It is difficult to evaluate the wide range of opinion about how best to end Fannie Mae and Freddie Mac’s conservatorships, or the alternatives Treasury and FHFA now have for doing so, without an understanding of the political battles that have engulfed the companies over the past two decades, which I call “the mortgage wars.”

Following two thrift crises in the late 1970s and late 1980s, Fannie and Freddie’s access to the international debt and mortgage-backed securities markets enabled the U.S. mortgage finance system to undergo a smooth transformation from having been heavily deposit-based in the mid 1970s (when nearly three-quarters of all single-family mortgages were held by thrifts or banks) to being much more evenly balanced between deposit-based and capital markets-based sources of funding in the late 1990s, with Fannie and Freddie either owning or guaranteeing two of every five residential mortgages in the country.

The increased competition with deposit-based mortgage lenders by capital markets investors, facilitated by Fannie and Freddie, benefited homebuyers by adding greater standardization and increased liquidity to the 30-year fixed-rate mortgage. But it also reduced deposit-based mortgage lender profitability, because capital markets investors could price 30-year mortgages more efficiently than depositories, who had to compensate for the risk of funding them with short-term deposits and purchased funds. This better pricing lowered mortgage rates in general, led to a relative shift in volumes away from depositories, and reduced the net interest margin on the mortgages depositories did hold. In addition, Fannie and Freddie’s influence over secondary market underwriting limited the ability of primary market lenders to customize or “brand” their mortgages, because they wanted  them to remain eligible for sale as Fannie or Freddie mortgage-backed securities.

Large commercial banks and bank-owned lenders chafed at the constraints imposed on the pricing, underwriting and profitability of their mortgage operations by the secondary market activities of Fannie and Freddie. In reaction, in June of 1999 three large banks, two mortgage insurers and one subprime lender formed a lobbying group called FM Watch, whose goal was to attempt to undermine the strong bipartisan support the companies had in Congress, and ultimately obtain legislation favorable to themselves. From its inception, the message of FM Watch to Congress, and the public, was that Fannie and Freddie’s unique federal charter needed to be amended or repealed because the companies were using it to take enormous financial risks at taxpayer expense (pre-crisis, this was always said about interest rate risk, and never credit risk), and to channel its benefits to shareholders and management rather than homebuyers. These claims were demonstrably false, and while I was at Fannie we easily could counter them in Congress with verifiable fact. Yet over time the constant barrage of FM Watch-based misinformation had a profound negative effect on Fannie and Freddie’s public image, and this paved the way for what Treasury was able to do to the companies during the financial crisis and afterwards.

Treasury had been advocating publicly for changes to the companies’ charters since 2000, without success. But in the summer of 2008 Secretary Henry Paulson saw an opening to achieve all of Treasury’s historical objectives for Fannie and Freddie, and then some. A series of negative articles about them (citing rumors from an unknown source) had caused severe weakness in their stock prices, and in response to one such episode Paulson made a public pledge on July 11 to support Fannie and Freddie “in their current form.” Paulson could not provide this support without the reform legislation Treasury was sponsoring—the Housing and Economic Recovery Act (HERA)—and as he writes in his book, On the Brink, “Fannie and Freddie needed to be brought on board, quickly. Without their support, legislation would go nowhere. On Saturday I called Dan Mudd and Dick Syron to get their cooperation.” Taking Paulson at his word that HERA would be helpful to their firms, both CEOs agreed not to oppose it, and the legislation passed easily.

Mudd and Syron had little reason to suspect that what Paulson really wanted was not to help the companies out but to take them over. At the time Fannie and Freddie were fully in compliance with their statutory capital requirements, and were the only healthy sources of residential mortgage financing in the market. The private-label securities market had imploded, and banks were suffering from mortgage delinquency rates three times those of Fannie and Freddie. Under the circumstances, Mudd and Syron can be excused for not having paid more attention to a clause in HERA not found in any other regulatory statute: “The members of the board of directors of a regulated entity shall not be liable to the shareholders or creditors of the regulated entity for acquiescing in or consenting in good faith to the appointment of the Agency [FHFA] as conservator or receiver for the regulated agency.” Paulson knew he would be able use this clause, together with what he termed “the awesome power of the government,” to force the boards of directors of Fannie and Freddie to accept conservatorship notwithstanding that neither company met any of the criteria for conservatorship listed in the HERA legislation they just had been tricked into supporting.

