Determined to Ignore Ways to Recap Fannie and Freddie and End Conservatorship

There are a lot of ideas on how to follow the law and end the conservatorship of Fannie Mae and Freddie Mac. This would enable them to resume their historic role in providing countercyclical liquidity in the home lending market and also make shareholders whole. But there is just as much creative thinking to justify why this is impossible.

The Wall Street Journal’s John Carney is again insisting there is simply no way for the GSEs to rebuild and maintain an adequate capital base.  In a blog last week, he took aim at a proposal by Tim Howard, the former CFO of Fannie Mae, to keep the companies in place with a risk-based capital requirement of two percent.  The reason why this is a bad idea in Carney’s eyes is that two percent is not nearly enough to fend off a future crash, which he assures could be as bad if not worse than 2008. This, presumably, could mean more taxpayer-funded bailouts.

He concluded the GSEs are Systemically Important Financial Institutions, or SIFIs. As such, they need to be subject to a more rigorous capital standard – capitalization at the 11% to 14.5% level.

Using the Basel III formula for such large institutions, Fannie alone, based on an estimated $3.2 trillion in assets, would have to maintain from $176 to $232 billion in capital. Looking at Fannie’s 2015 earnings of $11 billion, the capital would be far less than 11 percent he says would be needed. Plus this amount does not even include the fees Fannie would have to pay the government for the backstop. 

So where could that amount of money come from? Carney acknowledged it won’t be from capital markets. The rate of return on the investment is too low, he concedes.  On the other hand, if we simply let the GSEs accumulate capital from their earnings, it would take decades. Until then they would remain moribund, undercapitalized companies worth hardly anything to shareholders.  The answer, not surprisingly is to put them out of everyone’s misery and replace them “with something new.”

Of course, his analysis omitted discussion of at least one important fact. Since the Third Amendment Sweep in 2012, the government has raked in $246 billion in earnings from the two companies. (Carney conveniently looks only at Fannie’s 2015 earnings.)  True, even without the Sweep, Fannie and Freddie had to pay back $187 billion in bailout money. But they could have had some $50 billion to apply to building capital buffers since 2012.  Instead, as we have pointed out, Treasury has managed to warp the Housing and Economic Recovery Act to impose loans Fannie and Freddie neither wanted nor needed and with terms that would make repayment impossible.

In addition, Carney’s assertion that we need such high levels of capital because 2008 could happen again ignores reforms already adopted as well as a menu of ideas on what can be done to prevent a recurrence. After eight years, we know a muddled mission to provide access to affordable housing while competing with other market players to make big profits, and a flawed regulatory structure, helped put the GSEs in jeopardy. If the goal is to prevent that from happening again, don’t make the same mistakes. There is no reason to dismantle them. If your basement floods, invest in a sump pump but don’t raze the house.

Even if razing the house is the plan what is the “something new” that would replace it? Carney said it might be worth taking a look at a plan to wind down and replace the GSEs with a new system, perhaps along the line of the National Mortgage Reinsurance Corporation recently outlined in a paper by a group of economists and housing market veterans, Jim Parrott, Lew Ranieri, Gene Sperling, Mark Zandi and Barrry Zigas. On the surface, the plan looks like a mere shuffling of deck chairs. But a closer analysis raises questions about whether the proposal could cede the market to the nation’s largest banks and undermine the countercyclical liquidity function Fannie and Freddie performed well for decades.

This recent paper is just one of many ideas for ending the conservatorship that have been offered over the last year. The Urban Institute’s new Housing Finance Reform Incubator is now offering a spate of new ideas. Alex J. Pollock, the former president and chief executive officer of the Federal Home Loan Bank of Chicago from 1991 to 2004, has outlined a seven-point plan for reform.  In addition, Jim Millstein, an expert on restructuring in investment banking, laid out a plan on how to enable the GSEs to build up capital reserves while undertaking administrative reforms.  

Interestingly, Millstein, who was the Chief Restructuring Officer of the Treasury Department who spearheaded the AIG restructuring, seems to have taken a shot at Parrott. Citing the recent paper by Parrot et al, he reminded readers that it was the Sweep that deprived the Federal Housing Finance Agency, as conservator, of the opportunity to resolve the GSEs’ undercapitalization in the first place. Parrot, who is also a senior fellow at the Urban Institute in addition to being an advisor to financial institutions, was a top housing official in the Administration. He has been deposed in ongoing litigation on his role in the Sweep.

Investors Unite was formed to fight for economic justice for shareholders and not to endorse GSE reform proposals. Nonetheless, we have always called on policymakers to consider all facts carefully in devising a post-conservatorship housing finance system.  Of course, if the goal is to get rid of Fannie and Freddie and leave shareholders with nothing, there will always be rationales for overlooking ideas for ending the conservatorship, reforming, recapitalizing and releasing them. In the marketplace of ideas, we would say to policymakers, caveat emptor.