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, benefiting 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.