Getting From Here to There

Since Fannie Mae and Freddie Mac were forced into conservatorship in 2008, they have faced two daunting uncertainties: their near-term fates in that conservatorship, and their long-term fates in mortgage reform. The two are interrelated, and resolution of the first almost certainly will affect resolution of the second.

Before addressing why this is so, it’s useful to recap how we got to where we are.

In the mid-1970s, the U.S. had a deposit-based mortgage finance system: nearly three-quarters of all single-family mortgages were made and held by thrift institutions and commercial banks (with thrifts’ holdings being roughly three times those of banks). Two successive thrift crises—the first in the late 1970s triggered by deposit deregulation and the second in the late 1980s triggered by asset deregulation—caused that system to collapse. Thrifts’ share of single-family mortgages financed plunged from 57 percent in 1975 to just 17 percent in 1995. Financing by Fannie and Freddie filled almost the entire gap. The companies’ ability to tap the international capital markets for mammoth amounts of low-cost fixed-rate mortgage funding enabled the U.S. mortgage finance system to undergo a seamless transition from a deposit-based to a capital markets-based system, with little discernible adverse effect on homebuyers. At the end of the 1990s, Fannie and Freddie either owned or guaranteed more than 40 percent of all outstanding single-family loans, up from less than 5 percent 25 years earlier.

Fannie and Freddie’s rise to prominence as sources of mortgage finance coincided with a period of tremendous concentration of assets and originations among mortgage lenders. In 1990, the top 10 U.S. banks held 26 percent of banking assets; in 2000 that same share was over 50 percent. There was comparable concentration among mortgage originators. The independent mortgage banking company virtually disappeared between 1990 and 2000 (Countrywide being the prominent exception), with most being acquired by banks. During that same period the origination share of Fannie’s top 10 customers more than doubled, rising from 17 percent to nearly 40 percent.

We entered the 21st century, therefore, with Fannie and Freddie dominating mortgage financing in the secondary market, and large banks dominating mortgage originations in the primary market. It was a relationship that worked efficiently: the cost of origination came down, credit was widely available, and underwriting standards were disciplined so both credit losses and guaranty fees remained low. But the relationship also was fraught with tension. The standards Fannie and Freddie set for their secondary market operations placed severe constraints on banks’ operations in the primary market, specifically their product offerings, pricing and profitability. The large banks, in particular, chafed under those constraints. At the time the U.S. residential mortgage market was the largest credit market in the world (the Federal budget had temporarily gone into surplus, and Treasury debt was shrinking). Banks did not wish to cede control of that market to Fannie and Freddie, and what I refer to as the “mortgage wars” began.

It is critical to understand that the mortgage wars were fought not over who could provide the lowest-cost or safest mortgages to homebuyers, but to determine who could get the most power in the mortgage market and thus command the flow of profits from it. The fight took place at a time when the principal financial regulators, the Federal Reserve and the Treasury, were embracing free market principles and declining to police any lending practices or mechanisms. In that environment, the combatants had free rein to turn underwriting from a tool to prevent losses into a weapon to produce market share. They did this to an unprecedented degree, with the subsequent “race to the bottom” in lending standards resulting in a cascade of bad loans and uncontrolled overheating in the housing market that once underway sped to an inevitable meltdown.

The great irony in this meltdown was that, as it was occurring, the two entities whose regulatory policies created the conditions that led to it—the Fed and the Treasury—were given extraordinary latitude to create winners and losers out of the carnage. Fannie and Freddie had by far the best lending practices of any sources of mortgage credit leading up to the crisis, but consistent with longstanding Fed and Treasury policy objectives they were singled out for punitive treatment. With no basis in statute, and against the companies’ will, Fannie and Freddie were put into conservatorship and saddled with a senior preferred stock purchase agreement designed to enable their conservator, FHFA, to bury them under a mountain of non-repayable senior preferred stock intended to keep them in conservatorship until Treasury or others could figure out a way to replace them.

Replacing Fannie and Freddie, however, turned out to be a much more challenging task than anyone, including Treasury, had counted on. In part this was because the companies were so successful: their business model works, while most alternatives to them do not.

All of which brings us to where we are at present. At Treasury’s direction, FHFA has been managing Fannie and Freddie not to prepare them for release from conservatorship but to ultimately wind them down. We now know from the “Promising Road to Mortgage Reform” proposal released in late March that the current plan of what I call the Financial Establishment—large banks and Wall Street firms, and their supporters at Treasury and elsewhere—is for Congress to at some point turn Fannie and Freddie into a single government corporation with an explicit federal guaranty on its securities. Consistent with this goal, FHFA has required the companies to collaborate on building a common securitization platform, and mandated that they do the types of securitized risk-sharing transactions the Financial Establishment would like to see become the standard means of managing mortgage credit risk in the future.

There is, however, a huge potential roadblock in the “Promising Road,” and that is the plethora of lawsuits challenging Treasury and FHFA’s treatment of Fannie and Freddie, not just with the net worth sweep but prior and subsequent to that action as well. To get around that roadblock, Treasury and FHFA must prevail in the lawsuits. Oral argument on April 15 in one of those cases—the appeal of Judge Lamberth’s September 30, 2014 lower court decision dismissing a suit brought by Perry Capital—highlighted just how hard it will be for them to do so.

