BNA INSIGHTS: The Lawless Limbo of the Fannie and Freddie Conservatorships

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By Ike Brannon and Mark Calabria

Ike Brannon is a senior fellow at the George W. Bush Institute and president of Capital Policy Analytics, a consulting firm in Washington DC.

Mark Calabria is director of financial regulation studies at the Cato Institute.

The Housing and Economic Recovery Act of 2008 (HERA) spelled out the terms of the conservatorship of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac. Both entities were effectively bankrupt not long after the law's passage, victims of poor management, imprudent investment, dubious home loans, and a collapsing housing market.

The purpose of HERA was to create a path that would return Fannie and Freddie to a “sound and solvent” condition, or — if that proved to be impossible — a route toward their liquidation or reorganization. The legislation, combined with the economic recovery, government support and the concomitant rebound in the housing market, returned them both to profitability: By 2012, the GSEs were on their way to repaying the government's investment.

However, the Obama administration's Third Amendment to HERA, in which Treasury set aside the 10 percent dividend and instead laid claim to the entire net wealth of Fannie Mae and Freddie Mac, essentially forged a new outcome for the GSEs and is the reason for their current awkward limbo.

The problems with the current arrangement under the Third Amendment are many: By sweeping the net wealth into Treasury's coffers each quarter, it has prevented the GSEs from accumulating sufficient capital, leaving the taxpayer potentially on the hook should another decline in the housing market develop.

What's more, it essentially ignores the statutes contained in HERA—as well as precedent—by creating the federal government's continued claim on the net wealth of Fannie and Freddie, transforming the purpose of the conservatorship from a process that would heal the companies and reconstitute them as instruments for housing policy into one that instead makes them little more than a revenue source for the federal government.

Finally, it has effectively set aside HERA's requirement to maintain Fannie Mae and Freddie Mac as a private shareholder-owned company.

The status quo for the GSEs is a recipe for disaster: the Third Amendment is inconsistent with the very notion of a conservator and has done little to advance the explicit goals of HERA. Congress intended the GSEs' regulator, the Federal Housing Finance Agency (FHFA), to follow the precedents of the Federal Deposit Insurance Corporation (FDIC) when dealing with a troubled GSE.

The FHFA, however, has implemented the conservatorship in a manner drastically different than that historically used for commercial banks. The administration should resolve the status of the GSE's posthaste, and should it hesitate to do so, then it is incumbent upon Congress to prod them on the matter.

What HERA Wrought

After five years of continued effort, Congress finally enacted reform of the regulatory structure of Fannie Mae and Freddie Mac in 2008, shortly before the full force and fury of the financial crisis hit the markets.

The primary goal was to create a framework for the GSEs that closely mirrored the one for banks. While such a mechanism was not fully achieved, HERA did create a resolution regime based upon the pre-existing and well-understood authorities of the FDIC. Were a GSE to become insolvent or simply financially distressed, HERA dictated a path. This path was not a mystery, as it was the same regulatory approach used for troubled banks.

HERA offered the new GSE regulator, the FHFA, two paths. If a GSE had just “hit a bump in the road” but was fundamentally sound, FHFA could place the GSE into conservatorship, or something akin to a regulatory “timeout.” Once the GSE addressed its issues, it would be expected to be released from conservatorship. However, if a GSE was not fundamentally sound and not likely to become such in a short amount of time, FHFA would invoke a receivership, allowing FHFA to address issues of insolvency directly and without cost to the taxpayer.

Conservatorship was never meant to be permanent or even long lasting: The longest commercial bank conservatorship was 18 months, and it was well understood by the drafters of HERA that a conservatorship would be temporary.

Conservatorship was never meant to be permanent or even long lasting: The longest commercial bank conservatorship was 18 months, and it was well understood by the drafters of HERA that a conservatorship would be temporary. It was also meant to be rare. HERA's authors intended to build upon the bank reforms of the early 1990's, which had attempted to limit the FDIC's ability to engage in open-ended failed bank assistance. The purpose of a conservatorship is, in essence, just like it sounds: conserve the assets of the company and nurse it back to health.

If a GSE could not be expediently nursed back to health then FHFA was intended to, and under some circumstances required to, place a GSE into receivership. This would allow the basic operations of the GSE to continue, providing support to the mortgage market while also directing addressing any insolvency. Receivership would function basically as a “bridge bank” — a structure well understood by bank regulators. Of course, receivership would have exposed GSE creditors to potential losses, but then that's somewhat the point: Imposing any necessary hair-cuts and moving any equity-holders to the “bad GSE” while creating a “good GSE” would enable a clean end to receivership.

