Everyone in Washington favors “reform.” Unfortunately, the term can be highly deceptive. Such is the case of the Housing Finance Reform and Taxpayer Protection Act of 2014 (S.1217), a bill that would abolish troubled mortgage giants Fannie Mae and Freddie Mac in favor of a federally-backed private insurance system. Last Thursday, the Senate Banking Committee approved the measure by a 13-9 vote. Yet the bill, sponsored by Sens. Tim Johnson, D-S.D., and Mike Crapo, R-Idaho (in photo), may never reach the Senate floor – and not undeservedly. For the real problem with Fannie Mae and Freddie Mac, which now are profitable and have more than repaid their federal bailout debt, is not their existence; it is their subjection to tight federal control. The “new” system would retain and even expand this control, while not restoring the rights of shareholders left high and dry.
National Legal and Policy Center several times during the past year (such as here and here) has explained the precarious situation of the Washington, D.C.-based Federal National Mortgage Association (“Fannie Mae”) and the McLean, Va.-based Federal Home Loan Mortgage Corporation (“Freddie Mac”) in the context of a political culture of government bailouts. These congressionally-chartered companies, though shareholder-owned, have operated with a unique public mission: the creation of residential mortgage liquidity. At their rudimentary level, Fannie Mae and Freddie Mac, as “secondary” market mortgage providers, buy existing home loans from primary lenders, such as banks and savings & loan associations, and then either hold these loans as investments or (almost inevitably) package them into pools of marketable bonds known as “mortgage-backed securities.” Fannie Mae and Freddie Mac effectively serve as middlemen, linking housing and capital markets. Ideally, everyone benefits. Banks shed potentially unproductive long-term assets in return for quick cash and thus expand their possibilities for lending; institutional and individual bond investors receive a guaranteed steady yield; and homebuyers realize interest rate reductions of typically anywhere from 20 to 50 basis points (i.e., 0.2 to 0.5 percentage points). But the story hasn’t worked out according to script.
Congress chartered Fannie Mae and Freddie Mac as corporations, respectively, in 1968 and 1970, under heavy pressure from the real estate industry, civil-rights and affordable housing groups to promote homeownership. Maximizing opportunities to own a home, argued lawmakers, ought to be a national goal of the highest priority. As designated Government-Sponsored Enterprises (GSEs), these corporations would receive competitive advantages, such as an automatic line of credit from the U.S. Treasury and exemption from state and local taxes, unavailable to competitors. In effect, Fannie and Freddie had a mission whose importance rendered them “too big to fail.” Driven by market advantages, an aggressive approach to marketing securities, and an eventual stock offering, the firms gradually became a dominant force in mortgage finance. In 1980, the companies bought a combined 7 percent of new mortgages. Nearly 30 years later, that figure had risen to about 70 percent. Currently, the companies guarantee or hold nearly $5 trillion of the roughly $11 trillion in outstanding residential mortgage credit and back roughly 60 percent of new mortgages. This high volume, however, can’t disguise a government-induced downside that few envisioned or addressed during the go-go years.
Fannie Mae and Freddie Mac actually were latecomers to the credit expansion of the decade preceding the financial meltdown of 2008. And to the extent they matched the recklessness of primary lenders, they were adapting to the Safety and Soundness Act of 1992, which mandated that the companies do far more to facilitate home purchases on behalf of households with weak credit histories and low incomes. Increasingly, Congress, along with the Clinton and then the Bush administration, leaned on the GSEs to increase their portfolios consisting of risky mortgages – that is, loans granted to people who normally would not be approved. To guard against excessive risk-taking, the law also raised Fannie Mae/Freddie Mac minimum capital standards. Over time, however, Congress lowered the capital requirements in hopes of meeting affordability goals. This is why in 2008, when the nation’s entire financial system suddenly was in peril, Fannie Mae and Freddie Mac were in peril as well. The unthinkable – depletion of reserves and mass bond default – was now possible. Accordingly, company stock had become close to worthless.
