Fannie Mae”) and the McLean, Va.-based Federal Home Loan Mortgage Corporation (“Freddie Mac”), came in. Fannie Mae and Freddie Mac, chartered by Congress as for-profit Government-Sponsored Enterprises (GSE), respectively, in 1968 and 1970, are secondary mortgage lenders. As such, they don’t make home loans, but rather buy them from primary lenders such as banks and savings & loan associations. After purchase, the companies either hold the mortgages as assets or (much more commonly) bundle them for sale to investors in the form of bonds known as “mortgage-backed securities.” The purpose of all this is to expand market liquidity. In theory, it’s a win-win-win situation. Primary lenders gain an infusion of cash with which to underwrite loans over broader geographic territory. Institutional investors, such as banks, pension funds and equity funds, gain access to a high-yield income stream. And home mortgage borrowers realize a reduction of about 20 to 50 basis points (i.e., pay interest rates that are 0.2 to 0.5 percentage points less than what they normally would pay).
Fannie Mae and Freddie Mac in effect perform a “middleman” function, expanding and smoothing flows of capital between Main Street and Wall Street. And though they are for-profit shareholder-owned corporations, they operate with a special public mission that renders them “too big to fail.” They constitute a federally-created duopoly, enjoying advantages unavailable to would-be competitors. Such advantages included access to emergency U.S. Treasury credit and exemption from state and local taxes. GSE status drove decades of high growth. In 1980, GSE purchases accounted for only 7 percent of new mortgage originations. Within 30 years that share had risen to 70 percent. At present, Fannie Mae and Freddie Mac hold or guarantee a combined nearly $5 trillion in assets. This is a sum representing close to half of all outstanding residential mortgage debt in the U.S.
“Too big to fail,” however, also means too big to succeed – at least on one’s own terms. From the very start, Fannie Mae (which actually began as a federal agency back in 1938) and Freddie Mac have been tethered to the politics of housing finance. This has rendered them virtual adjuncts of the federal government. And herein lay their downfall. Beginning in the early Nineties, Congress, along with the Clinton and the Bush administrations, leaned hard on Fannie Mae and Freddie Mac to increase their purchases of loans to marginally qualified borrowers. The risk of this strategy presumably would be absorbed by securitization. During the last decade, the ingredients for a train wreck were coming together: an unprecedented house price bubble; easy mortgage terms for barely qualified borrowers; and exposure of world financial markets to risky mortgage bonds. During 2007, and accelerating rapidly in 2008, the edifice came crashing down. Hundreds of banks failed or were close to doing so. Prices in markets throughout the U.S., especially in Western states, were dropping precipitously. The proportion of mortgages in foreclosure and/or “underwater” (i.e., debt exceeds market value) rose to historic highs. The Bear Stearns, Merrill Lynch and Lehman Brothers investment houses either filed for bankruptcy or agreed to be sold. And Fannie Mae and Freddie Mac now were in danger of being unable to satisfy bondholder claims worth hundreds of billions, and possibly trillions, of dollars. America had a full-fledged crisis.
In response, Congress in July 2008 passed the Housing and Economic Recovery Act, which President Bush quickly signed into law. This emergency measure, among other things, created an independent agency, the Federal Housing Finance Agency, to regulate Fannie Mae and Freddie Mac. FHFA would replace the firms’ existing regulator, the Office of Federal Housing Enterprise Oversight (OFHEO), part of the U.S. Department of Housing and Urban Development. But the engine for collapse already was in motion. Early that September, FHFA Director James Lockhart, with the full support of Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, seized Fannie Mae and Freddie Mac, placing them under emergency conservatorship. Weeks later, Congress passed and President Bush signed into law the Troubled Asset Relief Program (TARP), which enabled banks and other financial institutions to tap into a $700 billion pot of U.S. Treasury aid. Much of our financial system effectively was being nationalized.
The Federal Housing Finance Agency, as conservator, now found itself the guardian and trustee of Fannie Mae/Freddie Mac finances. While conservatorship is not outright nationalization, it is much more intrusive than mere regulation. OFHEO Director James Lockhart became head of FHFA, serving until the summer of 2009, when he took a job at a private equity fund in New York. Lockhart’s replacement was Edward DeMarco, FHFA’s chief operating officer. A trained economist and career civil servant, DeMarco would become a lighting rod of controversy – and for the wrong reasons. He understood, as did few of his critics, that FHFA is a temporary agency and shouldn’t play favorites.
