American Mortgage Giants Fannie Mae and Freddie Mac: Ending the Unceasing Conservatorship.

• Author: Vukovich, Caleb

1. INTRODUCTION 550 II. FANNIE MAE AND FREDDIE MAC BACKGROUND 550 A. An Origin Story 551 B. The Move to a Government Sponsored Enterprise 552 C. The Creation of Freddie Mac 553 D. The Lead up to the Great Recession 554 E. The Great Recession Fallout 554 F. Conservatorship 556 G. Shareholder Litigation 557 H. The Move Out of Conservatorship 557 III. AN ANALYSIS OF THE DEFECTS LEADING TO CONSERVATORSHIP AND THE 557 LEGITIMACY OF THE CURRENT SHAREHOLDER DERIVATIVE LITIGATION A. Moral Hazard and the Governments Implicit Guarantee 557 1. Time Inconsistency 558 2. Privileged Status 559 B. Shareholder litigation 560 1. The Constitutional Structure Challenge 560 C. Privatizing the GSEs 563 IV. RECOMMENDATION FOR THE FUTURE FANNIE AND FREDDIE 564 A. The Capital Requirement 564 B. Returning to the Private Market 567 1. Removing the GSEs Privileges 567 2. Depoliticizing Fannie and Freddie 568 3. Establishing a Living Will 568 C. Keeping Fannie and Freddie Nationalized 569 D. Supreme Court's Ruling in Collins v. Yellen 569 V. CONCLUSION 570 I. INTRODUCTION

   Fannie Mae and Freddie Mac (Fannie and Freddie) are notorious for their role in the housing market bust-up that precipitated the Great Recession. (1) The companies were subsequently brought under a form of federal government control called conservatorship, where they remain. (2) This sustained experiment in conservatorship for a pair of companies that have long operated as Government Sponsored Agencies (GSEs) has spawned a sea of reports and analyses that seek to assess the efficacy of this unique model. This Note builds on such scholarship, taking stock of the GSE model in general and Fannie and Freddie in particular with reference to changing political winds and recent court holdings. Not only did a Republican succeed a Democratic president who was in office for the majority of the conservatorship, but that Republican president also appointed three Supreme Court Justices and the head of the Federal Housing Finance Administration (FHFA). Additionally, when this Note was written, Collins v. Mnuchin was pending in the Supreme Court. (3) Even after the Supreme Court released their opinion, Fannie and Freddie will still be affected by litigation. This Note proceeds by giving a brief overview of the GSE's background, analyzing their current state of affairs, and making a two -part recommendation on how to proceed. The recommendation section also considers possible outcomes surrounding the Supreme Court's remanded portion of Collins v. Yellen. (4)

   The business reporter Bethany McLean argues that Fannie and Freddie enjoy the "worst of both worlds" as a result of their conservatorship. They are "too political to be financially secure, but too financially insecure to accomplish their political mission. They have become a deficit-reduction device for the federal government." (5) This begs the question, what in Fannie's and Freddie's past led to their current state, and where do they go from here? In light of the previously mentioned changes in circumstance since a majority of papers have been written, this Note serves as a meta-analysis of previous works and builds on previous publications to account for new events. Most notably, the new Trump administration and the Supreme Court case of Collins v. Mnuchin (6)

2. FANNIE MAE AND FREDDIE MAC BACKGROUND

   The story of Fannie Mae (Fannie) and Freddie Mac (Freddie) is a story, as Mervyn King puts it, of how the United States chose to socialize the market for mortgages while most countries chose to socialize their health care system. (7) By the beginning of 2008, Fannie and Freddie guaranteed 80% of mortgages issued in the United States. (8) This market power can partly be traced to the belief, proven true by time, that the two GSEs had an implicit guarantee that the government would not let them fail. (9) This helped ensure the safety of their investments in the eyes of investors, (10) a moral hazard dilemma that precipitated the GSEs' current state of limbo.