Congress, at the urging of the Bush administration, in July 2008 responded by passing the Housing and Economic Recovery Act (HERA), which among other things, created a new Fannie Mae/Freddie Mac regulator, the Federal Housing Finance Agency (FHFA), to replace the Department of Housing and Urban Development’s Office of Federal Housing Enterprise Oversight. But it would not be enough. During the next several weeks, the companies would become even more exposed to default. Early that September, FHFA Director James Lockhart, strong encouraged by Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke, seized Fannie Mae and Freddie Mac, and placed them under emergency conservatorship. While conservatorship was not outright receivership, it still was a good deal more intrusive than standard regulation. The federal government effectively had become their shadow CEO, guiding their business decisions. Weeks later, Congress passed, and President Bush signed into law, the Troubled Asset Relief Program (TARP), which authorized a $700 billion line of credit from the U.S. Treasury Department for troubled financial institutions.
With conservatorship came a bailout. Fannie Mae and Freddie Mac, in increments, received a combined $187.5 billion in U.S. Treasury funds. This was anything but free money. In retrospect, it has proven more trouble than it was worth. As part of the deal, the companies had to transfer warrants to own 79.9 percent of common stock to the Treasury, and with no opportunity to buy back the shares later on. In addition, they had to forward all dividends on senior preferred stock to the Treasury at an unusually high 10 percent annual rate. The repayment process proceeded, if fitfully. Then, during 2011-12, less than expectedly, the housing market came back. Seeing an opportunity to hasten the collection of debt, the Treasury Department changed the rules of the game. In August 2012, it instituted a Sweep Amendment, effectively forcing Fannie Mae and Freddie Mac to give up all profits in perpetuity. Then-Acting FHFA Director Ed DeMarco, in the process of downsizing the companies’ operations, complied with the directive, which took effect last year. By the end of calendar year 2013, the corporations had paid back the government virtually all of the $187.5 billion borrowed. While the repayment of debt was necessary, one had to wonder why the government found it necessary to lock up profits. Conservatorship wasn’t intended to be permanent.
Repayment and profitability have gone hand in hand. Earlier this month Fannie Mae and Freddie Mac reported a combined net income of $9.3 billion for the First Quarter of 2014, with $5.3 billion representing Fannie Mae profits and $4 billion representing Freddie Mac profits. This was, respectively, their ninth and tenth consecutive profitable quarters. In addition, the companies plan to send a combined $10.2 billion in dividends to the Treasury this June, pushing the cumulative total of forwarded dividends to $213.1 billion. That would represent about $25 billion more than what they had borrowed. The Treasury Department and FHFA, the latter since this January under the direction of former North Carolina Congressman Melvin Watt, have indicated no intention of ending conservatorship. Fannie Mae and Freddie Mac have become prisoners of the bailout that was supposed to liberate them.
Federal officials counter that the outlook is far more problematic than recent earnings data would suggest. First, they note, most of the $9.3 in First Quarter profits – around $7.5 billion, in fact – were derived from the 2012 settlement between major banks and state attorneys general. This was the culmination of the so-called “robo-signing” scandal in which bank servicing subsidiaries had been found to process mortgage foreclosure documents in an overly hasty manner. Being a one-time phenomenon, this windfall can’t be sustained. Second, on April 30 the Federal Housing Finance Agency released its “stress tests” for Fannie Mae and Freddie Mac; these tests project profits and/or losses under various scenarios. In its worst-case scenario, the FHFA reported, the GSEs sustained a combined long-term loss of $190 billion. Yet that hardly means Fannie Mae and Freddie Mac will need a $190 billion bailout. This scenario assumes a housing and general economic collapse at least as bad as the one of 2008-09. The federal government conceivably could justify hijacking profits as long as collapse has even the tiniest possibility of materializing. But is this risk assessment realistic? Fannie Mae CEO Timothy Mayopoulos, for one, doesn’t think so. “We expect our annual earnings to remain strong over the next few years but substantially lower than what we experienced in 2013,” he stated.
Whatever their future earnings, shareholders of Fannie Mae and Freddie Mac stock aren’t likely to see a dime. Many have made their displeasure known via the legal system, something discussed at length by NLPC a few months ago. Last July, a New York-based hedge fund, Perry Capital LLC, acting on behalf of shareholders, filed suit in District of Columbia federal court against Treasury Secretary Jack Lew alleging that the sweep rule amounts to an unconstitutional taking. The suit also accused FHFA of reneging on the terms of its conservatorship by not challenging the Treasury Department’s decision to impose the amendment. Though seeking no monetary damages, the plaintiffs, represented by Bush-era Solicitor General Ted Olson, are requesting that the government abide by the authority granted to it under the 2008 HERA law. In another case, Fairholme Funds Inc. v. U.S., shareholder-plaintiffs are seeking monetary damages. In all, there have been more than a dozen investor lawsuits. The Obama administration counters that the companies might not be around without the bailout and that the economy could be jeopardized by placing an increasing portion of housing assets under the control of hedge funds. Those are weak arguments in the face of legalized theft from shareholders.