DeMarco had a limited hand with which to play. Fannie Mae and Freddie Mac had received Treasury aid in increments totaling $187.5 billion, but it was a bailout with heavy strings attached. The companies had to hand over senior preferred stock and warrants totaling 79.9 percent of equity, with no opportunity to buy back shares in the future. And they had to forward to the Treasury all future dividends on government shares, set at 10 percent, a rule superseded in August 2012 by the “sweep amendment,” which forced each company to give up all profits. This move amounted to a virtual receivership. DeMarco imposed restrictions on their operations which were designed to downsize operations and reduce debt. These measures, combined a strong rebound in the housing market these past couple years, have enabled Fannie Mae and Freddie Mac to achieve profitability and generate dividends. Indeed, at the end of Third Quarter 2013 they had forwarded $146 billion in dividends and vowed to send another $39 billion in December. The GSEs at that point had paid back the federal government almost in full.
Critics of DeMarco and the FHFA, however, were anything but impressed. Many had expressed outrage in 2012 when he resisted calls to forgive outstanding loan balances on behalf of about a half-million homeowners facing foreclosure with new funds for Fannie Mae and Freddie Mac. Such assistance, DeMarco countered, would give homeowners, whether or not distressed, every incentive to skip or delay future payments. Moreover, he said, it would escalate bailout costs and undermine investor confidence. Such objections mattered little to Senators Barbara Boxer, D-Calif., and Elizabeth Warren, D-Mass., each of whom openly demanded his replacement. California Attorney General Kamala Harris likewise called for his removal. Radical activist organizations held up DeMarco as a public enemy. One of these groups, Change.org, launched an online petition in March 2012 to remove him. Another group, the New Bottom Line, included a “Dump DeMarco” section on its website. Edward DeMarco, claimed the group, is “the biggest obstacle to serious economic recovery.” Lost amid this feeding frenzy was the fact that DeMarco, far from serving as a “heartless” front man for Wall Street, was looking out for the public. “Mortgage-backed securities are critical elements in the investment of our retired citizens that have bond portfolios and are relying on that as a source of income,” he noted in the fall of 2012. “We’re thinking, ‘This isn’t some huge hedge fund that’s at risk here. This is citizens across the country.’”
Pressure was mounting on President Obama to replace DeMarco, who had yet to receive formal approval from Congress; his title all the while had been “Acting Director.” Despite DeMarco’s effectiveness, Obama was not in a position to ignore his base. He went about finding a replacement. As early as late 2010, in fact, the president had nominated North Carolina Banking Commissioner Joseph Smith to become permanent director. But Smith, after receiving approval by the Senate Banking Committee, faced a GOP filibuster; he wound up withdrawing his name in January 2011. The “Dump DeMarco” movement rising over the next couple years to a fever pitch, President Obama eventually named another North Carolinian for the position: Rep. Mel Watt, a close ally of the president who helped secure his native Charlotte as the site of the Democratic Party national convention in 2012.
Melvin Watt, now 68, a black, combines financial acumen and racial grievance. A graduate of the University of North Carolina and Yale Law School, he practiced law, with a specialty in minority economic development, before entering politics. He first was elected to Congress in 1992, largely due to post-Census gerrymandering designed to achieve a black majority district in North Carolina. And he plays to his racial audience. In October 2005, for example, at a hearing held by the National Commission on the Voting Rights Act, he declared: “There would be a substantial majority of white voters who would say that under no circumstances would they vote for an African-American candidate.” Such voters, he said, “need to be factored out of the equation” because “I’ve got no use for them.” Yet Watt also knew how to schmooze with the financial community to coax campaign donations, receiving more than $365,000 in contributions from commercial banks alone. In return, as a member of the House Financial Services Committee, he helped pave the way for repeal by Congress in 1999 of the Glass-Steagall Act, a Depression-era law that separated banking from investment. More recently, Watt held receptions at his home for lobbyists just before key votes on the Dodd-Frank bank reform legislation, an activity that for a while attracted the attention of Office of Congressional Ethics.
President Obama, undeterred, nominated Congressman Watt for FHFA director last May 1, praising him: “Mel has led efforts to rein in unscrupulous mortgage lenders. He’s helped protect consumers from the kind of reckless risk-taking that led to the financial crisis in the first place. And he’s fought to give more Americans in low-income neighborhoods access to affordable housing.” More accurately, this “reckless risk-taking” was heavily driven by community and civil-rights groups demanding that the government apply the affirmative action principle to primary and secondary mortgage lending. Congress and successive administrations were all too eager to oblige these demands. Much so-called “predatory lending” is the result of the establishment of goals and timetables to increase loan volumes to “underserved” populations.
