The Path Forward

At the beginning of this year, in a post titled “Economics Trumping Politics,” I wrote: “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.”

Based on the Mnuchin comments, my expectation had been for a relatively quick settlement of the lawsuits against the government for its handling of Fannie and Freddie in conservatorship, followed by a reform and recapitalization plan for the companies that would have provided them with regulatory and capitalization schemes designed to maximize their effectiveness as mortgage guarantors. Such a result would have been driven both by the interests of shareholders behind the lawsuits and the interests of Treasury, which holds warrants for 79.9 percent of the companies’ common shares, and would have been in the best interest of mortgage borrowers. While the large banks and the political opponents of Fannie and Freddie would have objected to keeping the companies alive, without a workable legislative alternative they would not have been able to prevent it.

On February 21, however, the U.S. Court of Appeals for the D.C. Circuit in the Perry Capital case unexpectedly (and inexplicably) held that plaintiffs’ statutory claims against the net worth sweep were barred by the anti-injunction provision of the Housing and Economic Recovery Act. Shortly afterwards two suits challenging the sweep in lower courts—Roberts in Illinois on March 20 and Saxton in Northern Iowa on March 27—were dismissed in opinions citing the Perry Capital decision. Still another lower court case, Collins in Texas, challenging not only the net worth sweep but also the constitutionality of the Federal Housing Finance Agency (FHFA) as a federal agency headed by a single director removable by the president only for cause, was dismissed on May 22.

The Perry Capital ruling and the subsequent dismissals of other net worth sweep cases in lower courts halted whatever near-term momentum administrative mortgage reform might have had. Treasury had no justification for initiating settlement of a case it so evidently was winning—and that was bringing over $15 billion per year into its coffers—and without resolution of the sweep Fannie and Freddie cannot be removed from conservatorship.

With administrative reform efforts stalled, the spotlight returned to the legislative side. On April 20 the Mortgage Bankers Association put out a white paper arguing (incorrectly, in my view) that legislation was essential to achieve the consensus objectives of “protecting taxpayers, attracting capital to Guarantors, and ensuring consumers and borrowers have access to affordable housing.” Then, on May 23, the American Bankers Association sent Secretary Mnuchin a paper (“Reforming the Housing Enterprises—Sustaining Homeownership and Protecting Taxpayers”) taking virtually the same position, while also advocating additional restrictions on credit guarantors and more benefits or flexibilities for primary market originators.

Yet while the focus of mortgage reform may have changed, what hasn’t changed are the relative degrees of difficulty of legislating something new and untested versus administratively fixing something that already exists and has been proven to work.

Legislative reform efforts never have been about devising a secondary market system that produces the lowest cost and most available mortgage financing for homebuyers; their core objective instead has been to remove or restrict two companies—Fannie and Freddie—whose operations have made it more difficult for large commercial and investment banks to exercise the control over and make the amount of money they wish to from the $10 trillion single-family residential mortgage market. For that reason proponents of legislative reform have as an unconditional requirement that Fannie and Freddie either be eliminated or altered to a degree that they no longer can operate as effectively and efficiently as they once did. Advocates for these changes may say publicly that they are remedies for a “failed business model,” but the reality is that they end up having to propose secondary market credit guaranty mechanisms that work less well than Fannie and Freddie now do, or have a risk of not working at all.

Legislating the replacement of the known and proven with the unknown and uncertain always is difficult, and there are four factors that make it even more so in the current environment. The first is the extreme partisanship and divisiveness in both houses of Congress today. Second, setbacks to attempts by the Trump administration to replace the Affordable Care Act and achieve consensus on an approach to tax reform further complicate the task of knitting together a coalition capable of agreeing on and passing reform legislation. Third, there are fundamental, and seemingly irreconcilable, philosophical differences between the Senate and the House on whether there should be an explicit government guaranty on securities issued by the envisioned successors to Fannie and Freddie: the Senate supports one, whereas a significant number of members in the House insist that the future secondary market be “fully private,” with no government support at all.

Finally, to put and keep the companies in conservatorship Treasury has had to single out their shareholders for unprecedentedly punitive treatment—forcing the companies into conservatorship, having FHFA add massive temporary or artificial accounting expenses to make them take unneeded and non-repayable senior preferred stock, and then, when the effects of the accounting expenses reversed, taking all of their net income in perpetuity. Advocates of “winding down and replacing” Fannie and Freddie through legislation seem to be wishing away the challenge of convincing investors to put up $150-$200 billion in capital for new and untested credit guarantors at the same time as the government is expropriating the capital previously invested in the two existing secondary market entities.

For these reasons I believe it is highly unlikely that mortgage reform legislation can pass before the 2018 midterm elections (beyond which time prediction is foolhardy because of possible changes in the political landscape). It is tempting to conclude that the status quo will continue indefinitely, since it will be favored by Congress—whose leaders see it as preferable to administrative reform preserving Fannie and Freddie—and it also benefits the administration, which can keep the companies’ net income while publicly exhorting Congress to end the legislative impasse. Ultimately, though, the lawsuits make the status quo unsustainable.

