Rightfully or not, the banking system has shouldered the brunt of blame for the 2007-2008 Global Financial Crisis. The storyline goes something like this: Years of low inflation and stable growth perpetuated lenders’ complacency and risk-taking, and regulators tolerated this recklessness. A “savings glut” in Asia pushed down interest rates, and European banks borrowed greedily from American money markets and invested in dodgy securities. Taken together, these factors caused debt to swell in what appeared to be an investors’ paradise.
Often overlooked is the role that Fannie Mae and Freddie Mac played in shaping the Wall Street incentives that led to the meltdown, which we covered in Part I of this two-part series. In Part II, we’ll take a look at post-recession attempts to reform the GSEs, and why these reforms haven’t gone far enough to safeguard against a similar collapse in the future.
Post-Recession Attempts at Reform
Some have argued that the hybrid structures of Fannie and Freddie were destined to fail. The GSEs singular exposure to the residential real estate market and implicit guarantee of their liabilities created inherent risk. But as a report by the Federal Reserve Bank of New York explains, “serious reform efforts were portrayed as attacks on the American Dream and hence politically unpalatable.”
But when the market collapsed, reform couldn’t be put on hold any longer.
HERA, FHFA and the Taxpayer Bailout (2008)
The first attempt at reform was the Housing and Economic Recovery Act (HERA), which Congress passed in July 2008. HERA included significant reforms to the GSEs’ regulator, their capital standards, their portfolio limits and their prudential management and operations. Most notably, HERA temporarily gave the U.S. Treasury unlimited investment authority in the two firms.
Two months later, in an effort to prevent further free fall, the GSEs were placed under the conservatorship of the Federal Housing and Finance Agency (FHFA). At the same time, the Treasury entered into a senior preferred stock purchase agreements with each institution. Under these agreements, the GSEs received a $187.5 billion taxpayer-funded bailout—just as many speculated they would all along.
The U.S. Treasury’s “Profit Sweep” (2012)
In 2012, in an effort to compensate taxpayers for the bailout, the U.S. Treasury made the unprecedented decision to sweep all profits generated by the GSEs until further notice. Understandably, the GSEs shareholders were in awe. The news sent shockwaves throughout the investment community and shares of GSE preferred stock plummeted. The Treasury has since been repaid all bailout money (and then some), and the GSEs have returned to profitability. As of July of this year, Fannie’s debt had been reduced to $362.3 billion and Freddie’s $389.4 billion.
These measures were intended to stabilize the housing and financial markets, and to a large extent have been successful. Yet September of this year marks the eighth year of conservatorship, a move that was only intended to be temporary. Despite pleas (and lawsuits) from investors, the profit sweep continues. Just this month, a U.S. District Court dismissed one such case, stating that a federal agency is within its rights to sweep assets when designated conservator.
Calls to “Recap and Release”
Investors, led by hedge fund speculators that scooped up GSE shares at rock bottom, have spent the last several years lobbying Congress and the FHFA to recapitalize the GSEs and release them from conservatorship. “Recap and release” advocates argue that profits should be used by the Treasury to build up companies’ capital reserves. Doing so would provide enough of a capital cushion to then release the GSEs’ from conservatorship and dividends could once again be paid to private shareholders. The end result: the GSEs’ risk would be shifted from taxpayers back to the private sector—one of the goals of housing finance reform.
The White House disagrees. “None of us should be misled by the increasingly noisy chorus of the advocates of recap and release, many of whom have placed big bets against reform so they can make a profit, and are doing everything they can to make sure that those bets pay off,” says Michael Stegman, a top advisor to President Barack Obama.
Antonio Weiss, advisor to Treasury Secretary Jacob Lew, echoes this sentiment. “We learned the hard way that the old business model of privatizing gains while socializing losses doesn’t work,” he wrote in a Bloomberg Op-Ed. The only viable alternative is Congress-led housing finance reform—which is something high-ranking officials have acknowledged is unlikely to happen until after the 2016 election.
Why not do away with the GSEs altogether?
If the GSEs put taxpayers at such high risk, why not do away with the GSEs altogether? Indeed, some have suggested the federal government step out of housing finance entirely. Mortgages would be originated, held and sold by the private sector only.
On the surface, this may seem like a logical approach. But the GSEs are needed for a number of reasons:
- The GSEs are necessary to serve all lending institutions—not just large banks. Community banks can provide more flexible loan products to underserved borrowers. If the federal government wants to promote homeownership, the role of community banks cannot be understated. Yet to remain viable, community banks need access to the secondary mortgage market.
- The GSEs have several affirmative obligations. First, they must ensure credit flows to traditionally underserved borrowers. Latinos and African Americans, two of the nation’s fastest-growing populations, have historically had trouble accessing conventional loan products. Similarly, the GSEs have an obligation to lend in underserved markets—like rural areas. Winding down the GSEs would have a tremendous impact on these affirmative obligations, and threatens to drag the economy down and perpetuate income inequality.
- The GSEs provide liquidity during market cycles. If Fannie and Freddie hadn’t provided $5 trillion in housing credit following the recession, there is a good chance the recession would still be going today. Banks need the GSEs in order to continue lending during market downturns when access to capital is otherwise constrained.
For these reasons and others, general consensus is that reform is needed. But winding down the GSEs isn’t the answer.
Moving Forward
By all indications, housing finance reform will remain at an impasse until after the November elections. In the meantime, a handful of policymakers are laying the groundwork for reform next term.
How soon Congress takes up the issue under a new administration is still to be determined. Only one thing is clear: the existing system is unsustainable. If the Treasury continues its profit sweep, investors won’t buy shares in Fannie Mae and Freddie Mac. Unless the private sector is willing to buy shares of these companies, U.S. taxpayers will once again be at risk of funding another GSE bailout. And the federal government can only point fingers at the banking system for so long without acknowledging its role in the housing market, should the bubble burst again.
The bulk of the risk must be transferred from the public to the private sector – once and for all.
To be sure, there’s no way we can cover all of the complexities of Fannie Mae and Freddie Mac in this two-part series. But we hope it leaves property owners and managers with a better understanding of the GSEs role in the housing finance market and why reform is needed. Next time you pick up the newspaper and see Fannie or Freddie’s names splashed across the headlines, you’ll know what all the fuss is about.
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