The Third Amendment

Despite the clear intentions of Congress, the Treasury Department and FHFA made a different decision — or rather a nondecision. As noted above, HERA allows for conservatorship, with an eventual exit, or receivership with a resolution. Apparently Treasury Secretaries Henry Paulson and Timothy Geithner did not share the preferences of Congress and decided to pursue a third path despite lacking any statutory authority to do so.

Secretary Paulson made a number of decisions to keep the GSEs out of receivership and FHFA essentially ignored the law and complied with Paulson's wishes, the most egregious of which was ignoring that the law required a receivership in the event of insolvency.

With the election of President Obama came a new Treasury secretary, who saw no reason to change Treasury's approach to the GSEs. Just prior to departing Treasury, Geithner chose to “lock in” his policy preferences with an amendment to the preferred share agreements that Paulson had struck with the GSEs.

This “third” amendment replaced the previous arrangement from one of a regulator setting dividend payments to one where the Treasury expropriated the net wealth of the entities via a full profit sweep. While this change meant that the GSEs would not be digging themselves any deeper of a hole, since they would no longer have to borrow from Treasury to cover any required dividends, it also meant the GSEs would never build any capital. With one maneuver, Geithner managed to take both an end to conservatorship and the possibility of receivership off the table.

This is not the case of Congress failing to give regulators sufficient and needed authorities: HERA provides FHFA all the tools it needed to resolve a troubled GSE — conservatorship or receivership, depending upon the circumstances, with both being well-tested by the FDIC. However, Treasury wanted the powers of a receiver without the responsibilities, and chose a path not provided for by any legislation.

Going Forward

The Third Amendment has left the GSEs with very little capital and scarcely any maneuverability should another housing downturn occur, and everyone in America is painfully aware that housing prices can and do fall. Should we see a future decline in housing prices, Fannie Mae and Freddie Mac will almost certainly not have enough capital to deal with their losses, necessitating that it receive another infusion of capital from the Treasury Department.

An announcement by Treasury that it must spend more money propping up the GSEs will set off a political firestorm, and one that won't be assuaged by claims that the government has already made a tidy profit off its previous bailout and can well afford to help them out once again. The ostensible purpose of the reform was to make sure they wouldn't need the government again, which the Third Amendment effectively obviated.

The time to resolve Fannie Mae and Freddie Mac's limbo is today. A good place to start would be for the Senate Banking and House Financial Services Committees to hold hearings that examine the status of the GSEs and their relationship with Treasury. The department conducts regular “stress tests” of the major U.S. banks and loudly announces the results as proof positive that its reforms are working. Why the same is not being done for Fannie and Freddie is a question worth asking.

It would also be worthwhile to ask about the administration's long-term plan for the GSEs. The quarterly sweep of their net worth leaves them with increasingly little capital each quarter, and by 2017 they will be left with nothing, according to the terms of the Third Amendment. What will occur then? No one is saying. Perhaps Congress should press them to say what their plans are — the fact that they are dumping this on their successor is not an excuse for not having an explicit goal.

It would also be worth Congress' time to ask Treasury in a public venue about its reluctance to provide various documents relevant to Treasury's decision to implement the Third Amendment. The Administration has rebuffed various entreaties for the document, citing various claims of executive privilege that make a mockery of the very notion. If the department and FHFA refuse to release such documents, Congress would be wise to subpoena them: These are critical public policy issues which merit a full public airing.

Were Congress to conclude that the GSE model can be fixed, we would propose a few modifications that would reduce the chances of a future GSE failure and rescue:

• eliminate the loan limits and make mortgage eligibility based on income, similar to the U.S. Department of Agriculture's Rural Housing Service loans, in order to make sure these entities actually serve middle-class America, rather than merely be a subsidy to the well-off;

• break up the GSEs. This might be the most controversial, but simply allowing other institutions to enter the market is unlikely to guarantee sufficient competition. The two companies should be broken into at least six separate, distinct entities and barred from merging. Existing shareholders would get shares in the offspring companies;

• require more mortgage insurance. To protect the taxpayer, mortgage insurance companies should take the first 35 percent of loss, instead of the customary 20 percent; and

• limit the GSEs' portfolios to be used for an inventory function only. A minimum of 90 percent of debt issued should be required to be mortgage-backed securities (MBS).

Fannie Mae and Freddie Mac were (and remain) the poster children for Too-Big-To-Fail. The Dodd-Frank Act created a mechanism for resolving failing “systemically important” entities without cost to the taxpayer. HERA created a similar mechanism for Fannie and Freddie, and we saw how that worked out — any resemblance of its administration to the statutes of HERA are purely coincidental.

If we are to avoid an indefinite limbo for the next AIG, then we must put an end to the current limbo for Fannie Mae and Freddie Mac. HERA provides a path for such: It only needs to be followed.


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