While the proposal by Senators Tim Johnson (D-SD), the chairman, and Mike Crapo (R-ID), the ranking member, was announced with great fanfare, it simply follows the outlines of another bipartisan bill, offered last year by Sens. Bob Corker (R-TN) and Mark Warner (D-VA). The idea is to get rid of the two government-sponsored enterprises (GSEs) that provide mortgage financing today for most American homes and replace them with a system of private lending with securities explicitly backed by the federal government.
In going through contortions to reinvent the housing finance system, the senators have avoided the obvious solution: keep the basic platform that has generally served American homeowners well but reform it to reduce risks. Instead, Johnson and the others have come up with a contraption that resembles the Affordable Care Act in its convolutions and its potential for unintended consequences.
It’s hard to understand why legislators think that government can restructure this one-sixth of the economy any better than they are restructuring the one-sixth represented by health care.
But the problems with Johnson-Crapo-Corker-Warner don’t end there. The legislation would also add $5 trillion to the liabilities side of the federal balance sheet and tempt ratings agencies to demote government bonds again. And, in defiance of the rule of law, the senators blithely strip shareholders of all their assets in two major businesses. This is behavior you expect in Venezuela, not in the United States, and it will certainly lead to an erosion of investor confidence.
Some history is in order. Fannie started as a federal agency in 1938 and went public in 1968; Freddie sold stock in 1989. Partly because Congress pressured the GSEs to back riskier mortgages with inadequate capital, the two got into deep trouble in 2008 and helped spark the global financial crisis.
The federal government stepped in with a rescue that totalled $187 billion. After reforms were imposed, Fannie and Freddie emerged from the disaster sound and profitable. They have already repaid $185 billion to the Treasury and later this month are scheduled to add $18 billion more, giving taxpayers a solid profit. Without dividends from Fannie and Freddie, the federal deficit last year would have been greater by nearly one-fifth.
For its bailout funds, the Treasury five years ago received common and preferred stock, and the assumption was that, when taxpayers got their money back (plus a nice profit), the feds would exit as shareholders. Fannie and Freddie would then continue to operate as stock companies with stronger regulatory safeguards, less political interference, more capital, and (many of us hoped) an end to the implied government guarantee on their debt.
The original deal required Fannie and Freddie to repay the Treasury with a 10 percent annual dividend, but the government unilaterally changed the terms in 2012 to something called a “net worth sweep,” with all profits each quarter going to the Treasury.
Citigroup, AIG, and other recipients of bailout funding paid back what they owed, and those companies still exist – and, in most cases, thrive – with private capital provided by large and small shareholders and lenders. Fannie and Freddie, on the other hand, are zombies, stripped of their capital, with shareholders hanging on in hopes that the feds will come to their senses and abide by the rule of law.
At a forum on Feb. 5, lawyer Ted Olson, the former U.S. solicitor general, revealed that in December 2010, then-Treasury Secretary Timothy Geithner initialed a memo declaring that the government would not let shareholders touch the Fannie’s and Freddie’s profits. Ever.
The memo, which until last month was secret, referred to the administration’s “commitment to ensure existing common equity holders will not have access to positive earnings from the GSEs in the future.” Shareholders were not told what the government had in store for them—a severe breach, if not of securities law then certainly of the conventions of honesty and transparency that make markets work.
The breach was only one of many. Ralph Nader, a shareholder in the GSEs himself, complains that a long list of government officials, including Fed chairman Ben Bernanke, told investors that Fannie and Freddie were sound, and community banks were pressured by regulators to invest in these government-sponsored enterprises, or GSEs.
Encouraged by such statements, many investors held onto their pre-2008 Fannie and Freddie shares, and others bought after prices collapsed. Olson, the former U.S. Solicitor General, represents Perry Capital, a hedge fund that’s among several investors suing to demand that the government follow its original 2008 agreement and stop taking shareholders’ money beyond the original payback deal for the bailout.
Nader, by the way, has been admirably consistent. Asked at the forum if he thought that hedge funds and small investors should be treated differently, as some in Congress believe, he said definitively, “No. That’s political preferences. Basically, the decision as to how to treat investors is based on the status of their investment—common, preferred, bondholder—not on the status of who holds the investment, whether it’s a hedge fund, brokerage firm, bank, or individual or a mutual fund.”
The feds laid the groundwork with their treatment of General Motors and Chrysler bondholders, who in 2009 were given short shrift at the expense of politically favored unions. But the GSE grab is far worse, and the obvious question is why so few policy makers, especially conservatives, aren’t outraged.
One notable exception is Sen. Pat Toomey (R-PA), who stood up for shareholder rights in a set of pointed questions to Treasury Secretary Jack Lew. For example: “What comfort can you give to private sector investors considering investing in the future of the housing finance system when they believe that the government arbitrarily changed the rules of the game mid-stream?”
But most conservatives seem blinded by animosity toward Fannie and Freddie and are only too happy to see them vaporized. In recent decades, the GSEs were tightly connected to the Democratic political establishment and reveled in throwing their weight around. Now, conservatives want to see Fan and Fred get their comeuppance. A Wall Street Journal editorial even claimed that the GSEs should keep paying in penance for creating the financial crisis and for “the election of Barack Obama.”
In addition to this over-the-top “Fannie-mosity,” many conservatives simply are not convinced that Fannie and Freddie, which have been effectively reformed, will stay that way. Rather, they worry, the GSEs will be exploited to promote liberal social policy or return to funding loans to low-income borrowers who might not afford them – and we’re back where we started.
It’s a legitimate concern, but it can be handled with capital requirements and regulatory oversight as too-big-to-fail financial institutions. Have the president state clearly that the GSEs no longer have their guarantee, explicit or otherwise, from the U.S. government.
What is unacceptable is for the federal government to thumb its nose at the rule of law and treat shareholders with contempt – which is precisely the approach that the new Senate legislation will enshrine in law.
(This article first ran in The Weekly Standard on March 18, 2014 and is reprinted with permission)
James K. Glassman, former U.S. under secretary of state for public diplomacy and public affairs, is a visiting fellow at the American Enterprise Institute and a member of the Securities and Exchange Commission’s investor advisory board. These views are his own.