Treasury and the Financial Establishment

On Monday, Judge Margaret Sweeney removed the protective order on seven of the tens of thousands of documents covered by it that have been produced during discovery in lawsuits brought before her in the United States Court of Federal Claims.

Just these few were enough to show that Treasury has not been truthful in two critical areas relating to the conservatorships of Fannie Mae and Freddie Mac. First, they make clear that Treasury knew the companies were about to report a large jump in profitability at the time it “agreed” with FHFA to replace Fannie and Freddie’s 10 percent dividend requirement with a net worth sweep, taking all of their net income in perpetuity. Second, they leave little doubt that contrary to black letter law it has been Treasury, not FHFA, which has been calling the shots on virtually every key decision related to the companies since they were put into conservatorship (at Treasury’s initiative) in September 2008.

The fact that Treasury has not been truthful about its actions related to the takeovers of Fannie and Freddie and its subsequent management of the companies will come as a shock to most. But this deception and dishonesty is more understandable when placed in the context of the near two decades-long battle between supporters of Fannie and Freddie and members of what I call the Financial Establishment—large banks and Wall Street firms, and their advocates and alumni at Treasury and elsewhere—for control of what now is a $10 trillion financial market (and was an $11 trillion market before the housing collapse and the nationalization of Fannie and Freddie). I covered this battle in detail in my book, The Mortgage Wars, calling it “a no-holds-barred fight among giant financial institutions and their regulators over who would have the dominant position in this market—and the profits that went along with it.” In a fight this fierce not everyone plays by the rules, and Treasury, as now is apparent, has been one that has not.

In earlier stages of the mortgage wars, Treasury and its partner in the fight, the Federal Reserve, made decisions and took actions that were unwise but not improper or illegal. These included declining to regulate risky subprime lending practices, and changing bank risk-based capital rules to give private-label securities (PLS) the same risk weights as Fannie and Freddie mortgage-backed securities in spite of the obvious differences in the nature and structure of the credit protection offered by each. The combination of risky primary market loans, no effective discipline on what could be financed in PLS, and the Wall Street risk-shifting (or -disguising) innovations of collateralized debt obligations (CDOs) and synthetic CDOs produced the housing boom and bust that followed.

When the PLS market imploded in the fall of 2007, rather than admit that the Financial Establishment’s goal of substituting private market capital for financing by Fannie and Freddie was dangerously misguided, Treasury doubled down on it, using the impending financial crisis as a pretext to disguise a takeover of Fannie and Freddie as a rescue, then installing a conservatorship that it, through FHFA, illegally managed with terms and actions designed to prevent the companies ever from emerging from that conservatorship. At the same time, and against all factual evidence, opponents of Fannie and Freddie successfully promoted the myth that these two companies—not unregulated, undisciplined and careless private market participants—were the ones to blame for the calamities in the mortgage and housing markets.

We’re now in the late stages of the mortgage wars, and little has changed. The Financial Establishment still is attempting to get rid of Fannie and Freddie and replace them with “private sources of capital,” asserting that this will be in the best interests of all. Indeed, their latest plan for the future of the mortgage finance system was laid out just three weeks ago: it is the Parrott, Ranieri, Sperling, Zandi and Zigas “A More Promising Road to GSE Reform” proposal. What gives this away as the Financial Establishment’s plan is that two of its core elements—the common securitization platform being developed by Fannie and Freddie and the companies’ undertaking a series of large, programmatic securitized risk-sharing transactions—have been well underway for years, at the instigation and under the direction of Treasury and its captive conservator, FHFA.

As I noted in an earlier post, it’s astounding that the authors of “Promising Road” would again propose to replace a secondary market mechanism that has been proven to work—relying on specialized companies such as Fannie, Freddie and the mortgage insurers to grade, price, diversify and manage mortgage credit risk—with anything remotely resembling the disastrous experiment of a decade ago of basing a ten trillion dollar market on the ephemeral investment preferences of leveraged capital markets investors with no particular mortgage credit risk appetite or expertise. While financial institutions that back and benefit from such an approach may wish to try that again, few if any others should—particularly homebuyers, who were burned so badly the last time.

