The blog of the Urban Institute
May 30, 2014

Why the GSEs need Congress to exit conservatorship

May 30, 2014

Urban Institute fellow Jim Parrott and guest Jim Millstein discuss the prospect of long-term administrative reform of Fannie Mae and Freddie Mac. The discussion begins with Parrott’s commentary, “Why Long-Term GSE Reform Requires Congress” and continues with Millstein's blog post, “It’s time for administrative reform to end the GSE conservatorships.” This is the concluding post.

In “Why Long-Term GSE Reform Requires Congress” I conclude that Fannie Mae and Freddie Mac (the enterprises or the GSEs) are hemmed into conservatorship by the terms of their Preferred Stock Purchase Agreements with Treasury (PSPAs). In “It’s time for administrative reform to end the GSE conservatorships,” Jim Millstein offers the logical response: why not just change the terms of the PSPAs?

Unfortunately, it’s not that easy.

Section 6.3 of the PSPAs limits their amendment, prohibiting any changes that would compromise the interests of the agencies’ mortgage-backed security (MBS) investors. And nothing would compromise their interests more than removing the government’s full faith and credit from their investment. So it is difficult to see how the Treasury and FHFA could change the agreements to make it easier to escape conservatorship without that protection.

Exiting with the backstop poses a similar challenge. Recall that under the PSPAs the taxpayer is owed a dividend and a fee equal to the value of the backstop, which together would render the enterprises economically unviable outside of conservatorship (for an explanation, see my original commentary). To make them viable, the Treasury and FHFA would have to reduce or eliminate one or both- yet this does not appear to be permitted under federal law.

Under 31 U.S. Code § 3711 and 31 CFR 902.2 the government can only “compromise a debt” owed the taxpayer when the debtor cannot pay, the cost of collection is prohibitive, or there is significant doubt as to the government’s ability to prove that the debt is owed. None of those apply here, so the Treasury would appear to be prohibited from reducing or eliminating these commitments.

While those with more creative legal minds may ultimately see a way out of this box, the challenge is more than a matter of weakness of political will, as Mr. Millstein suggests.

It is important to be clear about what this actually means for reform, though. Mr. Millstein claims that I take any administrative reform to be futile, which fortunately is not true. What I am skeptical of is an administrative path for long-term reform, reform that is intended to last decades, and not just until the next rough patch in the housing market.

For that kind of reform, we need Congress.

Of course, Congress is unlikely to pass long-term GSE reform into law any time soon and even then it will take years more to transition the enterprises out of conservatorship. So while it is important to continue to push for legislated long-term reform, it is also important, in some ways almost equally important, to take steps to reform the enterprises while in conservatorship.

To my mind this means increasing the stability and efficiency of the enterprises, so that they provide broader access to credit at less risk to the taxpayer. Director Watt laid out many such steps in his strategic plan earlier this month. It also means putting them into better position to transition to a future system that is in line with the broad consensus we've seen build over the last year. This is a more controversial aim, but increasingly worthy of debate the longer conservatorship drags on.

Some of Mr. Millstein's proposal may make sense within this framework of improving the system while in conservatorship. He is, after all, primarily focused on ways to bring more private capital into the system without undermining much of what historically has worked, objectives we should all share.

But it should not be mistaken for a viable plan for long-term reform. That will require the hand of Congress. Freddie Mac image from Frontpage /


