Economics Trumping Politics

For the past eight years, what I refer to as the Financial Establishment—large banks and Wall Street firms, and their advocates and alumni at Treasury and elsewhere—has been engaged in a well designed, carefully scripted and highly orchestrated political campaign to convince Congress to replace Fannie Mae and Freddie Mac with a mechanism more financially beneficial to themselves. Then, seemingly out of nowhere, five weeks ago Treasury Secretary-designate Steven Mnuchin announced his intention to “get [Fannie and Freddie] out of government control…reasonably fast.” With this statement, the odds immediately flipped to favor the prospect that the fates of Fannie and Freddie will be determined not by a misinformation-based political process likely to benefit banks, but by a fact-based economic process likely to benefit borrowers.

Banks’ battle for control of the U.S. residential mortgage market began in earnest in the late 1990s, following a decade of concentration of assets and mortgage originations in that industry. Large banks saw Fannie and Freddie’s activities in the secondary market—principally their underwriting standards and the impact of their guaranty fees and mortgage-backed security (MBS) yields on mortgage rates—as constraints on banks’ flexibility to customize and price their mortgages in the primary market. In 1999 three large banks, one subprime lender and two large mortgage insurers banded together to create and sponsor a lobbying group called FM Watch, whose purposes were to put out information depicting Fannie and Freddie in as negative a light as possible, and to lobby Congress for changes to the companies’ charters to raise the cost and restrict the scope of their business. FM Watch had relatively little success in its efforts, however, in large part because they so transparently served banks’ interests at borrowers’ expense.

The 2008 financial crisis provided Treasury with a serendipitous opportunity to accomplish what the large banks and FM Watch could not. Under pretense of a rescue, it forced Fannie and Freddie into conservatorship, against their will and without statutory authority, and deliberately withheld from them the onerous terms that would be imposed in the aftermath, which were intended to prevent them from ever returning to private, shareholder-owned status.

The takeovers of Fannie and Freddie in 2008 were accompanied by an aggressive and highly coordinated disinformation campaign that was far more ambitious and audacious than anything attempted by FM Watch. Using the technique of “fake facts” that since has become a standard weapon in the political arsenal, members and supporters of the Financial Establishment ignored the obvious evidence—including the disastrous credit performance of loans financed with private-label securities and the vastly lower delinquency numbers put out by Fannie and Freddie each month—and simply blamed Fannie and Freddie for the crisis. With that, they had a mantra they could repeat endlessly: Fannie and Freddie had a “flawed business model;” they (alone) caused the financial crisis, and it had taken $187 billion in taxpayer money to paper over their mistakes. The Financial Establishment also had a proposed remedy: the companies must be “wound down and replaced,” with whatever secondary market mechanism it recommended.

This complete misrepresentation of the causes of the crisis—and the appropriate response to it—encountered virtually no resistance or opposition. That, too, was by design. One of the conditions imposed by FHFA on Fannie and Freddie, in writing, on the day they were put into conservatorship was that “all political activities—including all lobbying—will be halted immediately.” The executives at Fannie and Freddie had the most knowledge about the true causes of the crisis, but with the FHFA edict their voices, and those of the consultants and lobbyists they employed, were silenced. And when discussions on mortgage reform began in Washington in 2009, it was understood even by the independent think tanks that in order to have a “seat at the table” you had to accept as a given that the mortgage finance system of the future would not include Fannie and Freddie, or any entity that looked or functioned like them.

The mortgage reform debate in Washington should have been an economic exercise in how best to apply the lessons from the housing bubble and subsequent meltdown to make our mortgage finance system safer and more resilient, while maintaining its accessibility and affordability for consumers. Instead, it became a political exercise in deliberately misstating and distorting those lessons, to justify giving control over the availability, terms and pricing of $10 trillion in mortgages to the large banks and investment firms.