One would think that any Fannie Mae/Freddie Mac-related reform legislation would focus on lifting the suffocating federal control of the two companies, thus allowing them to operate on their own and allowing shareholders to realize dividends. Unfortunately, the recent Senate reform proposal, the Housing Finance Reform and Taxpayer Protection Act of 2014 (S.1217), goes mainly in the opposite direction. Rather than end the conservatorship of Fannie Mae and Freddie Mac, the bill, introduced in March by Sens. Tim Johnson, D-S.D., and Mike Crapo, R-Idaho, respectively, the chairman and ranking minority member of the Senate Banking Committee, would end Fannie Mae and Freddie Mac altogether, phasing them out over a five-year period. A prototype Senate bill unveiled last June by Sens. Bob Corker, R-Tenn., and Mark Warner, D-Va., likewise mandates a five-year liquidation period. A House bill unveiled last July by Rep. Jeb Hensarling, R-Tex., the Protecting American Taxpayers and Homeowners (PATH) Act (H.R. 2767), also would abolish the companies, though thankfully with less possibility of a public subsidy. The House Financial Services Committee passed the measure last July, but the full House has taken no action since.
The Johnson-Crapo measure, heavily based on the Corker-Warner bill, is the most significant of the reform bills. Last Thursday, the Senate Banking, Housing and Urban Affairs Committee passed the measure by 13-9, with seven Republicans and six Democrats voting in favor. Like Corker-Warner, the bipartisan bill would replace Fannie Mae and Freddie Mac with a new entity, Federal Mortgage Insurance Corporation (FMIC). And like Corker-Warner, it would create a new financing system whereby private companies would insure the first 10 percent of all losses on mortgage-backed securities, and FMIC would cover all losses beyond that. It also would reorganize FHFA as part of FMIC, unlike Corker-Warner, which would have FMIC replace FHFA.
Yet despite Banking Committee passage, the Johnson-Crapo bill might not make it to the full Senate floor. One observer, Isaac Boltansky, an analyst with Compass Point Research and Trading, a Washington, D.C.-based investment firm, puts it this way: “We doubt that there is either the legislative capacity or the political willingness to address [Fannie and Freddie] reform further in this Congress.” He predicted that GSE reform, if it happens at all, won’t occur until 2017. It’s noteworthy that Tim Johnson, the Democratic chief sponsor, is retiring at the end of this year when his term expires.
Opposition to this centrist measure is coming from both the Right and Left. Opponents on the Right, led by Sen. Richard Shelby, R-Ala., say the measure is too complex and would continue to expose taxpayers to financial failure. “Unfortunately, we’ve had decades of government intervention that, ironically, did not even deliver on its main goal of providing sustainable home ownership for millions,” said Shelby. “We’ve seen what happens when government becomes too entrenched in housing and the system becomes too complicated even for regulators to oversee.” And should the Senate pass the measure, it would have an even tougher time in the GOP-majority House. Rep. Hensarling, for one, doesn’t like the Johnson-Crapo bill. Last Thursday he explained: “While there are several commonsense provisions in the Senate bill that are similar to those we included in the [House] bill, the Senate bill features a controversial and irresponsible new politicization of mortgage credit insisted by Senate Democrats under the guise of affordable housing. This wealth redistribution scheme, far worse than that of the current system, would be a multibillion-dollar annual invitation to return to the lower credit standards, higher risks and unsustainable lending that created the crisis in the first place.”
