Journalism in the Public Interest

Congress Bungles Fannie and Freddie Reform

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Nearly five years after the government took over the mortgage giants Fannie Mae and Freddie Mac, Congress is slouching toward remaking how Americans buy homes.

Gingerly, Sens. Bob Corker, Republican of Tennessee, and Mark R. Warner, Democrat of Virginia, have been working up a bill. Yet it's striking how much the process is being dominated by emotional battles and financial interests.

In the right corner — politically as well as figuratively — we have the contingent that despises Fannie Mae and Freddie Mac. These people continue, against the evidence, to consider them the central cause of the financial crisis. Their preferred solution is to wipe these companies from the earth and somehow get the government out of housing. The hope is that a thousand flowers will bloom on their graves, as private investors rush in to finance mortgages.

In the left corner — politically speaking, we are talking left of center — is a group of financiers that favors a plan to bring back Fannie and Freddie. The argument, forwarded by the banker James E. Millstein, who served as the chief restructuring officer in President Obama's Treasury Department, is that they can be fixed.

Investors like the hedge fund manager John Paulson and Bruce Berkowitz of Fairholme Capital Management have embraced this idea, contending that Fannie and Freddie can pay back taxpayers, be recapitalized and live again. Not incidentally, they could profit handsomely if this works, as they have bought up positions in Fannie and Freddie. It's a time-honored strategy: Make one Wall Street investment and then make a second investment in some Washington lobbying to protect the first.

The Corker-Warner plan creates a government insurance operation, similar to the Federal Deposit Insurance Corporation, that would insure mortgage-backed securities. Private investors would have to shoulder the first losses, probably about 10 percent. Taxpayers would not have to bail out those investors should things go south.

It's an appealing notion and the plan has commendable aspects. But if the system worked as advertised, it could make the next housing crisis worse.

To understand why, we should revisit what we have learned about the American housing and mortgage market.

First, we learned that the housing market is so central to people's wealth and the economy that the government will try to save it in a crash. At least Corker and Warner's plan grasps that, unlike the most fervent conservatives.

Second, Fannie and Freddie were fatally flawed. They were hybrids, privately held institutions with government charters — along with too much political influence and too little capital. Investors believed they were implicitly guaranteed by the government, and so they were. (Shareholders got hugely diluted, but not wiped out.) The plan tries to solve this by making the insurance explicit and then supposedly cutting off the private players from the government trough.

Neither of the two senators' offices made someone available for comment. A statement from Corker's spokesman emphasized the plan's protection for taxpayers; Warner's added a goal to maintain access to credit.

The Corker-Warner proposal, which borrows ideas from the recent Bipartisan Policy Center proposal and the left-leaning Center for American Progress, depends on getting three things exactly right. Private investors will need to have enough incentive to buy the securities (or, to use the jargon, there will need to be adequate liquidity in the market). These private entities will also need to put up enough money to have enough skin in the game to prevent taxpayers from taking a bath on the mortgages. On top of that, these firms and insurance companies will need enough capital to prevent taxpayers from having to step in to take over the companies.

There's reason to be skeptical that Congress will succeed in fine-tuning all of this. Unless the new insurance corporation regulates all housing-related investors, they will be subjected to different oversight from different agencies. Typically, businesses will gravitate to the most lenient agency and the one requiring the least capital.

If the Corker-Warner proposal were to go through, the private companies that have pole position would be the private mortgage insurers. The Republican Party has a fondness for this industry, going so far as to blow it a kiss in the party's 2012 platform. Uncomfortably, private mortgage insurers were quietly a major part of the problem after the housing bubble burst. They were woefully undercapitalized and have been operating almost as zombie institutions.

The 10 percent private investor number also poses a concern. It's a satisfyingly high number. But it's a number that will probably create big problems when housing goes into a downturn. Remember the Great National Housing Crash? Private investors fled. Fannie and Freddie needed to step in to provide liquidity. And the real Big Daddy was the Federal Reserve.

Without some mechanism to ease the requirement, the contemplated reform could exacerbate a panic, not ameliorate one. A Harvard finance professor, David S. Scharfstein, has a proposal that would remedy this, with the government stepping in during a crisis, ramping up its mortgage insurance business only in a downturn when private investors are fleeing.

What's striking is how much we've learned about housing since the crisis that isn't reflected in the reform efforts.

We have learned, for example, that the mortgage servicers have been unholy disasters, foreclosing on homeowners incorrectly, fighting principal reduction and dragging their feet on mortgage modifications that would have helped people stay in their homes. One lesson, then, is that separating mortgage servicing from ownership is a bad idea. The banks that kept loans on their books have been more ready to work out loans to keep people in their homes. The current Washington plans don't do much about this.

We've also learned that having an oligopoly of giant banks controlling the mortgage market leads to higher rates. And, because of the backlash against Fannie and Freddie, we are in danger of turning against the idea that the government has an important role in providing access to credit for those who might not be able to otherwise buy or rent homes.