Large bank mortgage originators in the primary market have long known that the most sure way to minimize the constraints and disciplines imposed upon them by credit guarantors in the secondary market is to make those guarantors less efficient by forcing them to hold (and price for) more capital than is warranted by the risks they insure. Thus, the one consistent element in every reform proposal made or endorsed by the Financial Establishment has been that any entity or mechanism that replaces Fannie and Freddie must have bank-like levels of capital backing its credit guarantees. Advocates for this position advance two politically powerful arguments to support it: to create a “level playing field” for all competitors, no form of financing mortgage credit risk should have a lower capital requirement than any other, and “more capital is better” because it keeps the taxpayer safer.

Economically, however, a single, artificially high capital ratio applied to the entire range of credit risks for all single-family mortgages made throughout the country violates the principle that capital must be related to risk, and cripples the credit guaranty business model (which the Financial Establishment understands). For example, a 5 percent fixed capital ratio requires a credit guarantor to charge an average annual guaranty fee of between 80 and 90 basis points (before the 10 basis point payroll tax fee paid to Treasury) to earn a market return on its capital. To average an 80 to 90 basis point fee rate on the mortgages being made today—which have an expected annual loss rate of less than 4 basis points—a credit guarantor would need to significantly overcharge for most of its guaranteed loans, and grossly overcharge for higher-quality loans. Borrowers would be badly hurt by those pricing distortions, while banks and Wall Street firms would profit from them.

Interest rates on 30-year fixed mortgages are based on the cost of selling into MBS, so any increase in average guaranty fees would be passed on directly to borrowers. Let’s say that excessive capital requirements result in 40 basis points of “unnecessary” guaranty fees. On average, mortgage borrowers would pay that amount, while portfolio lenders would receive it. Commercial banks today hold $1.7 trillion in single-family first mortgages in their portfolios (up 9 percent from a year ago); a 40 basis point rate increase rolling into them, as old loans pay off or refinance and new ones replace them, would raise banks’ net interest income by almost $7 billion per year. Higher 30-year fixed mortgage rates, over time, also would lead more borrowers to choose adjustable-rate mortgages—which banks can match with their short-term deposits, with borrowers bearing the risk of interest rate adjustments—and, for Wall Street firms, would make private-label securitization more competitive with (overpriced) guaranteed MBS. Finally, 40 basis points more in mortgage rates and 80 to 90 basis point guaranty fees would allow banks to increase their interest income and reduce their credit losses by keeping their lower-risk mortgages in portfolio (funded with low-cost, government-insured deposits) while swapping and selling their higher-risk mortgages as guaranteed MBS.

The Financial Establishment is well set up to obtain these results from the political process. Eight years of constant and unchallenged repetition of falsehoods about the causes of the financial crisis and the alleged weaknesses of the Fannie and Freddie business model has erected a solid wall of disinformation in the media, among the general public and in Congress that has proven very difficult even for confirmed facts to break through. In my view, all that has kept the Financial Establishment from being successful in Congress has been its inability to come up with a workable alternative to the two companies it so desperately wants to replace. (Its latest attempt—risk-sharing securities that only pretend to transfer credit risk—is a step backwards.)

Now, however, comes Mnuchin’s pledge to resolve the impasse over Fannie and Freddie “reasonably fast,” which decisively changes the reform dynamic. In an administrative process, responsibility for accomplishing mortgage reform shifts from a large number of misinformed members of Congress with political incentives to get it wrong to a small number of informed finance professionals with economic incentives to get it right. Moreover, the deceptions, inventions and falsehoods about Fannie and Freddie that have served the Financial Establishment so well in the legislative process will work against it in an administrative process, where the focus will be on facts produced in the course of judicial proceedings.

A key element of Treasury’s strategy of blaming Fannie and Freddie for the financial crisis was to bury them under a mountain of non-repayable senior preferred stock by directing FHFA, as conservator, to put massive amounts of non-cash expenses on their books. But because the resulting losses were not real, there was nothing FHFA or Treasury could do to keep those losses from reversing. Between the fourth quarter of 2012 and the first quarter of 2014, most of them did. Recognizing that this was about to happen, Treasury and FHFA entered into the net worth sweep in August 2012, preventing the companies’ from rebuilding their capital by taking all of their future income for the government. Treasury’s public defense for the sweep was that it was in Fannie and Freddie’s own best interest, to avoid their entering “death spirals” of borrowing to pay the dividends on their senior preferred stock.