   1. An Origin Story

      The origins of Fannie and Freddie take us back to Great Depression-era policymaking. (11) Before 1932, the housing market was primarily funded through private sector investment. (12) The terms of these loans were drastically less appealing than the terms of modern-day loans. (13) Some common features included "high down payments (approximately half the home's purchase price), short maturities (ten years or less), and large balloon payments." (14) High interest rates reflected the main issues with the housing market, such as illiquidity, interest rate risk, and the high risk of default. (15) The reliance on private investment and lack of a national mortgage market also led to large disparities in borrowing costs between different regions. (16) In addition to an already precarious housing market, "the Great Depression would prove traumatic to the nation's housing market." (17) As unemployment rose to 23.6% by 1932, the inability to pay debts also began to rise. (18) By 1933, more than 25% of homeowners defaulted on their mortgage and lost their home to foreclosure. (19) This resulted in banks not having sufficient funds to pay deposits, (20) contributing to the banking crisis by undermining depositor confidence. (21)

      Starting in 1932, the federal government implemented multiple policies in an attempt to provide liquidity and stability to the housing market. (22) To better facilitate the post-depression era housing market, the federal government, through an amendment to the National Housing Act, created the Federal National Mortgage Association (more commonly known as Fannie Mae) in 1938. (23) Fannie Mae's original objective was to purchase mortgages insured by the FHA, thus providing liquidity to private lenders who could in turn make more loans. (24) Through a consistent supply of liquidity, Fannie Mae facilitated greater access to mortgages and further reinforced the modern mortgage structure of long terms, fixed rates, and self-amortization. (25) In 1948, Fannie Mae expanded its portfolio to include mortgages that originated under the GI Bill. (26)

      After a period of significant growth, (27) the Federal National Mortgage Association Charter Act of 1954 withdrew government support from Fannie Mae and allowed private capital to fund the organization's borrowing, creating a semi-public-private corporation. (28)

   2. The Move to a Government Sponsored Enterprise

      In 1968, fueled by Fannie's continued growth and the pressure of the Vietnam War on the national budget, President Johnson removed Fannie's debt from the government balance sheet by transitioning Fannie Mae into a GSE through the Housing and Urban Development Act of 1968 (HUD Act). (29) By converting Fannie into a GSE, the government relinquished all ownership of the corporation and in its place instituted a private shareholder-owned company. (30) However, through HUD the government retained regulatory oversight of the corporation. (31) Not only did HUD make structural changes to Fannie, but significant operational changes were made as well. HUD expanded the loans that Fannie could purchase to include non-FHA insured home mortgages. (32) Additionally, the government created a dual mandate for the corporation. (33) Not only was Fannie responsible for making profits to fulfill its obligation to its shareholders, but HUD required that Fannie devote part of its purchases to low-and moderate-income home mortgages. (34) This dual mandate would become problematic in the future. (35)

   3. The Creation of Freddie Mac

      In 1970 the government created the Federal Home Loan Mortgage Corporation (Freddie Mac) through the Emergency Home Finance Act in order to expand the secondary housing market (36) and stop Fannie Mae from becoming a monopoly. (37) Freddie Mac's purpose is to "provide liquidity, stability, and affordability to the mortgage market." (38) Freddie Mac issued the first conventional mortgage-backed security (MBS) in 1971. (39) Freddie Mac tended to focus its business on buying mortgages from thrift institutions (40) and smaller banks that provided more community-based banking services. (41) In 1989, the federal government reorganized Freddie Mac into a GSE like Fannie Mae through the Financial Institutions Reform, Recovery, and Enforcement Act. (42)

   4. The Lead up to the Great Recession

      Throughout most of the 1970s-1990s, the two GSEs conducted their business as usual. However, in 1992, fueled by the fear that Fannie and Freddie were only focused on making money for shareholders rather than making mortgages affordable to Americans, Congress enacted the Federal Housing Enterprises Financial Safety and Soundness Act of 1992. (43) The Act established a new regulatory agency within HUD called the Office of Federal Housing Enterprise Oversight (OFHEO), which was tasked with conducting "safety and soundness examinations of Fannie Mae and Freddie Mac...." (44) Along with creating the OFHEO, the Act created an affirmative obligation for Fannie and Freddie to facilitate housing for low-and middle-income earners by purchasing a number of their mortgages each year. (45) This mandate was part of a broader policy: the so-called "ownership society," where easy credit would usher an ever-greater circle of Americans into the asset-owning Capitalist class. (46)

      The increased political pressure began an era of looser standards for the two GSEs. (47) Despite venturing into purchasing more risky mortgages, the investors purchasing the MBSS from Fannie and Freddie were not overly concerned with the risk because Fannie and Freddie had a "gold-plated guarantee" on their securities. (48) This guarantee ensured that investors would get paid the principal and interest on their investments if the homeowners were unable to make their mortgage payments. (49) Accompanying the "gold-plated guarantee" was the implicit guarantee that the government would not let their GSEs fail should financial difficulties arise. (50) The implicit...