More than ten years after Fannie Mae and Freddie Mac were placed into conservatorship, and more than two years after Treasury Secretary-designate Steven Mnuchin said to Bloomberg News, “It makes no sense that [the companies] are owned by the government and have been controlled by the government for as long as they have,” and that “we gotta get them out of government control….and we’ll get it done reasonably fast,” the White House made its first formal pronouncement on this issue in a March 27 memorandum on  Federal Housing Finance Reform, saying “The housing finance system of the United States is in urgent need of reform,” and for that reason “the Secretary of Treasury is hereby directed to develop a plan for legislative and administrative reforms” of this system.

Participants in and followers of the secondary mortgage market reform dialogue rightly view the White House memorandum as a significant development, but beyond that there is little agreement as to what it means for how, when or even whether the longstanding battle over the fates of Fannie and Freddie might be resolved. Proper interpretation of the memo, I believe, requires an understanding of the context in which it was produced.

The debate over Fannie and Freddie’s role in U.S housing finance has been going on for decades. It has elements that are ideological, political and competitive. It has cut across administrations, and been driven more by institutions than individuals. Since the Reagan administration the most consistent institutional participant in what I call “the mortgage wars” has been Treasury, whose position for the last forty years has been that Fannie and Freddie’s federal charters give them too much market power and allow them to take too much risk, and that for those reasons their operations should at least be constrained and perhaps eliminated entirely. Supporters of the companies argue that the benefits of their charters flow primarily to low- and moderate-income homebuyers, that their interest rate and credit risks have been well controlled, and that the motive of many of their opponents is to shift market power and profits to primary market lenders at homebuyers’ expense.

The 2008 financial crisis presented Treasury with a unique opportunity to gain control of  two companies it had historically opposed by effectively nationalizing them in the guise of a rescue, then using them to help stabilize the housing market after the private-label securities market imploded and banks had curtailed their lending because of the massive amounts of high-risk mortgages on their books. As I documented in my amicus curiae brief for the Jacobs-Hindes lawsuit in Delaware, Fannie and Freddie were taken over not because they were the weakest sources of mortgage financing going into the crisis but because they were the strongest. The conservatorships of Fannie and Freddie were pre-planned by Treasury for policy purposes, done without statutory authority and against the will of the companies’ managements, then handed to FHFA as a fait accompli to be carried out, which they were.

Treasury’s professed rationale for pushing Fannie and Freddie into conservatorship was that their regulatory capital was overstated because of favorable accounting treatments that made them look far stronger than they “truly” were. Consistent with this contention, FHFA as conservator and at the direction of Treasury booked a series of non-cash accounting expenses at both companies that totaled a mammoth $326 billion through the end of 2011. This wiped out their capital and forced them to draw $187 billion in non-repayable senior preferred stock from Treasury, on which they were required to pay an annual dividend of 10 percent after tax. But because the great majority of the accounting entries were based on extremely pessimistic estimates or only were timing differences, in 2012 they began to reverse, and in huge amounts. In just 18 months Fannie and Freddie recorded a combined $158 billion in book earnings, half again what they had earned over their entire existence. To prevent these earnings from becoming a torrent of returning capital—making it obvious that the companies’ failures had been engineered—in August of 2012 Treasury and FHFA amended the terms of their conservatorships to require all of their earnings to be paid to Treasury in perpetuity, in what was called the net worth sweep.

At the time they agreed to the net worth sweep both Treasury and FHFA were committed to managing Fannie and Freddie in a way that accommodated and would encourage a wind-down of their operations and their ultimate replacement by Congress. A Draft Internal Memorandum to Secretary Geithner produced at Treasury in December 2011 contained “a plan with FHFA to transition the GSEs from their current business model of direct guarantor to a model more aligned with our longer-term vision of housing finance.” Components of this plan included guaranty fee increases that would continue “until pricing reaches levels that are consistent with those charged by private financial institutions with Basel III capital standards,” securitized sharing of credit risk, a single security for Fannie and Freddie and a “faster retained portfolio wind down”—all of which were put into effect. FHFA for its part published a strategic plan in February 2012 titled “The Next Chapter in a Story That Needs an Ending,” one of whose three principal goals was to “Gradually contract the Enterprises’ dominant presence in the marketplace while simplifying and shrinking their operations.”