From the moment the companies came under government control, the official narrative about them differed markedly from economic and financial reality, and closely tracked the mantra created by FM Watch almost a decade earlier of “flawed charter, excessive risk to taxpayers, and questionable benefits to homebuyers.” In conservatorship Fannie and Freddie no longer were free to counter this narrative, and the media did not question it, in spite of the many contradictions between what Treasury and FHFA said was happening with the companies and what was readily observable about them. One early example was Treasury’s claim that Fannie and Freddie urgently were in need of financial help, and then having its first requirement of them be that they shrink their mortgage portfolios by ten percent per year, even though the net interest income from those portfolios was helping to absorb the losses from their credit guaranty businesses. That didn’t matter to Treasury: shrinking or eliminating Fannie and Freddie’s portfolios had long been on its “hit list,” and it now had the power to require that.

The companies’ critics also got away with completely switching the focus of their claims of excessive risk-taking. Prior to the crisis they uniformly asserted that the threat posed by Fannie and Freddie to taxpayers came from the interest rate risk in their portfolios (which were tightly duration matched, rebalanced continually, and performed superbly during the downturn), and that they weren’t taking enough credit risk with their affordable housing initiatives (and instead were “gaming the system” and making only safe, profitable loans) because their credit losses were so low. But post-conservatorship these same critics instantly, and shamelessly, began saying the opposite: that Fannie and Freddie’s “flawed business model” had caused them to take so much credit risk as to trigger the mortgage crisis. Of course, both before and after the crisis contemporaneous data on mortgage credit performance were freely available to anyone who cared to look at them, and they consistently showed Fannie and Freddie’s delinquency and default rates to be about one-third those of banks and one-tenth those of subprime lenders and the loans in private-label securities. But that didn’t matter either; the media ignored the facts and printed the fiction, while Fannie and Freddie remained within their enforced cones of silence.

I won’t retell in detail the story of how Treasury and FHFA engineered massive amounts of discretionary book losses for Fannie and Freddie between the third quarter of 2008 and the fourth quarter of 2011 to force them to take $187 billion in senior preferred stock from Treasury, at a 10 percent annual dividend, that they didn’t need and Treasury wouldn’t let them repay, nor of how Treasury and FHFA agreed to the net worth sweep in August of 2012 when they realized that a huge amount of these book losses were about to reverse and become income and then capital, which they desperately did not want the companies to be able to retain. The net worth sweep, however, proved to be “a bridge too far,” and it resulted in a flurry of related lawsuits against the two agencies. Suits filed in the U.S. Court of Federal Claims were granted fact discovery, and documents produced from it left no doubt that Treasury and FHFA had entered into the sweep not for the reason they gave at the time (to prevent a “death spiral” of borrowing to pay senior preferred stock dividends) but to prevent the companies from rebuilding their capital.

Paulson and others at Treasury never expected things to get to that point. The prevailing view among members of the Financial Establishment when Fannie and Freddie were taken over was that Congress would replace them relatively quickly with a secondary market mechanism more to their liking. Consistent with this expectation, Treasury and FHFA had openly managed the companies not to prepare them for release from conservatorship but to ultimately wind them down, with FHFA requiring that they collaborate in building a common securitization platform that could be used by their eventual successors, and mandating them to “de-risk” themselves by issuing non-economic credit risk-transfer securities. Yet even with no opposition from Fannie, Freddie or their past supporters, opponents of the companies never were able to come up with a viable replacement for them. The reason should have been obvious long ago: contrary to the now two-decades old label from FM Watch of Fannie and Freddie as a flawed business model, the two companies did and do work effectively and efficiently, while the ideas devised by the Financial Establishment for replacing them with something different did and do not.

When Treasury Secretary-designate Steven Mnuchin said in November of 2016, “we gotta get [Fannie and Freddie] out of government control….and in our administration it’s right up there in the list of the top ten things we’re going to get done, and we’ll get it done reasonably fast,” he undoubtedly believed that the path for releasing the companies would run through Congress. Today, he and FHFA director Mark Calabria both understand that the only way to make good on Mnuchin’s pledge is through administrative reform. But neither, I believe, has fully come to grips with the crucial fact that in switching between these two tracks, the fictions about Fannie and Freddie that were essential elements of the attempt to replace the companies in a legislative process become impediments when the goal is to successfully recapitalize and release them in an administrative process.