Yet six Democrats on the Banking Committee, among the most liberal members of Congress, also oppose the bill. These lawmakers – Charles Schumer (N.Y.), Elizabeth Warren (Mass.), Sherrod Brown (Ohio), Jack Reed (R.I.), Robert Menendez (N.J.), and Jeff Merkley (Ore.) – have banded together to declare that the measure doesn’t do nearly enough to promote affordable housing for lower-income households and that it engages in overkill. On the first point, at least, these lawmakers are way off the mark. The increasingly stringent affordable housing mandates placed upon Fannie Mae/Freddie Mac were a major factor in causing these companies to become undercapitalized in the first place. The six Democrats have not been assuaged by compromises made by supporters, such as allowing first-time buyers to make down payments as low as 3.5 percent. Sen. Brown epitomized the self-contradictory nature of the Left-populist position when he remarked recently: “It’s essential we do not create a flawed system by turning over Fannie and Freddie’s business to Wall Street.” Somebody wake this man up. Fannie Mae and Freddie Mac for decades have been selling their mortgages to Wall Street; that’s pretty much why they exist. Though the Obama White House strongly supports the Johnson-Crapo bill, Senate Majority Leader Harry Reid, D-Nev., has indicated that he isn’t likely to mobilize a floor vote unless the Left dissenters come around as well.
Yet the right course of action, even if undertaken for the wrong set of reasons, is still right from a strategic standpoint. There are indeed some sound and interrelated reasons why the Johnson-Crapo legislation, like the Corker-Warner bill it supersedes, should be opposed.
First, and most importantly, the new system would continue to socialize the risks of mortgage default and foreclosure, creating a new twist on the phrase, “old wine in a new bottle.” The Senate legislation creates a new entity, Federal Mortgage Insurance Corporation, to supervise a massive risk-sharing program. Under the proposed system, mortgage originators would underwrite mortgages for homebuyers and sell eligible loans to secondary market “aggregators,” which could include banks. The aggregators then would pool the mortgages and obtain insurance from a private-sector company. Then they would transfer the mortgages to a “securitization platform” through which securities would be issued to investors and guaranteed against loss. FMIC would cover guarantor losses beyond the first 10 percent.
It’s an innovative approach. But is it a better one? Like its Corker-Warner predecessor, the Johnson-Crapo bill would create a system heavily subject to political capture by interest groups, from builders to realtors to community organizations. These groups are not impartial observers. It is in their interest to maximize homebuying opportunities, and without regard for banking safety and soundness. And given the higher risks of default on mortgage bonds representing purchases by uncreditworthy borrowers, Congress and/or the administration will pressure the new FMIC into providing waivers to insurers from the 10 percent loss-sharing rule. The likely eventual result, as American Enterprise Institute Senior Fellow Peter Wallison argues, will be an explosion of unsustainable debt requiring an eventual infusion of public aid to cover FMIC losses – in other words, a situation similar to that of 2008.
It’s highly significant that the principal author of the Senate legislation, Senator Corker staffer Michael Bright, worked as a mortgage derivatives trader for Countrywide Financial and then Wachovia Bank during the years preceding the financial collapse. Republican political operative Tim Pagliara says of Bright: “[Bright’s] running the show. And Corker listens to him.” Given Bright’s track record, maybe the senator shouldn’t. Countrywide and Wachovia each lent recklessly during the mortgage run-up of the last decade and wound up insolvent. Countrywide was bought out by Bank of America in 2008 for $4 billion in stock. The Securities & Exchange Commission the following year charged Countrywide CEO Angelo Mozilo with insider trading and securities fraud; Mozilo eventually settled with the SEC in October 2010, agreeing to pay $67 million in fines ($20 million of which would be paid by his company) and permanently refrain from any official activity with a public company. The Charlotte-based Wachovia, meanwhile, was taken over by Wells Fargo, also in 2008. Michael Bright, effectively a banking industry lobbyist, is not the kind of person one would call upon to craft a reform bill.
Second, the Federal Mortgage Insurance Corporation will be more than a backstop for private-sector MBS losses. It would be a turbo-charged regulator. FMIC would be even more coercive than its predecessor, giving FMIC broad, sweeping powers. The corporation, in the words of the Senate Banking Committee, would act as “a strong regulator with supervision and examination powers” and would have “the authority to take enforcement actions against approved guarantors, aggregators, and [private mortgage insurers].” The specifics suggest these are hardly empty words.