Financial Establishment advocates for the “Promising Road” and earlier comparable plans justify their proposed elimination of Fannie and Freddie—or the requirement that the companies hold bank-like levels of capital that would render them ineffective if they were allowed to survive—by saying that while their recommendations may raise the cost of mortgages for homebuyers, they “protect the taxpayer.” Yet with nearly two-thirds of taxpaying households owning their own homes, more often than not the taxpayer and the homebuyer are the same person. It therefore is incumbent to ask, “who is being protected, from what, and at what cost?” Asking and answering that question, it becomes evident that most Financial Establishment reform proposals impose large and certain costs on the homebuyer/taxpayer to protect against risks that if differently structured, regulated and managed would have much lower costs for them, if any cost at all.

To illustrate this point, we can examine how the homebuyer/taxpayer fares under the regime I outlined in my proposal, “Fixing What Works,” compared with one in which Fannie and Freddie, or some new entity or entities, are required to hold 4 percent capital and pay an additional 10 basis points to insure against the possibility of credit losses greater than what the entities can cover with their capital and guaranty fees.

In my proposed regime, Fannie and Freddie would hold capital sufficient to protect against a 25 percent nationwide decline in home prices. Given their current mix of business or anything similar, and a 10 percent capped return target, Fannie and Freddie would charge about 40 basis points (before temporary payroll tax and affordable housing fees of 14.2 basis points) to guarantee a homebuyer’s mortgage. With 4 percent capital, a 10 basis point catastrophic risk premium, and pricing to a 12 percent return target, a guarantor would have to charge about 90 basis points (before the other fee add-ons).

There is no “risk to the taxpayer” in my proposed system, because the government would agree to provide short-term repayable support to the companies should their capital ever prove inadequate. And while my system does have moral hazard, it is greatly reduced by the limited returns the companies would agree to and by the conservative stress standards they would be required to meet, in exchange for the government backstop. Moreover, officers of the companies, as well as their shareholders, would have strong incentives to manage their affairs properly and prudently. Because the capped returns are set at pricing, the companies would retain any excess if the loans perform better than expected. And officers and shareholders each would suffer great hardships should the company in fact require short-term assistance. Top executives would lose their jobs, and the value of their and shareholders’ stock would plummet. In addition, the companies would have to replace the capital they lost by issuing new shares of common stock at very low stock prices, badly diluting the value of existing shares, even after the companies recover.

Were it possible to ask our homebuyer/taxpayer what is in his or her best interest, I could imagine putting the following proposition to them: “We can set this system up in three ways. In the first, we’d require the guarantor of your mortgage to have enough capital to withstand a 25 percent decline in home prices; you’ll pay 40 basis points per year to have your mortgage guaranteed, but if the guarantor ever runs out of capital you’ll need to make it a short-term loan that you, the homeowner/taxpayer, will get repaid. In the second alternative, we’d make the guarantor put up 4 percent capital and pay 10 basis points per year to the Treasury for catastrophic loss insurance; you’ll pay an extra half of one percent in guaranty fees—or about one percent of your annual income—compared with what you’d pay with the first system, but you’ll never have to worry about making a repayable loan to your guarantor if it runs short of capital. In the third system, we’d set up a new government corporation to guarantee your mortgage; unfortunately, though, we can’t tell you how much that guaranty will cost you, because it will depend on what a group of capital markets investors—mainly hedge funds—will charge to take the credit risk on your loan. Which of these would you prefer?”

It wouldn’t be a difficult decision. The homeowner/taxpayer, however, doesn’t have a say in what they’ll get, while the Financial Establishment does. That’s why we don’t yet have a sensible and workable system, and why we still could end up with another disaster.