What Treasury and FHFA wanted for Fannie and Freddie also was what the large banks wanted. To get it, they, their allies, affiliated trade groups and other supporters went to work drafting legislation aimed at replacing the companies with entities or mechanisms less threatening to banks’ underwriting and pricing flexibilities in the primary market. But in executing this task they fell victim to their own fictions. Their self-serving but false mantra of Fannie and Freddie as a “failed business model” ruled out the use of the main structures, elements or techniques the companies had used so successfully for decades. Instead, a series of proposals from Corker-Warner to Johnson-Crapo to the “Promising Road” to the Milken Institute’s “New Secondary Mortgage Market” all relied on new, mostly theoretical, generally incomplete and always unproven features that made them too risky for a $10 trillion market central to the smooth functioning of the U.S. economy. None could gain broad support, and legislative reform stalled.

In the meantime, a second group was thinking about the futures of Fannie and Freddie. The net worth sweep had come as a shock to the companies’ investors, and several of the larger ones filed suit against Treasury and FHFA under various theories of the law. One set of suits claimed that because the sweep violated the Housing and Economic Recovery Act (HERA) that created FHFA and gave it its powers of conservatorship and receivership, the sweep should be reversed and the capital swept by Treasury returned to the companies. Plaintiffs in another set of suits claimed that the sweep was an illegal government taking; these plaintiffs were granted discovery in their cases, and documents produced in that discovery showed Treasury had devised the net worth sweep not for the reason it gave the public at the time—to prevent Fannie and Freddie from a “death spiral” of borrowing to meet their 10 percent annual dividend requirement—but instead to keep them from being able to retain the capital Treasury knew was about to come back to them from the reversal of the effects of the non-cash book entries made by FHFA.

Armed with the facts about the companies’ financial condition and prospects, and confident that the suits challenging the legality of the net worth sweep at some point would meet with success, a group of non-litigating shareholders hired an investment bank, Moelis & Company, to develop a plan to recapitalize Fannie and Freddie and return them to private ownership. Moelis published its “Blueprint for Restoring Safety and Soundness to the GSEs” in June 2017, and updated that plan in November 2018. The Moelis plan does not require legislation; it relies on existing FHFA and Treasury authorities to set new capital standards for Fannie and Freddie, strengthen their regulation, and allow them to exit conservatorship following a series of new equity issues. Moelis also contends that under its plan Treasury, as holder of warrants for 79.9 percent of the companies’ existing common stock, could earn $100 to $125 billion from sales of stock acquired upon exercise of those warrants.

The Moelis administrative reform path developed and supported by investors created a viable alternative to the legislative reform path advocated by banks, and it had one crucial advantage: it was based on fact and market reality and could be implemented immediately, whereas all previous bank-sponsored reform plans had been based on fiction and theory and had failed to gain traction. Secretary Mnuchin did not comment publicly on the Moelis plan, but continued to say he would prefer a legislative solution or an administrative plan with bipartisan Congressional support. After the November mid-terms, however, this posture became untenable. With the Democrats in control of the House of Representatives, even the staunchest bank supporters were not expecting reform legislation before the end of 2020, and the two political parties are known to have different priorities for an administrative solution. As a consequence, Treasury now recognizes that to change the status quo for Fannie and Freddie it will have to take the lead, and make difficult choices.

As it does, Treasury will be working with a new director at FHFA—Mark Calabria, who was nominated to his position last December and confirmed by the Senate on April 4. Calabria appeals to both investors and banks, but for different reasons. Investors like the fact that he is an outspoken critic of the net worth sweep, contending, as one of the principal authors of HERA when he was a staffer for the Senate Banking Committee in 2008, that it violates the plain text of the law as well as established practices of conservatorship and receivership on which the law is based. Banks like the fact that Calabria is a long-time critic of Fannie and Freddie and the roles they play in our financial system. In a paper done for the Urban Institute in 2016, Calabria referred to mortgage securitization as “a false god that failed us,” and argued for mortgage lending to return to the “originate and hold model” of depository institutions, going so far as to recommend that Fannie and Freddie be given bank charters and converted to bank holding companies. And as recently as last week Calabria said he thought part of his job was to “urge Congress to act” to change the companies’ charters, because “I think we should go to a different model.”