Corker and Warner nod to providing greater access for small banks to compete with the big boys. And it provides a mechanism to provide access to housing for the credit-impaired. But in their fixation with solving Fannie and Freddie, the current Washington efforts give these important reforms short shrift.

The work is in the early stages. But the narrowness of the conversation is troubling.

I have a couple of problems with this comment:

1)  First, the GSEs were the enablers of the subprime crisis.  Jesse betrays his political leanings be taking this view.  In fact, the roots of the crisis actually go all the way back to Fannie Mae’s “privatization” Lyndon Johnson.

2) The second point is that the GSEs AND the big banks are a cartel.  This is why it is so pointless to argue the issue of causation.  The GSEs went first, developed the legal template and made a path for the idiocy and fraud of Wall Street. 

You cannot explain the crisis w/o giving everybody credit.  Big problem with Corker bill is that it ignores the central issue of the housing mess, namely that politicians in both parties like to use policy to garner votes.  That old game is over now, but still the theft of Fannie’s profits by Congress continues to attract support.


The commenter above seems oblivious to data. GSE loan performance over the past 40 years has been vastly superior to that of any other segment of the market.  Any suggestion otherwise is a bald faced lie.

The “GSEs were enablers of the subprime crisis” fantasy seems to be based on a false equivalency used by those unfamiliar with the word “nonrecourse.” Private label bonds lost four times as much as the GSEs. Wall Sreet’s originate to distribute model is antithetical to GSEs buy and hold model.

GSEs and banks are a “cartel” is another febrile effort at false equivalency. Does he really think that Wall Street dictated the GSEs’ credit standards, or vice versa?

Finally, empirical analysis has nothing to do with Mr. Eisenger’s political leanings.

“Investors believed they were implicitly guaranteed by the government, and so they were. (Shareholders got hugely diluted, but not wiped out.)”

The Fannie/Freddie investors who got bailed out were the bondholders of GSE-guaranteed mortgages - who were never forced to take any losses - not shareholders.  That Mr. Eisinger makes such a basic mistake about the GSE’s leads me to doubt that he should be offering advice on this topic.

The so called “bailout” of bondholders of GSE-guaranteed mortgages, referenced by the commenter directly above, is less that what it appears.

Based on actual credit losses, GSE bondholders would have lost no more than 4% of principal if the companies were liquidated. But since the GSEs continued operating and their guarantees remained in effect, the bondholders lost nothing and the profits from continued operations will fully pay back the government within one year.

The GSEs were just like Citigroup and Bank of America, too-big-to-fail private companies subject to government regulation. Bank of America, which, like its peers, engaged in industrial scale mortgage fraud, has so far incurred larger losses on mortgages than either Fannie or Freddie.

The “basic mistake” claimed by the commenter refers to his own false distinction.

Following up on Chris’s comments, I’m having a hard time understanding what role these mega-organizations have.  Apart from possibly trying to ensure fairness (which nobody seems to do, anyway), what’s wrong with individuals buying and selling, with buyers taking out mortgages from their local bank?

To my eyes (though I’m a life-long renter, which is why I’m asking), the only use of a Fannie or Freddie is to obscure responsibility and to create centralized points of failure.  The alternative angle is that Fannie and Freddie could guarantee loans, so that a problem causes buyers to lose their homes and taxes to go up to ensure that the banks or investors never lose money.

Neither of those seem in the public interest, so am I missing something?

@John,  You’re not missing anything.  This is not Right vs Left, it is free market vs crony capitalism.  Now, some will tell you (the democrat/progressive machine) that crony capitalism is a Republican trait.  Look at the current administration.  Who does Obama care help?  the industry or the the American people?  Who does immigaration reform help, industry or the American people?  Who did Dodd-Frank help?  Big Banks or the American people?  Fannie and Freddie burned more Americans than they helped.  Sure lots of people got new homes.  How many of them saw all their equity wiped out and go underwater thanks to CRA.  Lenders didn’t criminially ignore lending requirements, the CRA required them to.  Obama’s only work as a lawyer was blackmailing banks into ignoring lending requirements.  2008 was no accident.  Without it Obama’s administration could not have happened.  It is time Americans start reading history.  Germany in the 1930’s or Russia in the 1910’s would be very good, and scarry, places to start.

clarence swionney

June 15, 2013, 11:33 a.m.

  The Institute For Policy Studies new report on tax havens is awesome.
59 companies had $544 billion in U.S.  profits at he end of 2012.  They are holding offshore $1700-2000 Billion in “profits” much of which was gained in U.S. Sales. All taxes paid elsewhere are deducted from U.S. Obligations.
General Electric has 38B from 108B of income. Honeywell had a 43% increase to 11,6B in 2012.
If they return these profits to the U.S. They would not pay $544 Billion but US Tax Rate on it.
That would help but only dent the 700B Deficit . In 2010, corporations paid a 12..5% Tax Rate.
The firms say if they do return it then it would be used for job creation . Dream on!

Jesse Eisinger

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