If the best economic result were the overriding objective, getting Fannie and Freddie out of conservatorship would be no more difficult than it was to get them in: Treasury would settle the lawsuits by unwinding the net worth sweep and canceling its liquidation preference; FHFA would specify a true risk-based capital standard without excessive conservatism—making the companies attractive to new equity investors—and based on their updated capital requirements Fannie and Freddie each would prepare capital restoration plans for FHFA’s approval. In these plans they would use retained earnings to reach the critical capital requirement in the new standard, at which point they would be released from conservatorship under a consent decree and be free to raise new equity in whatever amount and at whatever pace they chose. Then, once they fully met both their minimum and risk-based capital requirements, they would be released from their consent decrees to return to their former status of independently managed shareholder-owned entities, under FHFA’s supervision and regulation.

But that’s not how the process will work, because of two carryovers from the failed legislative efforts of the past. The first is that the Financial Establishment and its supporters remain committed to their twenty-plus year goal of hamstringing Fannie and Freddie’s competitive position, and are hoping to accomplish this in administrative reform by convincing FHFA to subject the companies to excessive and unnecessary required capital and burdensome regulation by using the arguments of promoting safety and soundness and a “level playing field” for new competitors. The second is that Treasury as of yet has shown no signs of moving away from the false claims it’s been making about Fannie and Freddie since before the conservatorships, which it must do if it wishes them to be able to raise new capital. Investors will not put tens of billions of dollars into companies Treasury describes as having a “flawed business model.”

It seems that FHFA will be the first of the two agencies to reveal where it has come out in the choice between fiction- and fact-based alternatives, if as most observers expect it issues its revised Fannie and Freddie capital proposal for comment sometime this quarter. If FHFA removes some or most of the cushions and conservatism it built into its June 2018 proposal—which were designed to produce an artificially high but “bank-like” risk-based capital number of 3.5 percent—it would be a strong positive signal that it and Treasury are willing to go at least some distance towards allowing Fannie and Freddie to function efficiently as private entities. The consequence should be a relatively rapid recapitalization, fueled by significant access to private capital. A revised FHFA capital proposal with few changes to the 2018 version would send the opposite signal, foreshadowing a much slower recapitalization, accomplished largely if not exclusively through retained earnings, before the companies could free themselves of FHFA-imposed operating restrictions.

For its part, Treasury seems inclined to wait until the revised FHFA capital proposal is out and the timing of a potential Fannie or Freddie capital raise is more clear before giving any indication of its thinking about ending the net worth sweep and canceling its liquidation preference (which are essential steps before Fannie or Freddie could raise new capital). The key unknown is the critical capital requirement, which will be half the new statutory minimum. In my view it is likely that for minimum capital FHFA will select “Alternative 2” from its June 2018 proposal: 1.5 percent of trust assets (mortgage credit guarantees) and 4.0 percent of non-trust assets. Applied to the companies’ current balance sheets, these percentages would produce required minimum capital of around $60 billion for Fannie and around $40 billion for Freddie, and required critical capital—which could trigger release from conservatorship under a consent decree—of about $30 billion and $20 billion, respectively. Both companies are very likely to use retained earnings to meet their critical capital targets, which would push any potential capital raise by Fannie well into 2021 and by Freddie probably into 2022.

Based on this timeline, Treasury should have plenty of discretion to pick what it thinks is the best approach to and timing for a settlement of the lawsuits. I have long believed that Treasury will want some political cover for any settlement it negotiates, to avoid the charge (leveled loudly and often by Fannie and Freddie’s opponents) that it is “giving away the taxpayers’ money to hedge funds.” Treasury is closely monitoring the three suits that are moving towards trial on the facts—Collins under Judge Atlas, Perry Capital under Judge Lamberth, and Fairholme under Judge Sweeney—and I’m sure it realizes, because of the documents produced in discovery in Sweeney’s court, that it won’t prevail in any of them. My analysis is that Treasury will initiate serious settlement talks with plaintiffs when the first of those three suits (now most likely Collins) is getting close to the trial date, with the goal of of reaching settlement before that trial occurs in order to avoid a public airing of facts unfavorable to the government, as well a high-dollar settlement award to plaintiffs.

It is regrettable, though, that the sequencing isn’t reversed, with Treasury first settling the lawsuits and FHFA issuing its capital proposal subsequently. In that order, I believe there would be a much better chance for the investment community to convince Treasury that it has to structure Fannie and Freddie to succeed in order for their recapitalization to be a success as well, and for Treasury to be able to maximize the value of the warrants it holds for 79.9 percent of the companies’ common shares. Treasury then could convey this reality-based message to FHFA as it re-engineers its capital rule. But the sequencing die has been cast, and we now are left to wait to see whether the proposed future versions of Fannie and Freddie that emerge from Treasury and FHFA’s administrative reform process are based on historical fact or fiction. It will not be difficult to tell which it is.