Melvin Watt long has been tight with these activists. In other words, he is about the last person to head a federal agency overseeing trillions of dollars in assets. His view of FHFA is less a temporary overseer than a permanent conduit for economic redistribution. Republicans in the Senate, at least, harbored doubts. Following Senate Banking Committee approval, the full Senate last October 31 voted by a 57-41 margin to invoke cloture (i.e., close debate) over Watt’s nomination. That was a majority, but it was three votes shy of the necessary 60 votes. The president, though disappointed, vowed to resubmit Watt’s name. He made good on that promise. And this time he would get help from Senate Majority Leader Harry Reid.
Senator Reid, a master of the underhanded parliamentary maneuver, had seen too many Obama nominees rejected or dropped for his liking. The recent filibuster of Patricia Millet, a nominee for the U.S. Court of Appeals for the District of Columbia Circuit, irritated him to no end. Convinced that the longstanding three-fifths bar to break a filibuster was set too high, Reid sought to reduce it to a simple majority. Soon enough, Democratic leadership brought this proposed “nuclear option” to a full-floor vote. On November 21, the Senate voted 52-48 to require only a simple majority to invoke cloture on all presidential nominations other than those for the U.S. Supreme Court. Republicans, led by Minority Leader Mitch McConnell, pointed to a Senate rule requiring a two-thirds vote for all rule changes; McConnell called the rule change a “power grab” that defied two centuries of tradition. Democrats countered the Constitution allows the Senate to change its rules at any time. Legal or not, the Democrat-driven rule change left opponents of the Watt nomination outgunned. The Senate in short order voted for cloture and then, on December 10, voted 57-41 to approve Watt; during that time, senators also approved a number of judicial appointees whose nominations had been in limbo. Rep. Watt was in South Africa attending the funeral of Nelson Mandela at the time of his own roll call vote. He resigned his congressional seat only hours before yesterday’s swearing-in ceremony.
Republican opponents of Watt’s nomination preferred to avoid any hint of a racial angle. They focused instead on formal qualifications. But they were playing a weak hand. As a lawyer and a longtime member of the House Financial Services Committee, Watt long ago had won the confidence of his peers. The problem with Watt as FHFA director, as I explained in November, was not his lack of expertise; it was his lack of understanding of, and abundance of contempt for, the agency’s mission. If the GOP was looking for expertise, they already had that in Edward DeMarco. Indeed, one strains to find any practical reason beyond partisan politics why DeMarco should have been denied a full-term appointment. Now Mel Watt occupies that office. And he is almost certain to pressure Fannie Mae and Freddie Mac to dramatically boost loan purchases in black and Hispanic neighborhoods and provide forbearance for homeowners across the country facing foreclosure. In other words, he is likely to do the very sorts of things that created the mortgage collapse in the first place.
Congress continues to view Fannie Mae and Freddie Mac reform through the lens of the need for more efficient organization. Sens. Bob Corker, R-Tenn. and Mark Warner, D-Va., this past June introduced legislation that would replace these companies with an insurance-based system requiring investors to absorb the first 10 percent of any losses. Rep. Jeb Hensarling, R-Tex., in July sponsored an alternative bill that also would liquidate the companies, but with less taxpayer exposure. Former FDIC Chairwoman Sheila Bair, in a guest column a couple months ago for Fortune magazine, argued that abolishing Fannie Mae and Freddie Mac is an idea whose time has come.
All this amounts to symbolic action. The problem is not the continued existence of Fannie Mae and Freddie Mac. It is their official duopoly status. The federal government long had protected this status. And since September 2008, it has exploited it, leaving hapless shareholders in the cold. Once too big to fail, Fannie Mae and Freddie Mac are now too controlled to succeed. This situation must change. When they become fully solvent, these companies should be allowed to operate, only this time as unsubsidized for-profit enterprises. What should be discarded are the related assumptions that: 1) owning a home is a basic American right; and 2) mortgage underwriting and purchase standards should be lowered for blacks and other nonwhites. Publicly challenging these assumptions can be fatal to one’s career. Melvin Watt is not one to rock this boat.