Government Control of Fannie and Freddie in Historical Perspective: Are we on the right path with ongoing reforms or is government oversight of these mortgage giants a lost cause?

• Author: McKinley, Vern
• Position: BANKING & FINANCE

Just after Labor Day 2019, the Treasury Department released a report on reforming Fannie Mae and Freddie Mac, the government-sponsored enterprises (GSEs) that purchase mortgages in the secondary market. The report gets into the details of an issue that has been at the forefront of housing policy for the past 30 years, since the two mortgage behemoths began their massive growth during the 1990s. The issue has taken on greater importance in the last 12 years, as the GSEs have been under direct government control after they began to melt down as part of the 2007-2008 financial crisis.

Before we can wade into the report, we must appreciate the confounding history of the issues and the involved policymakers. Much of the coverage in the media has glossed over this complex history, leaving readers with many questions about how the pieces of this puzzle came together and what will change under proposed policy reforms.

To understand where the GSEs have been and where they will go in the future requires focus on a few core issues. Some of these can be addressed administratively under current law, such as what level of capital the GSEs require, how much longer Fannie and Freddie will remain as wards of the state, and how to make transparent to the public the last decade-plus of government authorities' decision-making over the GSEs. Changing the duopoly presence in their market will likely require legislation, although in the short run administrative measures can be used to shrink their asset base.

A DOZEN YEARS AND COUNTING FOR GOVERNMENT CONTROL

In early July of 2008, James Lockhart, then-director of the Office of Federal Housing Enterprise Oversight, which was Fannie and Freddie's supervisor at the time, gave assurances on the financial network CNBC that the GSEs were "adequately capitalized" according to the most up-to-date data from Fannie and Freddie. (Capital is used as a buffer against losses during difficult operational times.) Then-treasury secretary Henry Paulson echoed Lockhart's comments in testimony to Congress a week later, with then-Federal Reserve Board chairman Ben Bernanke backing him up.

In response to the early phases of the mortgage crisis, Paulson had shepherded the Housing and Economic Recovery Act (HERA) through Congress, granting new powers to Fannie and Freddie's supervisor to be used during times of market stress. HERA was signed on July 30, 2008, many weeks before anyone had even heard of the acronym "TARP," the moniker for the centerpiece bailout legislation during the crisis.

In his memoir, Paulson explained how he organized an effort in August 2008 to ascertain "the true financial condition of Fannie and Freddie." It was a volatile time for the GSEs as they struggled with the reality of the financial crisis and its effect on their mortgage holdings. As the situation deteriorated that month, he assembled a team made up of examiners from the Federal Reserve and the Office of the Comptroller of the Currency. He also brought in advisers from Morgan Stanley who worked for Treasury "for free" to undertake a full financial review. Their assessment was bleak, with both Fannie and Freddie having "true economic capital holes amounting to tens of billions of dollars." Required government capital injections were estimated at over $ 100 billion. This meant that Paulson and Bernanke would have to do an about-face on their earlier very public and sunny comments on the GSEs' capital position.

The next step after getting the details from the examiners and Morgan Stanley seemed logical to Paulson: intervene. In early September 2008, he and Lockhart--whose agency, by then, had been rechristened the Federal Housing Finance Agency (FHFA)--did just that, placing Fannie and Freddie in conservatorship, a legal procedure designed for the FHFA to manage them to health. A joint Treasury and FHFA announcement laid out the new narrative on capital: "Their statutory capital requirements are thin and poorly defined as compared to other institutions." The Treasury Department would stand ready to fund the operations of the GSEs, which was one of the largest of the 2008 bailouts in terms of upfront financial commitments. The announcement also made mention eight times of the "systemic risk" that the two GSEs posed to the financial system and in particular noted a need for policymakers to "resolve the systemic risk" created by the GSE structure.

The ensuing bailout / The terms of Fannie and Freddie's bailout were codified in separate senior preferred stock purchase agreements between the Treasury Department and the individual GSEs signed in late September 2008. In executing the agreements, the FHFA acted on behalf of the GSEs in its new role as conservator. Each of the agreements committed the Treasury to purchase up to $100 billion in senior preferred shares. Warrants were issued to the Treasury permitting it to purchase up to 79.9% of the GSEs' common stock. This structure would allow Fannie and Freddie's creditors to avoid suffering any losses.

Matters of restructuring financial institutions on the brink of failure should be straightforward. There are two paths: recovery and resolution. Recovery means troubled institutions fully address their problems and exit to more normal operations. Resolution means problem areas cannot be so easily addressed and there is an exit strategy to put the institutions out of business...