A number of cases related to the net worth sweep are still pending. There is the Jacobs-Hindes case in Delaware District Court, asserting that the sweep violates Delaware and Virginia law applicable to Fannie and Freddie and thus is void and unenforceable. An appellate court decision in favor of the plaintiffs in any one of four cases—Robinson in Kentucky, or Roberts, Saxton or Collins—would conflict with the finding of the D.C. District Court Appeals in Perry and trigger “a split in the circuit,” making it likely that the Supreme Court would hear and decide the issue. And just this past Thursday (June 1), a new suit challenging the constitutionality of FHFA was filed in the District Court in Western Michigan. While the timing on the final disposition of all of these cases is uncertain, and the appellate decision in Perry has reduced the odds of the sweep eventually being overturned, as long as any suit remains outstanding the government is at risk of losing it.

Moreover, if the net worth sweep is upheld across the board the government still must contend with the breach of contract claims remanded to the Lamberth court in the Perry Capital case, as well as the regulatory takings charges in the Federal Court of Claims under Judge Sweeney. Breach of contract and takings are constitutional claims, the remedy for which is monetary damages. In the absence of legislation eliminating Fannie and Freddie they will remain at the center of the secondary market and become increasingly profitable. Were plaintiffs to prevail in one of the constitutional cases, particularly the takings case, requested damages could be staggeringly (and appropriately) large.

I believe Secretary Mnuchin sees and understands this bigger picture. Even if he hadn’t already pledged to remove Fannie and Freddie from government control, he knows he has to take the initiative on mortgage reform while he still has some control over the outcome. With his path to administrative reform blocked for the moment by the Perry Capital decision, his only practical option is to work with industry leaders, lobbyists and members of Congress on the legislative efforts they now are pursuing. In doing so, however, he should and I think will set a high bar for what he deems to be an acceptable reform package. Treasury has a 79.9 percent stake in the two companies that have the best past record of secondary market performance and the best prospects for future success, but which Congress, under the influence of the banking lobby, is intent on phasing out or re-chartering. Politically motivated reform that replaces Fannie and Freddie with a less effective alternative would eliminate Treasury’s payments from the net worth sweep (for as long as they remain legal), make its warrants for the companies’ common stock worthless, and raise the cost and reduce the availability of mortgage credit for homebuyers. Those are not outcomes Mnuchin wants.

While Congress tinkers with legislative reform, therefore, Mnuchin will continue to assess his options for administrative reform. In this regard, a plan released late last week by the investment bank Moelis & Company, which describes itself as “financial advisers to certain non-litigating preferred stockholders of Fannie Mae and Freddie Mac,” may well gain traction. The Moelis plan, titled “Blueprint for Restoring Safety and Soundness to the GSEs,” relies on Treasury and FHFA’s existing authorities to set new capital standards for Fannie and Freddie, strengthen their regulation, and prepare them for exit from conservatorship following a series of equity issuances over a four-year period. Moelis contends that its plan also would net taxpayers $75 to $100 billion from sale of Fannie and Freddie stock acquired upon exercise of Treasury’s warrants.

I will have more to say about the Moelis plan in a future post; overall I find it to be very promising, but believe its fixed, bank-like capital standard needs to be refined in order to produce the business results Moelis is projecting, and to enable Fannie and Freddie to price their guarantees in a way that offers affordable financing to a broader range of borrowers. For now, though, the important point to make about the “Blueprint” is that it puts a concrete, third-party administrative proposal into the public domain for evaluation against the multitude of competing plans for legislative reform.

A significant weakness of the many legislative reform plans that have been offered over the last few years has been a lack of operational detail on how their proposed new credit guaranty mechanisms would work, and vagueness about the transition of $5 trillion in mortgage guarantees from the books of Fannie and Freddie to the envisioned new credit guaranty mechanisms or companies. The Moelis proposal, in contrast, uses an existing and proven infrastructure, includes detailed financial projections and a timeline for achieving its capitalization objectives and, in its words, “does not require a winding down of the existing GSEs, or use of market-destabilizing legal constructs like receivership, as envisioned by the MBA” that also would “[fail] to resolve existing shareholder litigation and would likely lead to new legal claims…that increase the prospect of a court-imposed solution rather than a policy-led solution.”

The president of the Mortgage Bankers Association, David Stevens, immediately responded to the Moelis plan by saying, “This proposal is clearly self-serving and designed to confuse unsuspecting, innocent taxpayers into supporting a plan that is intended to line the pockets of hedge funds who invested in Fannie and Freddie.” Tellingly, however, Stevens offered no specific criticism of the plan. Instead, he fairly begged critics of the MBA’s plan to respond by calling it “clearly self-serving and designed to confuse unsuspecting, innocent homebuyers into supporting a plan that is intended to line the pockets of banks who want the business of Fannie and Freddie.”

To date there has very little substance in the debate about what to do with Fannie and Freddie going forward. Together with the interest and participation of the Mnuchin Treasury, the Moelis proposal should help change that, by serving as a catalyst to shift the mortgage reform discussion in Washington from inaccuracies, political rhetoric and name-calling to a serious analysis of the competing plans on their merits. When and as that occurs—as I believe it will—the optimism in my “Economics Trumping Politics” post about a fact-based administrative reform process prevailing over a misinformation-based political process should again seem justified, although it will take longer to play out than I expected originally.