The Trump Administration appears ready to end the nearly 11 years of conservatorship of America’s largest government-sponsored enterprises (GSEs)—the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). However, the current terms of the government conservatorship would require the GSEs to raise the nearly $200 billion that they owe to the Treasury and an additional $200 billion to build a capital buffer. Many special interest groups are lobbying to alter the existing agreements to lessen the financial burden on the two GSEs, amounting to yet another taxpayer bailout for the failed companies. Fortunately, this bailout is not the only path to ending the conservatorship.
The Federal Housing Finance Agency (FHFA) has the authority to place the GSEs into receivership and proceed with a structured liquidation of their assets. Although the FHFA cannot revoke the GSEs’ charters without congressional approval, it can issue new charters—to new companies—with higher capital requirements, no credit lines with the Treasury, and neither implicit nor explicit taxpayer backing. Rather than invest in the GSEs, investors can provide capital to these new companies. This approach will reduce taxpayer risk, curtail the economic distortions caused by the government domination of the market, and gradually restore housing affordability.
I. The Housing Bubble Is Intertwined with the GSEs
In the 1990s, the GSEs Fannie Mae and Freddie Mac became the dominant actors in the secondary residential mortgage market by securitizing a growing share of residential mortgages. This process entailed buying residential mortgages, holding some of them as investments, and packaging others into securities for sale to the general public. These securities functioned like bonds, though their value was tied to the underlying residential mortgages, and the GSEs guaranteed the payment of principal and interest to the investors. The investors, in turn, understood these mortgage-backed securities (MBSs) to have implicit government backing because the GSEs had special charters and a line of credit with the U.S. Treasury. As a result, investors expected federal assistance in the event that the GSEs were unable to make scheduled principal and interest payments on their MBSs.
This implicit government backing led to riskier lending than would have otherwise taken place because it enabled investors in GSE bonds and MBSs to ignore the true financial risks of those underlying mortgages and securities. Beginning in the late 1990s, trillions of dollars flowed into mortgage markets, which were covering more mortgages for second homes and investment properties, as well as those with lower credit scores, minimal income documentation, less-stable employment history, and scant down payments. This flow of credit kicked off a home-price boom, with prices rising by 112.4 percent from 1998 through the middle of 2006, more than quadruple the overall rate of inflation of just 24.7 percent. The rapid run-up in home prices temporarily masked the decrease in credit quality, but home prices then plunged, losing 27 percent of their value by early 2012. As prices fell, delinquency rates on single-family mortgages soared from 1.61 percent in early 2006 to 10.34 percent by the end of 2009, and continued to rise until peaking at 11.54 percent in 2010. As delinquency rates climbed, mortgage defaults imperiled the GSEs’ ability to make the required principal and interest payments on their MBSs.
II. The 2008 Treasury Bailout of the GSEs
As more borrowers defaulted on the mortgages underlying the MBSs, the danger of bankruptcy loomed for the GSEs. Without an infusion of capital, the GSEs would soon be unable to deliver the promised payments on their MBSs. However, because any new capital would likely be immediately diverted to mitigate losses—possibly much greater losses—for existing MBS investors, many equity investors and private-sector creditors had little interest in supplying new capital.
As special interest groups ratcheted up calls for some kind of government action, Congress passed the Housing and Economic Recovery Act (HERA) in July 2008. This legislation placed regulatory control of the GSEs under the power of the new Federal Housing Finance Agency (FHFA), an agency with the newly created power to liquidate the GSEs through a receivership process (designed to dispose of their assets) or place the GSEs into conservatorship (designed to preserve their assets). As insolvency rapidly approached, two options existed: (1) a wind-up of the GSEs through the statutory receivership process or (2) negotiating a government bailout to continue their operations indefinitely.
In the case of receivership, the HERA states that the FHFA shall
place the regulated entity in liquidation and proceed to realize upon the assets of the regulated entity in such manner as the Agency deems appropriate, including through the sale of assets, the transfer of assets to a limited-life regulated entity established under subsection (i), or the exercise of any other rights or privileges granted to the Agency under this paragraph.
