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Risk Doctor

If Congress Won't End GSE Conservatorship Soon, FHFA Can

Last week, a D.C. District Court Judge struck down a lawsuit brought by shareholders in Fannie Mae and Freddie Mac who had been seeking to stop the government from taking the profits from the two agencies. The suit will be appealed, but setting aside the legal disputes for a moment, the U.S. government still has a big issue to confront: what to do about the two government-sponsored enterprises.

Congressional inaction has effectively forestalled any serious plan for bringing Fannie and Freddie out of conservatorship. The sheer complexity of GSE reform, coupled with a nearly unprecedented schism between political parties, explains why comprehensive change is, for the time being, elusive at best.

The situation is untenable. Under the current provisions of the agreements swapping preferred stock in the agencies for a Treasury backstop against credit losses, taxpayers effectively remain on the hook for future losses associated with outstanding mortgage-backed securities guaranteed by the agencies — which total approximately $6.5 trillion — until some resolution of Fannie and Freddie is completed.

Meanwhile, the U.S. housing finance system languishes in a form of suspended animation that poses considerable uncertainty to private investors and potential homebuyers alike. The right outcome for GSE reform, namely comprehensive legislation addressing Fannie Mae and Freddie Mac, is unlikely to occur for the reasons cited above.

However, a solution is feasible that would bring private capital back to housing markets, prevent future taxpayer bailouts of the agencies in all but extreme scenarios, and address the issues that precipitated the demise of the GSEs.

This solution is already possible within the Housing and Economic Recovery Act of 2008 by granting the Federal Housing Finance Agency authority to bring the housing GSEs out of conservatorship. It is important to keep in mind that conservatorship was not meant to be a long-term solution for the GSEs and the same broad powers that allowed the federal government to place the agencies into conservatorship also allow it to reconstitute both companies.

The principal factors directly attributable to the GSEs entering conservatorship -weak regulatory oversight, low capital requirements, unchecked retained portfolio growth, and poor underwriting standards — have effectively been addressed with one exception (the capital part). And with stronger regulatory oversight in place in the form of the FHFA, establishment of strong capital requirements would also be feasible and a prerequisite to any post-conservatorship environment for the GSEs. Had these deficiencies been addressed earlier, Fannie and Freddie would have survived the mortgage crisis battered but intact.

As many, including Congresswoman Maxine Waters, have noted, the conservatorship — now in its sixth year — was never meant to be permanent; nor was the government's 100% profit sweep meant to be perpetual. With the agencies in conservatorship, the federal government has effectively engineered a redistribution of capital out of housing and into the budgetary ether to help cover costs associated with the payroll tax cut extension through higher guarantee fees and by siphoning off profits from the companies well in excess of the costs incurred by the government to cover GSE credit losses.

To date the agencies have paid back either through dividend or profit sweeps a total of $218.7 billion against draws of $189.4 billion, putting the taxpayer back in the black. That's without taking into account the value of the preferred shares or warrants received by Treasury that give the holder the option to purchase up to nearly 80% of the common stock of both companies. Conservative estimates on the preferred share and warrants provide another $200 billion or more to the taxpayer.

One approach to accelerating a recapitalization of the GSEs would be to cancel the Treasury's senior preferred stock by declaring it "paid back," re-characterizing past payments of the profit sweep (minus the 10% dividend sweep) as a paydown of principal. The value from that cancellation would flow up through to the remaining common stock, benefitting the Treasury as owner of 80% of the common stock through the warrants that it still would hold.

Taking the step to end the conservatorship and recapitalize Fannie and Freddie is in the best interest of the taxpayers by monetizing a substantial profit from their investment in the GSEs over the last six years. And with changes already in place, coupled with strict risk-based capital rules, this step would virtually eliminate future taxpayer exposure to housing crises.

Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland and a principal in Chesapeake Risk Advisors LLC.

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Comments (5)
One of the problems FnF face is the Administration's set goal to wind down FnF while they are in conservatorship. Back in February 2011 the Administration published the White Paperss which "lay out the Administration's plan to reform America's housing finance market to better serve families and function more safely". It says "under our plan, private markets - subject to strong oversight and standards for consumer and investor protection - will be the primary source of mortgage credit and bear the burden for losses." The Administration will work with the Federal Housing Finance Agency ("FHFA") to develop a plan to responsibly reduce the role of the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac") in the mortgage market and, ultimately, wind down both institutions".

I know this is opposite of the goals FHFA set with regard to the conservatorship when it took control of FnF on September 7, 2008 Their stated goal at the time was to "Help restore confidence, enhance capacity to fulfill mission, and mitigate systemic risk that contributed directly to instability in financial markets. At the time they posted, "There are no plans to liquidate the Company". As conservator, the FHFA is legally bound to "preserve and conserve" the assets of a company and put it back in sound financial condition. So what to do about the Administrations White Papers goals?
Posted by thombiz | Sunday, October 12 2014 at 11:35PM ET
If there is only one thing that the world learned from the financial crisis it is that private gain in direct combination with public loss is a really bad idea.
Posted by P Ullman | Friday, October 10 2014 at 9:29AM ET
While I agree in principle with many of your points, you didn't address a major consequence of the policy solution you propose - namely the end to the "alternative Qualified Mortgage" that would occur automatically when the GSEs exit conservatorship. That would need to be addressed through a CFPB rulemaking in some way, or you run the risk of chilling residential lending. Unless you know some magic bullet to bring private capital into the non-QM space concurrent with the re-privatization of the GSEs, or propose that the FHFA allow the GSEs to securitize non-QM paper. (And neither of those situations address the increase in compliance risk that many institutions won't have the appetite for.)
Posted by PCitera | Thursday, October 09 2014 at 5:11PM ET
Oh my. I actually thought this was satire though the hedge funds that own worthless stock would love it!
Posted by wssimon1 | Thursday, October 09 2014 at 11:02AM ET
So the old system worked fine, it's just that no one thought to fix the capital requirements and regulatory regime? Why is that better than the current system of funding them with printed money?
If only the US had the climate to grow bananas, we could complete the transition.
Posted by kvillani | Thursday, October 09 2014 at 10:58AM ET
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