This post is from Peter J. Wallison of the American Enterprise Institute.
Having now become explicitly government-backed entities, Fannie Mae and Freddie Mac (and their supporters in Congress) can no longer argue that they do not pose a risk to taxpayers. It is not politically feasible for the government to back private companies when their shareholders and managements keep the profits but the taxpayers cover the losses. Thus, even if they escape their current precarious financial straits, Fannie and Freddie are now operating in a kind of twilight before they will eventually have to be nationalized, privatized, or liquidated. In addition, the recent attention to covered bonds as a way to finance mortgages suggests that, in the future, Fannie and Freddie’s traditional business–buying and holding or securitizing mortgages–will no longer be essential to U.S. housing finance. An analysis of the available options for policymakers suggests that the best course–from the standpoint of taxpayers–is not to keep Fannie and Freddie alive through the injection of government funds but to allow them to go into receivership. A receiver can continue their operations in the secondary mortgage market and–using the Treasury line of credit recently authorized by Congress–meet their senior debt and guarantee obligations as they come due. A decision to nationalize, privatize, or liquidate them can be made at a later time and can be implemented more simply and efficiently through a receivership than if the companies are helped to survive through government recapitalization.
It took a hair-raising crisis in the housing and international capital markets, but for Fannie and Freddie, the wondrously generous world of Washington–the world they have dominated for so many years with threats, intimidation, and sheer financial and political muscle–is at last coming to an end. Both companies are hovering near insolvency. Whether they can avoid eventual receivership will depend on how much further housing values fall. But even if they are lucky enough to survive this current crisis, their halcyon days will never return. This is not because Congress has learned any kind of lesson. Without question, the preferred position in Congress, especially on the Democratic side of the aisle, will be to reconstitute Fannie and Freddie as newly recapitalized government-sponsored enterprises (GSEs).
But this will not fly politically. The world was irretrievably changed by the Housing and Economic Recovery Act of 2008 (HERA) signed by President Bush on July 30, 2008. The act, in effect, authorized the bailout of the companies by giving the secretary of the treasury the authority to make unlimited loans to, and equity investments in, both GSEs. Thus, HERA resolved once and for all whether Fannie and Freddie were actually backed by the U.S. government; it provided the explicit backing that investors always believed would ultimately be there and that the enterprises themselves vigorously denied. But now that they are explicitly backed by the U.S. government, the GSEs can no longer claim that they represent no risk to taxpayers. As explicitly government-backed entities, they cannot deny the obvious: that their profits will go to their managements and shareholders while their losses will be picked up by taxpayers. This fact is crucial to their future.
The privatization of profit and the socialization of risk inherent in this new arrangement is politically untenable, even though it may take some time for Congress to see the substantial difference between their former status as merely government-sponsored and their new status as explicitly government-backed. Inevitably, however, the light will dawn and their form will have to be changed. The question, then, comes down to whether Fannie and Freddie will, in the future, become government agencies, private companies, or just unpleasant memories.
Moreover, there are strong indications that a far more efficient and sensible mechanism for financing home mortgages in the United States is about to be born. In mid-July, the Federal Deposit Insurance Corporation (FDIC) issued a final policy statement on how it would treat covered bonds in the event of a bank’s failure,[1] and at the end of July, the Treasury issued a long statement on best practices for covered bonds.[2] In a covered bond transaction, mortgages remain on the books of the bank or other depository institution but serve as collateral for bonds issued to finance the acquisition of the mortgages. If the mortgages in the covered bond pool default, the bank that established the pool has an obligation to replace the assets with performing mortgages that will continue to serve as collateral for the outstanding bonds.
In other words, this structure requires lending banks to retain an interest in the quality of the mortgages they make and addresses the problem that no one in the securitization process has a continuing interest in sound underwriting after the mortgages are sold to Fannie and Freddie. Trillions of dollars in covered bonds have been issued in Europe over many years without any substantial losses. There are, of course, issues associated with the widespread use of covered bonds in the United States–mostly in balancing the interests of the FDIC and bank depositors in gaining access to the assets of a failed bank–but if these can be balanced with the need for a strong residential finance system, covered bonds could, over time, make the Fannie and Freddie business model obsolete. This is one more indication that Fannie and Freddie, both as GSEs and as essential elements of the U.S. residential finance market, are on their way out.
The Gathering Storm
It is axiomatic that Congress only acts in a crisis, and this crisis was so serious that Congress was compelled to do three important things that under ordinary circumstances it would never have done: it adopted legislation, HERA, that significantly strengthened the regulation of Fannie Mae and Freddie Mac; it authorized the appointment of a receiver to take over either company if it becomes “critically undercapitalized”; and it gave the Treasury Department a blank check, limited only in time and by the U.S. debt limit, to make loans or equity investments in both companies. With its new powers, the regulator should be able to reduce the size of the GSEs and prepare them for one of the three fates: liquidation, privatization, or nationalization.
It need not have been this way. Congress was warned over two decades, by both Democratic and Republican administrations, about the dangers presented by Fannie and Freddie. But Congress, under both Democratic and Republican control, did nothing. The same process is now unfolding with respect to Social Security, Medicare, energy, securities class actions, and probably a dozen other long-term problems that Congress is seemingly unable to address. It makes you wonder why 98 percent of them are reelected.
Not that this and previous administrations are blameless. Although at their higher reaches–usually in the Treasury–they recognized the dangers, their bank regulatory arms continued to allow banks to invest in Fannie and Freddie securities without the percentage limitations normally applied to investments in privately owned business corporations. The regulators obviously believed that the government would eventually stand behind Fannie and Freddie and thus permitted U.S. banks to load up on Fannie and Freddie debt in preference to U.S. government securities. Now, thousands of banks hold more than their total Tier 1 capital in the form of Fannie and Freddie debt. A 2004 FDIC report showed that the holdings of GSE-related securities by commercial banks and savings associations aggregated more than 11 percent of the total assets of these institutions and more than 150 percent of their combined Tier 1 capital.[3] Holding Fannie and Freddie debt gave the banks some extra earnings over what they would receive from Treasuries, but it also sent signals to the capital markets that the government saw Fannie and Freddie as virtually risk-free. And when the prospect arose a few weeks ago that Fannie and Freddie debt might decline in value, Uncle Sam had to step in to prevent thousands of U.S. banks from becoming insolvent because of their GSE investments.
In any event, the Fannie and Freddie crisis has now arrived, and, in order to avert a disaster in the housing and financial markets, the United States government has been forced to put its credit behind these two ill-conceived and badly managed institutions. During the past month, as the dimensions of the problem have become clear, sensible people have actually wondered whether the credit of the United States might actually be impaired by the obligations it might be required to assume on Fannie and Freddie’s behalf. That idea, previously unthinkable, is still highly unlikely, but what is clear is that the size of the taxpayers’ losses will grow as housing prices continue to decline. There is no telling how deep into insolvency Fannie and Freddie might sink, and the further down they go, the more potential losses they will impose on the government and ultimately the taxpayers.
This, of course, is all water over the dam. The damage–allowing two privately owned companies to grow so large that they become both wards of the government and threats to the financial system–has been done. Now the only relevant question is how we get out of this mess with minimal cost to taxpayers. In the end, the options available to the Treasury Department and the new GSE regulator, the Federal Housing Finance Agency (FHFA), are both unpleasant and few. They are outlined below.
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