In dismissing the Perry Capital case, Judge Lamberth held, among other things, that the language in the statute governing FHFA’s management of Fannie and Freddie in conservatorship (the Housing and Economic Recovery Act) made FHFA immune from legal challenge no matter how egregious its conduct. Lamberth seemed sufficiently confident in his opinion on the law that he did not require FHFA to produce a full administrative record of the facts. Based on my reading of the transcript of the appeal’s oral argument, and the readings of many legal analysts, at least two of the three judges on the appeals court panel, Judges Ginsburg and Brown, disagree with Lamberth’s ruling on the law. If that interpretation is correct, Lamberth’s ruling has little chance of being affirmed; it either will be vacated and remanded to his court for further fact-finding, or be reversed, invalidating the net worth sweep.

I would not rule out reversal, but believe it more likely that the Perry Capital case will be remanded to Lamberth’s court, with instructions to develop a complete administrative record. Remand would allow the net worth sweep to remain in place for a while longer, but it still would not be a good development for the government. It would mean that in both the District Court and Judge Sweeney’s Federal Court of Claims, judges will have opined that facts matter. And if facts matter, what Treasury and FHFA did with Fannie and Freddie in 2012 with the sweep, and currently are doing with the companies in their management of them in conservatorship, at some point will be judged to be illegal. The only question is when.

The “when” on the net worth sweep is not easy to predict, because it depends on which court rules first. It probably is least likely for the first ruling to come from Sweeney’s Court of Claims. While Sweeney seems to have lost patience with the government’s foot-dragging on document production and excessive claims of privilege (saying in her ruling to release the seven documents prior to the Perry Capital oral argument, “The court will not condone the misuse of a protective order as a shield to insulate public officials from criticism in the way they execute their public duties”), the calendar she has set will take her at least a year to determine if her court has jurisdiction in the case. More likely to see the first net worth sweep ruling is Jacobs-Hindes in the Delaware District Court. That case currently is on hold pending a FHFA request to a Multi-District Litigation (MDL) panel to consolidate it with other District Court actions. But the MDL panel should rule on this request in early July, and I expect it to allow Jacobs-Hindes to remain in Delaware. If it does, the point of law in that case is straightforward—the suit claims the net worth sweep is illegal under Delaware state law, and is void ab initio—so it should proceed expeditiously, and very likely be decided in favor of the plaintiffs.

If and when the net worth sweep is overturned, there will be two possible remedies. The first would be for Treasury to write checks to each company for the difference between what they paid since the sweep began and what they would have paid had the 10 percent senior preferred stock dividend remained in effect. Currently that is about $130 billion—$79 billion to Fannie and $51 billion to Freddie—although those numbers should decline somewhat as time goes on, since the companies’ normalized earnings are likely to be less than their annual dividend requirements. Treasury might prefer this option, but it is not feasible politically because it would require a massive cash outlay that would increase the deficit. That makes the only practical alternative the second remedy: retroactively crediting all net worth sweep payments in excess of the companies’ original quarterly dividend payment as reductions in their amounts of senior preferred stock outstanding.

If done soon, this second method of unwinding the net worth sweep would not require Treasury to pay out any cash at all. Assuming that Treasury pays the same 2 percent per annum on its excess collections in the net worth sweep as the IRS pays on corporate tax overpayments, I calculate that unwinding the sweep would leave Fannie with about $12 billion in outstanding senior preferred stock at the end of 2015, and Freddie with about $5 billion. (The interest payments amount to only about $5 and $3 billion, respectively.) The longer the net worth sweep remains in place, however, the more likely it is that Treasury will have to make an outlay even under this option. Fannie could fully pay off its senior preferred stock with about $10.5 billion in net income this year, and Freddie could do so with about $5 billion in net income.

A ruling against the net worth sweep and an unwinding of the senior preferred stock (and removal of its 10 percent dividend), which I believe are now likely, would significantly change the dynamic of mortgage reform. Fannie and Freddie each would be operating successfully and profitably, be able to retain all (or nearly all) of their retained earnings to build capital, and be able to raise capital publicly. At the same time, an adverse ruling in a net worth sweep case would focus attention on Treasury’s true motives for having taken the companies over in the first place. With the alleged dangers posed by the continued existence Fannie and Freddie seen as the fabrications they are, it would be much more difficult to justify the risks of replacing them with untested alternatives—particularly those that raise costs for homebuyers to the benefit of financial institutions.

I have long felt that the biggest danger we face in mortgage reform is not inaction, as bad as that is, but doing something that sets the system back, whether in terms of cost, access or risk. To date there have been nine essays published by the Urban Institute in its “Housing Finance Reform Incubator” series, and they contain a rich mix of ideas. Some are promising, some are uninformed or misguided, and a few are dangerous. (I will have more to say about the essays in subsequent posts.) But if we as a nation can have a serious debate about these and other alternatives at a time when the myths about what happened during the previous crisis have been dispelled, we will greatly increase our chance of getting mortgage reform right, and avoiding serious mistakes. Developments in the court cases over the past few weeks leave me optimistic that the conditions that could produce such an outcome may be present before too much longer.


[A note to readers: This coming Saturday I will be leaving for a month of travel outside the country, returning on June 4. While away it is unlikely I will do much if any posting, and because I will not be checking this site nearly as often as I have since it was launched my response to questions and comments will be slower, and probably less frequent.]