It is against this complex backdrop that the Federal Housing Finance Reform memorandum from the White House can best be assessed. We know it was authored by Larry Kudlow, the Director of the National Economic Council and Assistant to the President for Economic Policy, because it stipulates that “The Treasury Housing Reform Plan shall be submitted to the President for approval, through the Assistant to the President for Economic Policy.” Kudlow is not a neutral participant. He has been unfriendly to Fannie and Freddie since at least the mid-1980s, when he was assistant to David Stockman at the Office of Management and Budget and Stockman’s point person for trying to get Congress to impose what were called “user fees” on the companies’ debt, to raise their cost of borrowing.

I interpret both the timing and the substance of the White House memo as an attempt by Kudlow to insert himself into the mortgage reform process to the benefit of the banks, who now are seeking to achieve through administrative reform what they previously had been seeking through legislation. Numerous elements of the memo reveal a pro-bank bias. Its very first paragraph states that Fannie and Freddie “suffered significant losses due to their structural flaws and lack of sufficient regulatory oversight.” That’s the (provably false) bank argument. The memo then sets as the second goal of mortgage reform, after ending the conservatorships, “Facilitating competition in the housing finance market,” and lists as a sub-objective “authorizing the Federal Housing Finance Agency (FHFA) to approve guarantors of conventional loans in the secondary market.” The multi-guarantor model is what the banks support, and is the opposite of the utility model favored by investors, affordable housing groups and community banks. Making “facilitating competition” a core objective of the reform process rather than an option to be assessed on its merits puts a heavy pro-bank thumb on Treasury’s scale.

Treasury’s institutional history of opposition to Fannie and Freddie, the involvement of Kudlow and Calabria, and the White House directive to Mnuchin to produce the Treasury Housing Reform Plan “as soon as practicable” all strongly suggest that the banks stand an excellent chance of getting what they want from this process. Yet they face a formidable obstacle that I doubt even Treasury fully understands, and I suspect Kudlow and Calabria do not at all: in an administrative reform process the investment community has effective veto power over any significant proposed changes to Fannie and Freddie, because the companies cannot be recapitalized without the new equity these investors must provide. Precisely for this reason, the weak and ineffective versions of Fannie and Freddie that the banks have put forth for so long in legislation simply are not options in an administrative process. For investors to put new capital into Fannie and Freddie, the companies must be set up to succeed, not struggle.

As Treasury and FHFA engage in serious dialogues with plaintiffs in the lawsuits about settlement and institutional investors about recapitalization, I believe they will realize that they and the investment community have very different views about Fannie and Freddie’s business operations, what has been done to them in the past, and what must be done to revive them as private companies in the future. Treasury and FHFA will find that investors do not share the view that Fannie and Freddie need to be drastically overhauled because they are a “failed business model” and caused the financial crisis (they know neither of these claims are true), nor do they share the goal of reducing the companies’ market power for the benefit of primary market lenders. And investors are acutely aware that since 2012 Treasury has been taking (they would say illegally) all of Fannie and Freddie’s profits to keep them in conservatorship while it decides what to do with them, and they will need to be convinced that nothing similar will occur in the future.

I can’t predict what particular set of proposals for Fannie and Freddie’s capital standards and regulatory postures will be deemed acceptable by investors, and thus permit the companies’ reform and recapitalization to go forward. But I do believe that FHFA’s most recent version of its risk-based capital standard and Mark Calabria’s advocacy of having Congress eliminate the companies’ charters each will need to change. As I noted in my public comment, FHFA’s June 2018 risk-based capital proposal has too many elements of conservatism designed to back into a “bank-like” average capital ratio that is incompatible with the risks of the credit guaranty business to which Fannie and Fannie are restricted, and which if not removed will limit the scope of the companies’ business, distort their risk profiles, and make them less profitable for no good reason. FHFA also must eliminate the standard’s extreme procyclicality, caused by linking the companies’ required capital to the market value of their loans (which no other financial regulator does). And, of course, Fannie and Freddie’s regulator cannot be asking investors to put capital into them at the same time as it advocates repealing the charters that give them their market value.

It won’t be an easy process—and it may take the prodding of a reversal by the Fifth Circuit Court of Appeals en banc of the net worth sweep to get there—but I believe Treasury and FHFA ultimately will have no alternative but to shape, and to pledge to regulate, the Fannie and Freddie of the future in a way that gives investors confidence that the companies will be successful, in spite of what the banks want.  If I’m right and this occurs, then the White House memo of March 27 will prove to have been the beginning of the end of Fannie and Freddie’s more than decade-long conservatorships.