Section 302(4)(A)(ii) of the Johnson-Crapo bill, for example, would grant FMIC the authority to approve risk-sharing mechanisms that “do not represent the first-loss provision with respect to single-family covered securities.” And Section 306 would give the agency the power “to prescribe, repeal, and amend or modify rules, regulations, or requirements governing the manner in which its general business may be conducted.” The legislation would grant FMIC enormous discretion in determining who participates in mortgage securities trading and what their capital standards would be. And it contains language that could trigger a rapid expansion of loans to borrowers who can’t afford to buy at a given price. Section 201 of the bill requires FMIC to ensure “fair access to financial services” and to facilitate “broad availability of mortgage credit” to all eligible borrowers. In practice, that will be a euphemism for maximizing outreach to lower-income borrowers and especially nonwhite minorities. That the Johnson-Crapo bill would have FMIC absorb the Federal Housing Finance Agency, rather than repeal it, is a bad sign. It would assure the transformation of FHFA, presumably set up to supervise a temporary conservatorship, into an aggressive promoter of easy mortgage credit. Current FHFA Director Melvin Watt would relish such a role.
Third, the Johnson-Crapo bill does nothing to make whole the shareholders of Fannie Mae and Freddie Mac stock who at present have been permanently deprived of dividends. The original version of the plan did not address whether investors would be compensated, once the firms were dissolved. The latest version is an improvement. The Senate Banking Committee adopted an amendment that would ensure that the bill did not supersede any court rulings in the shareholder cases. This is all to the good, assuming the courts rule in favor of the shareholders. But suppose they don’t. A defeat for the shareholders would represent a major blow not just to them, but to property rights generally in this country. Congress should proactively guard shareholder interests and not simply go along with this or that court ruling.
Whether or not the Senate reform plan represents an improvement over the current set of arrangements is secondary to the fact that each implicitly accepts the unspoken, and erroneous, assumptions that: 1) everyone has a right to become a homeowner; and 2) the federal government has an obligation to facilitate this outcome. The Johnson-Crapo bill, despite purporting to be a fresh start, would promote easy credit, even if unintended. The truth is, as the last half-dozen years has shown, not everyone is meant to own a home. And if they are, they shouldn’t be buying homes well out of their price range. Why is it necessary to compromise standards of risk assessment and underwriting for the sake of boosting the national homeownership rate by several percentage points and the real estate portion of the GDP? In the end, the public, whether as investors or taxpayers, will be exposed to high losses.
There is a broad economic argument as well. Shifting resources into housing from other sectors of the economy has natural limits. Then-Treasury Secretary Timothy Geithner, in a February 2011 speech before the Brookings Institution, made this point: “I think it’s absolutely the case that the U.S. government provided too much support for housing, too strong incentives for investment in housing. We just took that too far.” Edward Pinto, who served as Fannie Mae’s chief credit officer during the late Eighties, likewise wrote in a blog about the Johnson-Crapo plan for the American Enterprise Institute: “The pro-cyclical Johnson-Crapo plan would increase the wrong kind of debt for our economy – debt that bids up existing housing assets and the price of land they sit on, creating a temporary wealth effect and a crowding out of private capital management that is much needed for a productive economy and increased job growth.”
FHFA Director Mel Watt, who took over from longtime Acting Director Edward DeMarco this past January, unfortunately, does not appear to be of this view. In a speech a week ago, fittingly held at Brookings, Watt stated, contra Geithner, that he will do everything he can to keep Fannie Mae/Freddie Mac intact and to prevent any reduction of their “footprint” upon the housing market. Toward that end, he would rescind the reduction of the Fannie Mae/Freddie Mac maximum (“conforming”) loan limit advocated by DeMarco and maintain “foreclosure prevention activities and credit availability for new and refinanced mortgages.” But problem with Fannie Mae and Freddie Mac is not a lack of activity; it’s a lack of proper focus. These corporations shouldn’t be encouraging banks to aggressively increase mortgage lending to marginally qualified or (worse) outright unqualified borrowers. The Johnson-Crapo bill would eliminate the Fannie Mae/Freddie Mac brand names, but not their problems. Watt, like the six dissenters on the Senate Banking Committee, would restore the secondary mortgage market mission to that of its pre-2008 period, raising the possibility of a repeat performance of 2008.
Congress should allow Fannie Mae and Freddie Mac to continue as mortgage middlemen, but without the “Government Sponsored Enterprise” status and implied “too big to fail” backing. The firms have been profitable these past few years. There is no reason to abolish them. On the other hand, there is no reason to expand their “footprint” to levels that contributed to the collapse. The problem is not the existence of these two companies; it is their official duopoly status. The Senate bills, not to mention Rep. Hensarling’s House bill, restructure the mortgage securities industry but without addressing the core problem. Lawmakers would do better to retain Fannie Mae and Freddie Mac, and put them on a path to privatization where they would operate relatively free from political pressure.