What to do with Fannie and Freddie?
Was it really scarcely more than a decade ago that the United States was suffering under one of the worst housing crises in its 230-year history? It would be hard to see any evidence of this in the current real estate environment. Both single-family and multifamily real estate seem rock-solid, pillars of strength and stability buoying the entire real estate sector. Much of the credit for this resurgence must be given to two quasi-governmental agencies—Fannie Mae and Freddie Mac—which have channeled a virtual flood of capital into the surging residential real estate market. It’s odd to think that these two giant mortgage finance companies nearly collapsed amid the financial crisis and had to be bailed out at a total cost to taxpayers of $187 billion. In fact, under the terms of the 2008 conservatorship, these firms were given access to more than $250 billion. However, they have drawn on that support only once since 2012. So, by most accounts, the Obama-era bailout of these two entities was an unqualified success. Now, everything is set to change once again.
In September, the Trump administration proposed a new plan to re-privatize these two Federal mortgage agencies. Their proposed plan would reverse one of the first actions taken in order to address the great economic crisis of 2008. To be clear, the nationalization of these entities was never envisioned to be a permanent solution. It was only intended as a temporary measure. Yet, back in 2008, nobody stopped to consider how all of this would eventually be undone. So, eleven years later, Fannie Mae and Freddie Mac are still operating under the conservatorship of the United States government.
Treasury Secretary Steve Mnuchin’s plan seeks to take Fannie and Freddie out of public control while (hopefully) minimizing disruption to the mortgage market. It does not, however, close the door on future Federal bailouts. Granted, Mnuchin’s plan is certainly not the only one currently being discussed, but virtually all of the serious contenders leave the back door open for another Federal bailout in the future, if necessary. So, that raises the question of why bother to go through re-privatization at all if the goal is mostly to just keep things the same? But any modification of the status-quo would certainly have enormous ramifications for lenders and borrowers alike. If everything is working so well, why not just leave things as they are?
Where it All Began
Well, to fully understand what is being proposed, one needs to understand how all of this got started in the first place. And, to do that, we need to go back in time; all the way back to the Great Depression and the New Deal era that followed after it. Prior to that point in time, home loans were difficult to come by, and they were almost always short-term in nature. When these short-term loans came due, they normally required a large balloon payment. However, if the homeowner couldn't make this payment, or couldn’t refinance the debt elsewhere, the bank would foreclose. During the Great Depression, roughly 25% of the nation's homeowners lost their homes in this way.
In response to this urgent crisis, President Franklin D. Roosevelt and the United States Congress created legislation that was designed to encourage and enable home ownership, specifically including creation of the Federal National Mortgage Association (also known as “Fannie Mae” or “FNMA”). The idea behind the formation of this new entity was that FNMA could provide low-cost financing for residential real estate with funding through a relatively new concept known as “mortgage securitization.”
This novel funding mechanism was intended to encourage banks to issue more mortgages by minimizing the risks that they would assume in issuing loans for homes and apartment buildings. FNMA would borrow money to buy these mortgages from banks (and other non-bank lenders) and package them up to sell them off again as mortgage-backed securities. Since FNMA was a governmental agency, it could borrow money for its purchase of these mortgages at very low rates, and the benefit of these low rates was then passed on to consumers. On the other hand, community banks and regional lenders were able to trade in their local real estate loans—with their localized risk profiles—for a geographically-diversified pool of debt instruments. The result? Americans were suddenly able to borrow long-term money at attractive rates and terms, and the housing market flourished as a result.
Flash forward thirty years. In the Housing and Urban Development Act of 1968, President Lyndon Johnson transformed Fannie Mae from a government entity into a private company which raised capital through the sale of stock. Then, two years later, Congress created a new competitor for Fannie Mae known as the Federal Home Loan Mortgage Corporation (referred to as “Freddie Mac” or “FHLMC”) which, essentially, did the same thing.
Over time, these entities became known as “government-sponsored enterprises” (GSEs). Even though these were now for-profit corporations, financial markets found assurance in the fact that they still operated as if they were part of the federal government and, consequently, they were rewarded with interest rates on their borrowings that resembled the rates paid on federal government debt.
The 2008 Housing Crisis
Everything went along relatively smoothly until the housing boom of the mid-2000s, when lenders became greedy, lowered their underwriting standards, and offered home loans to borrowers with poor credit. In 2007, the housing bubble burst and hundreds of thousands of these borrowers went into default, which led to what was known as the subprime meltdown. This sent the financial markets into a tailspin and left Fannie and Freddie holding the bag for the nationwide housing crisis.
So, in 2008, a bailout plan was concocted. Congress authorized the Federal government to take Fannie and Freddie back “under conservatorship”. Under this arrangement, the government gave Fannie and Freddie access to that $250 billion so that they could keep paying their financial obligations and the nation’s home mortgage finance construct could continue operating. Unlike TARP (the Troubled Asset Relief Program), which was essentially a bailout for the shareholders of troubled banks (click here for an opposing viewpoint), Federal conservatorship of the GSEs was harsh. Although the shareholders of both entities were allowed (at least in theory) to retain their shares, government regulators now called the shots and the value of those shares plummeted. Nobody thought this was an especially great arrangement, but it was considered necessary at the time.
