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May 29, 2014

It's time for administrative reform to end the GSE conservatorships

May 29, 2014

This is a guest post in response to a recent Urban Institute paper on reforming the Government Sponsored Enterprises.

In a recent Urban Institute paper, Jim Parrott explains “Why Long-Term GSE Reform Requires Congress” and asserts that administrative reform of Fannie and Freddie is not economically viable. The firms are critically undercapitalized, allegedly unable to operate without their government backstop, the fair price of which their normalized earnings couldn’t bear. Mr. Parrott asserts that Fannie and Freddie therefore are doomed to remain wards of the conservatorship, the exits closed, until Congress decides to act. The “difficult math of GSE reform” makes it impossible and those of us advocating otherwise are fooling ourselves.

Parrott’s is a compelling case for Congressional action, but his premise is wrong: reform is not about the math; it’s about political will.

Yes, the companies today are undercapitalized. But the problem isn’t that they haven’t earned enough to rebuild their capital and restore public confidence in their creditworthiness. It’s that the current terms of the Federal bailout prevent it.

Why an act of Congress is unnecessary

The 2008 statute governing the conservatorships, the Housing and Economic Recovery Act (HERA) didn’t mandate any of those terms. Two administrations’ decisions over the past six years did. Ending the conservatorships won’t require an act of Congress—HERA already provides a path to its end. It does, however, require the administration to revisit and revise the bailout terms so as to facilitate reform.

In 2009, the Government faced a similar situation with AIG (holding a preferred stock with a fixed dividend that stood in the way of AIG’s recapitalization). It did what bank and insurance regulators generally prescribe to preserve capital: it stopped taking dividends when earnings couldn’t fund them. But with Fannie and Freddie, the government made a different choice.

The Bush administration—not HERA—dictated that Treasury impose a 10 percent cumulative dividend on the senior preferred stock it purchased in the two companies; that the 10 percent dividend be paid in cash, even when earnings were insufficient to fund the dividend payment. The Obama administration continued that decision.

That policy choice forced the companies to “borrow” additional taxpayer money to pay the fixed dividend on the money already “borrowed.” It is hard to know quite what compelled policymakers to force Fannie and Freddie to rob Uncle Sam to pay Uncle Sam, but it certainly wasn’t mandated by HERA.

It gets worse. The Obama administration—not HERA—decided to impose a dividend equal to 100 percent of the companies’ earnings and profits in any quarter to replace the fixed 10 percent dividend once the housing market recovered (as it did) and the companies’ earnings rebounded (as they have). That policy choice has made it impossible for the companies to rebuild their capital. Had the 10 percent dividend been kept in place and the 100 percent profit sweep not implemented, Fannie and Freddie could have retained nearly $130 billion in earnings over the past two years (while still paying Treasury almost $40 billion in cash dividends), putting them well on the way to supporting their outstanding guaranty liabilities without a federal backstop.

Finally, the Obama administration—not HERA—dictated that Fannie and Freddie operate with a mere $5 billion of combined capital to support in excess of $5 trillion in debt and guaranty liabilities. It wasn’t HERA that limited each company’s capital to a fraction of a fraction of what state insurance regulators would require a private insurance company to maintain. It was the Obama administration.

Cashing the check

Mr. Parrott would protest, however, that these federal dividend and capital policies were required to ensure taxpayers’ fair compensation for the enormous amount that the government committed to the two companies in 2008. So, let’s review the bidding:

Taxpayers have received $213 billion in dividends on their $187 billion investment in Fannie and Freddie’s Senior Preferred Stock. And the future is equally bright, according to the Office of Management and Budget: it projects that, over the next 10 years, the Treasury Department will receive an incremental $154 billion in dividends from the two companies.

But in order to cash those checks, Fannie and Freddie, the two largest participants in the mortgage funding markets, must continue to remain undercapitalized, subject to continuing government control and support for the next 10 years.

As Mr. Parrott’s paper suggests, the fact that the companies are and must remain “undercapitalized” to produce these taxpayer returns severely limits the Administration’s options for “administrative reform.” But if the administration were to reverse or modify these dividend and capital policies, a range of administrative reform options would emerge. These options would allow the FHFA to end the conservatorships, reform the business model elements that got the GSEs into trouble, and accelerate the day when private capital once again plays a significant role in mortgage credit formation without sacrificing taxpayer returns.

The simple math of GSE reform

The “difficult math of GSE reform” is not a function of some iron economic law of taxpayer compensation as Mr. Parrott suggests. With $213 billion of profit already in its pocket, the Treasury still owns substantially all of the equity capital in two businesses that, properly capitalized, would have substantial value in the public equity markets. The taxpayers therefore stand to make an enormous profit on the Treasury’s investments if the administration were prepared to recapitalize, reorganize, and sell Fannie and Freddie’s mortgage guaranty businesses back to private investors. All it takes is the political will to do so.

The responsible path forward is not to continue to wait for new direction from a divided Congress, but rather to lay the groundwork for “administrative reform” by reversing the administrative policies that have kept the companies from rebuilding their capital. Permitting the two companies to recapitalize would create a capital cushion in front of the Treasury’s existing backstop, relieving taxpayers from having to cover potential future losses, giving the FHFA the option to sell the mortgage guaranty businesses once properly capitalized, increasing taxpayer profits from the monetization of Treasury’s investments and reducing the government’s now dominant position in the mortgage market.

It’s not about the math. It’s about political will.

Photo: A sidewalk gets shaped in front of new construction in Omaha, Neb. (AP Photo/Nati Harnik)

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