Taxpayers and the housing markets would lose big if the government-sponsored enterprises Fannie Mae and Freddie Mac were dismantled.
It would be the economic equivalent of cutting off one's nose to spite one's face.
But restructuring and re-regulating the GSEs would yield several benefits:
- Taxpayers would get their investment back, plus a substantial profit
- Housing markets would benefit from vastly strengthened, yet familiar, mortgage financing entities
- Private parties would gain an incentive to participate in the mortgage market
- By avoiding nationalization, this solution would prevent the federal debt from growing by $5 trillion or more, and thus avert additional downgrades of the U.S. credit rating
- Private entities would be less prone to bureaucratic involvement due to public shareholder oversight
- New regulations would safeguard taxpayers
Two years ago, when I publicly predicted that the GSEs could recapitalize themselves if allowed to do so, most analysts scoffed at the notion that they could repay the $188 billion of taxpayer capital. Since then, Fannie and Freddie have already paid back 70% of the Treasury's investment. Despite this, under the terms of their conservatorship the GSEs have no repayment mechanism no matter how profitable they may become. Never mind that the term "conservatorship" implies that the assets are supposed to be conserved to pay back taxpayers and creditors in priority order. (Full disclosure: my fund has long and short positions in the GSEs' preferred and common shares.)
The fortunes of the GSEs have turned assuredly positive. Because of improving housing markets, reversals of worst-case loss assumptions, improved loan standards and increased guarantee fees, Fannie earned $17 billion and Freddie earned $11 billion in 2012 prior to the mandated dividends and profit sweep to Treasury.
Historically the g-fees that the GSEs charged for guaranteeing conforming mortgages were 20 to 25 basis points per year, well below the threshold where others were willing to step in and assume that risk. GSE market share at that time "only" approximated 50% because many loans were nonconforming. Although g-fees have since increased to 50 to 55 basis points, GSE market share has reached a whopping 90%. This leads to two significant conclusions: 1) g-fees are still too low to attract private capital; and 2) to transition the housing market from its dependency on Uncle Sam, the GSEs ironically must first traverse a road of profitability to lure private competition. Fannie and Freddie need to further increase g-fees to entice private capital. We estimate that at 85 basis points, Fannie and Freddie will lose market share yet still earn $20 billion and $13 billion per year, respectively. The fruits of those profits ought to benefit the taxpayer first, and then, as in a free market system, creditors and equity holders. Currently, the Treasury has full control over those profits with no accountability.
Pragmatically, the remaining taxpayer investment and the old preferred stock should be converted to common equity and the common stock sold back to the public. Projected earnings suggest enterprise values of $200 billion to $300 billion. Taxpayers could realize $140 billion to $220 billion from such a sale, not counting the $132 billion that has already been paid (which should count toward repayment). Similar restructurings of taxpayer investments in AIG and General Motors reinvigorated the two companies, which are back in private hands and once again generating significant profits. We contend that the same result will occur here if the government does what's best for taxpayers, creditors and the economy and stops waging the quixotic battles of the past.
Since 2008, politicians on both sides found the GSEs to be a convenient scapegoat for the financial crisis. They want to punish the "bad actors"at Fannie and Freddie along with other financial institutions that abused the system. But the bogeymen are no longer there. The GSEs have refocused on vanilla conforming loans, downsized, and are no longer rewarding bad behavior with skewed pay packages. Furthermore, it was the Treasury that required Fannie and Freddie to raise $18 billion of the $36 billion of old preferred shares outstanding between December 2007 and May 2008. Also forgotten is the fact that the community banks and retirees that bought these AA-rated securities were assured that they represented "safe" investments to guard against losses. We count at least 10 community banks that went bust directly as a result of these purchases since "conservatorship" wiped out these investments. A failure of regulation led to the financial crisis. Neither dismantling a 70-year-old infrastructure that served the housing markets well, nor punishing investors who were misled by the Treasury, will help our economy or encourage new private capital to come in.
In fact, the existing public/private model shapes up as the best and least risky solution to ensuring a stable, recovering housing market. Our economy is caught between a rock and a hard place. Dismantling the GSEs "cold turkey" with their 90% market share would smash the housing market, put the $10 trillion residential mortgage-backed securities market into a tailspin and put us right back into a Great Recession. Nationalizing the housing market would add more than $5 trillion to the existing $16.5 trillion of national debt and would continue to fully expose taxpayers to losses. Furthermore, with the GSEs dominating the market with inefficiently priced g-fees, there is simply no feasible way to attract private capital.
We have yet to see a better proposal than a better-regulated version of the current model. A proposed hybrid solution of dismantling the GSEs and replacing them with a Federal Mortgage Insurance Corp. (patterned after the FDIC) that would supposedly bring in "first-loss capital" raises serious doubts. It would shut down existing agencies only to replace them with another agency that does essentially the same thing but lacks the infrastructure built up over decades. Its g-fee would be based on a model that may or may not reflect reality despite potentially insuring 100% of the conforming market. The FMIC would be required to retain capital equal to 2.5% of the insured amount, yet it would lack Fannie and Freddie's ability to earn that capital. In order to support the current mortgage market, the FMIC would need almost $150 billion and have no reasonable way of earning it. Fannie and Freddie do.
The GSEs have helped our economy for over 70 years and even in their currently hampered state they've shown that they can earn back taxpayer money and trust. Recapitalizing Fannie and Freddie while making sure they behave well is a path with far fewer risks of missteps and potential damage to the economy. And it would be the right thing to do for disenfranchised creditors and investors in a country that prides itself on the rule of law.
Michael Kao is the founder and CEO of Akanthos Capital Management, a hedge fund in Los Angeles.