Since then, lawmakers have debated endlessly about what to do with these two quasi-governmental agencies. As could have been expected, this discussion quickly turned into an ideological dispute and resulted in decidedly partisan positions on the matter.
The Current Status-Quo
Then, a surprising thing happened. Somewhere along the way, Fannie and Freddie started to become profitable again. In their 2012 response to this development, the Obama administration declared that all Fannie and Freddie profits would be “swept” into the main Treasury account, leaving only meager cash on the GSEs’ books. (By “meager,” they meant something on the order of $3 billion each).
Around this same time, a small group of hedge fund managers came up with an idea they liked even better. They bought up tons of the nearly worthless shares in the GSE companies and began promoting a solution they called “recap and release.” In other words, they wanted the Treasury to stop sweeping up profits and, instead, let the money remain in the agencies’ coffers. That would allow them to build up a large enough cash buffer to operate as viable businesses and, in this way, “recapitalize” themselves, at which point the government could simply “release” them from conservatorship. Not surprisingly, that would also create a huge financial windfall for the hedge funds that had bought all of that worthless stock.
The Obama administration fought this idea vehemently, which is one reason why two of the main hedge fund managers behind “recap and release”, John Paulson and Steve Schwarzman, became solid Trump supporters. But liberals chafed at the idea of giving these investors such a huge windfall and conservatives didn’t like the “release” part of “recap and release” since it would simply set the country up to revisit the boom-bust-bailout cycle all over again.
So, this topic continued to fester until the Treasury Department released last month’s proposal. The new Treasury plan sidesteps the question of what happens to the existing Fannie and Freddie shareholders. Instead, it just mandates that the entities should be privatized through some unspecified mechanism, (although it is difficult to see how such recapitalization would result in anything but a boon for the existing shareholders). But rather than continuing the implied government guarantee of the agencies’ obligations, Mnuchin’s plan does the opposite. It calls for an explicit ongoing government guarantee of this entity’s obligations that would be structured like a kind of insurance policy similar to the guarantees provided by the FDIC, which has been insuring bank deposits since 1933. Fannie Mae and Freddie Mac would both pay an annual premium for this insurance and, in exchange, their loans would be guaranteed by the federal government. Shareholders, on the other hand, would—in horse racing parlance—win a perfecta. The share prices of these GSEs would soar, while Paulson, Schwarzman and the other hedge fund managers would now own stock in a company that essentially couldn’t go bankrupt.
On the surface, this plan seems to provide what many politicians have said that they want—the affordable 30-year mortgages that only government support can provide—but without leaving the federal government at the helm of the housing finance system. On the other hand, it’s unclear how this system is any improvement over having these companies be public entities (that is, for anyone other than the existing shareholders).
What Happens Next?
You can see how this tenuous stand-off has now become a powder keg. The battle lines are sharply drawn, with Treasury Secretary Mnuchin, HUD Secretary Ben Carson, and Federal Housing Finance Agency (FHFA) Director Mark Calabria all promoting the proposal before the Senate Banking Committee. This panel has been the incubator and battleground for several previous failed attempts to free Fannie and Freddie from federal control, including a 2014 bill from the panel’s own former chairman, now-retired Sen. Tim Johnson (D-S.D.), and Sen. Mike Crapo (R-Idaho), who is the committee’s current chairman. The Johnson-Crapo bill was actually approved by the banking panel with a slim bipartisan margin, but it died in the full Senate under fire from both progressives and conservatives. Sen. Elizabeth Warren (D-Mass.), then an emerging progressive force and now a 2020 presidential candidate, helped to rally Senate liberals against the bill, effectively dooming it in the then-Democrat-controlled Senate. Since then, the issue has only become even more politically charged. Housing policy has been a central focus of several 2020 Democratic presidential campaigns, including Warren’s, who has already excoriated the Trump administration plan.
At the heart of Mnuchin’s proposal is the governmental guarantee of Fannie Mae and Freddie Mac obligations, and this clearly requires an act of Congress. To even get that far would require bi-partisan legislation from the Democrat-controlled House of Representatives, and approval would require 60 votes in the Republican-controlled Senate. That is all highly unlikely to happen in the vastly polarized State of the Union leading up to the 2020 elections. Yet the Trump administration is adamantly pushing for action on their ambitious, if open-ended, plan for housing finance reform.
For now, there’s no sign that the Treasury has engaged with House Democrats on any of these issues (or any issues at all, for that matter), which makes any path forward very hard to see. In the meantime, refusing to be constrained by convention (or the Constitution), Trump-appointed regulators have promised to act even if Congress doesn’t. Any such end-run on the President’s part would certainly set the media afire yet again and likely find its way to the dais in the upcoming Presidential debates.
In the meantime, both Freddie and Fannie have curtailed their activities in the securitization market considerably, the once-surging housing market has begun to cool, and everyone is left wondering what, if anything, is going to happen to Franklin Roosevelt’s wonderful invention.
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