Treasury had gotten away with countless dishonesties about the companies before, but this was too much. Numerous lawsuits were filed challenging the legality of the sweep (with one challenging the conservatorship) in several courts under different theories of law. The judge in one of the courts—Margaret Sweeney in the U.S. Court of Federal Claims—granted plaintiffs requests for discovery. From this discovery, documents have slowly emerged, and more are in the process of being compelled, that make clear that far from rescuing Fannie and Freddie, Treasury planned and carried out their takeovers for ideological and policy reasons, then lied to both the public and the courts about what it had done and why.

Plaintiffs in the court cases have had three and a half years to learn the facts about what really happened to Fannie and Freddie. Mnuchin’s plan to “get [the companies] out of government control” requires settling the lawsuits, and when settlement talks begin he, and the rest of his (new) senior Treasury staff, will learn those facts. Just that quickly, eight years of investment by the Financial Establishment in a fictitious account of the mortgage crisis, and a mythical depiction of Fannie and Freddie, will lose its influence. Fiction only has power where facts aren’t known.

The fact-based settlement discussions between plaintiffs in the lawsuits and senior economic and financial officials in the Trump administration also will set the tone for how the parties think and decide about what the post-settlement secondary market system should look like, and how it should function. Plaintiffs know that Fannie and Freddie were not the causes of the financial crisis, that they didn’t need to be rescued by the government, and that their secondary market business model works better than any other. They also know that because the alternatives to Fannie and Freddie proposed by the Financial Establishment are deliberately designed to be inefficient, it would be impossible to raise the requisite amount of capital to set them up (a point continually missed by advocates of these alternatives), whereas recapitalizing Fannie and Freddie post-conservatorship is eminently achievable. Plaintiffs emphatically will make these points, and others, to Mnuchin and his team.

In an administrative reform process, plaintiffs and the government each will have powerful economic incentives not just to reform, release and recapitalize Fannie and Freddie, but also to set them up to succeed. Plaintiffs know that Fannie and Freddie have much more value as ongoing entities than in liquidation, and both Bruce Berkowitz and Bill Ackman have said repeatedly that “there is no alternative” to the companies. For its part, the Trump administration will have at least two reasons to support them. First, it will understand from facts unearthed for the lawsuits that a secondary mortgage market built around Fannie and Freddie is far better for consumers and the economy than the bank-centric proposals supported by the Financial Establishment, and will know it will be held accountable for the negative consequences of choosing the latter. Second, the Trump Treasury will inherit the warrants for 79.9 percent of Fannie and Freddie’s common shares created by the Bush Treasury, which will become worthless if the companies are wound down.

While the Trump Treasury could (and should) cancel those warrants on the grounds that they were granted improperly, their financial value makes this unlikely. And as warrant holder, the Trump Treasury will share the plaintiffs’ goal of setting Fannie and Freddie up to operate as cost-effectively and efficiently as possible (benefitting borrowers as well as shareholders). It also will have strong incentives to alter the terms of the warrants—their strike price, percentage amount or both—and to manage the timing of conversions so as to maximize the value of all three categories of stock the companies will have as going concerns: existing shares, converted warrants, and the new issues of equity required for recapitalization. Plaintiffs, the Trump administration, existing shareholders and borrowers will be aligned around common objectives.

Members and supporters of the Financial Establishment will fiercely oppose an administrative solution to mortgage reform that maintains Fannie and Freddie—indeed they’ve already begun to do this in the media—but they will be dealing from a position of weakness. They have no realistic legislative alternative to offer, and because Republicans in the executive branch will know the facts about Fannie, Freddie and the financial crisis from discovery in the court cases, Republicans in Congress will not be able to sustain their myths about them. There never has been any economic case against reforming, releasing and recapitalizing the companies, and without the myths the political case falls apart.

It is by no means a certainty that the Trump administration will arrive at the right solution on mortgage reform. But because it has made the issue a “top ten” priority, and the path to a successful outcome is so obvious and wide open, for the first time in quite a while there is great cause for optimism.