Treasury revision of Fan/Fred payments seals their fate

U.S. Treasury Department

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  • The greatest obstacle to GSE reform is the possibility that Fannie and Freddie will return to profitability.

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  • Geithner's objective was to make sure Fannie and Freddie did not survive their conservatorship.

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  • Fannie and Freddie will either become a Ginnie Mae-like centerpiece or gradually wind down.

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The Treasury Department's announcement last Friday--changing the payment arrangements on the preferred stock it holds in Fannie Mae and Freddie Mac--seems to seal their fate. Under the new plan, the dividends that the Fannie and Freddie owe to Treasury on that stock will be equal to all of their earnings each quarter. With no opportunity to accumulate retained earnings, the two government sponsored enterprises (GSEs) will have no net capital, no chance to function independently of the government and thus no chance to be released from the conservatorship that now controls their activities. This leaves two options for their future--conversion to a government housing finance agency along the lines of Ginnie Mae, or a gradual wind-down as contemplated in Paul Ryan's House budget plan.

"With no opportunity to accumulate retained earnings, the two government sponsored enterprises (GSEs) will have no net capital, no chance to function independently of the government and thus no chance to be released from the conservatorship that now controls their activities." -Peter J. WallisonThe Treasury's action reflects a recognition that the greatest obstacle to GSE reform is the possibility that Fannie and Freddie will return to profitability as the housing market recovers. This would generate enormous political pressure from the housing industrial complex and speculators in their stock to release them from the conservatorship with their government backing intact. The new Treasury plan seems to make this virtually impossible.

From the time he took office in 2009, Treasury Secretary Geithner made no secret of his view that Fannie and Freddie were dangerous examples of the moral hazard that poorly designed government policy can create. In early 2011, he was the co-author with the secretary of Housing and Urban Development of an administration white paper that set out three options for the a new system of housing finance--all of them aimed at the elimination of the GSEs. Only Geithner's memoirs will tell us why the administration never moved on any of the ideas in that paper--one of which would have created a fully private housing finance system not unlike what is in the House Republican (Ryan) budget resolution--but there was never any doubt that Geithner's objective was to make sure Fannie and Freddie did not survive their conservatorship and again get the chance to take risks at the taxpayers' expense.

With no legislative action during the Obama administration, time was on the side of those who want to restore the GSEs to a central role in the housing finance system. As the housing market gradually recovers in the future, the GSEs' enormous current market share would likely return them to profitability, with earnings that exceed the $19 billion in preferred stock dividends that they currently pay to the Treasury. The resulting profits--and their gains on mortgages and mortgage--backed securities they hold in portfolio-would become retained earnings, recapitalizing them over time.

It is easy to foresee that with the GSEs independently capitalized and making profits, there would be little basis for keeping them locked into the conservatorship. Under these circumstances, it is likely that a future Congress would give up the difficult process of housing finance reform and return them to their original status as independent firms with implicit government backing.

What's more, because their common and preferred shares are still available in the market, hedge funds and others that are speculating in these shares will add their voices in support of allowing Fannie and Freddie to become independent again. Indeed, legislation that would let them exploit their monopoly for a period of years--with homebuyers paying the bill through increased guarantee fees--has already been introduced in Congress, and other similar ideas are making the rounds among the housing finance associations in Washington and elsewhere.
The sweetener for many of these proposals is the idea that eventually the GSEs would be sold off for the benefit of the taxpayers, but the likelihood that this will happen is exactly nil. When the time comes for such a sale, there will be loud protests that privatization would raise mortgage rates because the GSEs would no longer have government backing. Meanwhile, they would continue to assure the housing industry of a steady and government-backed flow of funds and provide a windfall for those who had bought their preferred and common shares for next to nothing.

By ending these possibilities, the Treasury plan brings some clarity to the GSEs' future. Depending on the outcome of the election, they will either become a Ginnie Mae-like centerpiece of a government-backed housing finance system, or gradually be wound down as provided in the House Republican (Ryan) budget. The Ryan plan would replace the GSEs with a wholly private market. Although Mitt Romney hasn't yet outlined a specific housing finance proposal, it is likely that he will endorse something close to the Ryan vision, especially because of its overwhelming support among congressional Republicans.
The ultimate structure of the U.S. housing finance system is yet to be determined, but in the wake of the Treasury action it is now reasonably clear that Fannie and Freddie will not return to the housing market as government-sponsored enterprises.

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.  He was general counsel of the Treasury and White House counsel in the Reagan administration and a member of the Financial Crisis Inquiry Commission.

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