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And the reason I have spent so much time on the administrative path (and taken the risk of incurring the ire of those of you who are so devoted to the legislative path) is the obvious inability of the Congress to agree on simple things, let alone something as ideologically charged as housing finance. If we want to end the conservatorships (the worst of all worlds), we have to take advantage of HERA, not engage in false hope that the Rs and the Ds can cross the great divide between the market purists supporting PATH and the market reformers supporting Corker Warner. HERA gave a new regulator power to fix what the Government got wrong in the last crisis (lax capital regulation) and what the gses got wrong (too much leverage and too much portfolio), with enough capital backstop budget authority to fund the transition to a better regulated, better capitalized system. We should get on that asap, while still debating what a more perfect world might look like.
Yes, it is true the PSPAs were put in place was to protect the GSEs creditors, including the beneficiaries of their MBS guarantees, against loss. But, the means by which this was done was NOT, as Parrott states, by putting the full faith and credit of the Federal Government behind their claims. Rather, it was by the Treasury Department’s commitment to buy “senior preferred stock” in each GSE to cure any net worth deficiency arising from their losses. These are known as “keep well” agreements, a promise to keep the GSEs solvent so that they could pay their creditors’ claims in the ordinary course. And, unlike a “full faith and credit” guaranty (such as stands behind the debt securities issued by the Treasury Department), the Treasury Department’s commitment to buy “senior preferred stock” in each GSE is NOT unlimited, but subject to budgetary limits imposed by Congress under HERA. Having already purchased $186 billion of such stock, the Treasury Department “only” has an additional $260 billion of budgetary authority to purchase more stock to “keep” the GSEs “well”. This budgetary limitation is important to keep in mind, as it helps elucidate the amendment provision of the PSPAs that Parrott asserts is a bar to the type of recapitalization transaction I have proposed. While it does include a limitation on amendments that might adversely affect the GSE's creditors, it expressly requires that standard to be measured "after taking into account any alternative arrangements that may be implemented concurrently with such waiver or amendment". The recapitalization transaction I have proposed is in fact an arrangement that the amendment provision could permit. Indeed, given the budgetary limits on Treasury’s ability to purchase additional preferred stock, the very kind of recapitalization transaction I have proposed may be the only way to protect the GSEs' $5 trillion of creditors against loss over the long term. And, it would also have the salutary effect of protecting Treasury from having to fund any more of its remaining $260 billion commitment by creating a “first loss” layer of capital ahead of taxpayers. I’m not enough of a student of the additional statutory provisions cited by Mr. Parrott (yet again) as a limitation on Treasury’s ability to engage in the type of recapitalization transaction I have suggested, but I would note that the GSEs do not owe Treasury a “debt” of the kind purportedly covered by those provisions. Treasury owns "stock" not "debt" in the GSEs. Whether the statute to which Parrott refers applies at all to how Treasury deals with its "stock" interests is therefore an open question in my mind. This looks to me to be just another red herring or an excuse for inaction. Regardless, even if the statute were be deemed to apply, the type of recapitalization transaction I have proposed would not involve any compromise of the value of Treasury's preferred stock or warrants at all. If implemented as I have suggested, it would be a way to maximize not compromise the value of those stock ownership interests. Again, I am afraid Mr. Parrott is spending too much time trying to get to “no” rather than trying to find a way to get to “yes”. Jim Millstein
If by “getting to yes” you mean getting sustainable long-term reform, then as you well know I’m as committed as any. The only reason that I bother casting a cloud on the administrative path (and taking on the ire of so many committed to it) is that I worry that we may commit a terrible mistake in letting the air out of the legislative effort because folks assume that we ultimately don’t need it. By walking through why the administrative path does not lead to long term reform, my hope is that we can focus our attention on the two paths in parallel: legislative efforts to overhaul the system over the long term, and administrative reform to strengthen it in the meantime. We run a great risk if we ignore either.
Could both Jims be wrong? Perhaps the GSEs should remain in conservatorship and even be put through statutory receivership. Neither entity is really profitable. If you leave aside the positive effect of tax assets and look at actual operating earnings, then factor in the remaining legacy exposures to bad loans, TDRs and REO assets, the resulting deficit drives both GSEs into the red. Falling securitization volumes is a factor here as well. Since Treasury is taking all of the net capital out of both entities, an argument can be made that they should simply be wound down in a receivership process. This would have the positive effect of wiping out the supposed private equity holders, who have never actually supported the risk capital needs of either enterprise. As and when FHFA gets around to lowering G-fees and LPPAs to pre-2008 levels, this because of the abysmal situation in the 1-4 family mortgage lending sector, the true financial posture of the GSEs will be apparent. Perhaps then the receivership choice will become more politically palatable. Or do we wait until Treasury is required to make new capital infusions? Keep in mind with receivership, the GSEs emerge on the other end of the process "born again" as they were at inception.