For conservatorship, the HERA gave the FHFA the authority to:
take such action as may be: (i) necessary to put the regulated entity in a sound and solvent condition; and (ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.
On September 6, 2008, the FHFA chose to place the GSEs under conservatorship, rather than receivership. In accordance with its broad conservator powers, the FHFA entered into an agreement with the Treasury on behalf of the GSEs to bail the companies out of trouble with two $100 billion credit lines (one for each company). In exchange for this new line of credit, each GSE issued 1 million shares of a new class of senior preferred stock to the Treasury with an initial valuation of $1,000 per share.
The goal of this credit backstop was to bolster the capacity of the GSEs to make payments on their issued MBSs despite the growing defaults on the underlying mortgages, and to encourage investors to continue purchasing MBSs to keep the housing finance sector moving. The Preferred Stock Purchase Agreements (PSPAs) between the FHFA on behalf of the GSEs and the Treasury specify the terms and conditions of this bailout. The initial September 2008 PSPAs contained a number of taxpayer protections, such as:
- Absent Treasury approval, dividend payments on classes of stock other than the specially created senior preferred stock are suspended until the GSEs repurchase this preferred stock from the Treasury.
- Treasury holds the right (through warrants) to purchase up to 79.9 percent of the GSEs’ common stock.
- A “liquidation preference” specifies that any funds derived from either new capital infusions or the liquidation of assets must first be used to compensate taxpayers for the bailout, and the GSEs cannot emerge from conservatorship without paying this liquidation preference in full. Initially set at $1,000 per share ($1 billion for each GSE’s senior preferred stock), the liquidation preference adjusts upwards as the GSEs draw on their lines of credit and also if the GSEs choose not to pay periodic commitment fees on the senior preferred stock in cash to Treasury. In the event of dissolution, the liquidation preference also specifies that honoring these obligations takes priority to liabilities due other investors or creditors.
- GSEs must pay quarterly dividends on the Treasury’s senior preferred stock. The initial PSPAs set these dividends equal to 10 percent (on an annualized basis) of the value of the liquidation preference if paid in cash and 12 percent if the GSEs choose to utilize the Treasury commitment (thereby increasing the liquidation preference). Dividend payments increase as total credit extended by the Treasury increases. Notably, dividend payments on senior preferred stock do not diminish the value of the liquidation preference. In effect, the dividend payments on the senior preferred stock functioned as interest on a loan, and the balance of the liquidation preference reflects the unpaid principal.
- To further protect taxpayer interests, until the senior preferred stock is repaid or redeemed in full, the GSEs must also obtain permission from the Treasury prior to issuing additional capital stock.
In 2008, the GSEs recorded combined net losses of $109 billion, a figure that surpassed their cumulative net income over the prior 40 years. More important, these losses completely exhausted the $90 billion of total capital that the GSEs had available to cover such losses. The bailout through the FHFA conservatorship proved crucial in securing the GSEs’ survival as going concerns.
Over the next four years, the companies continued to struggle and had difficulty meeting their financial obligations under the PSPAs. While the FHFA could have placed the GSEs into receivership, the FHFA and the Treasury chose instead to amend the PSPAs three times; each rendition effectively forced the taxpayers to bail out the GSEs again. These are the four bailouts from 2008 through 2012:
- In September 2008, Treasury bailed out Fannie Mae and Freddie Mac, promising to provide each with up to $100 billion in credit. In return, the companies each gave the Treasury 1 million shares of senior preferred stock, worth $1 billion each. In just the first three quarters of conservatorship, Fannie Mae exhausted one-third of its Treasury credit commitment; Freddie Mac exhausted more than half of its commitment.
- In May 2009, with losses rapidly consuming the existing commitment, Treasury promised to provide each GSE with up to $200 billion in credit (double the prior agreement) and allowed them to own an additional $50 billion in mortgage assets. The doubling of the credit commitment diminished the growing threat of imminently exhausting the entire line of credit.
- In December 2009 the companies were still struggling, so Treasury changed its commitment formula, allowing it to provide more than $200 billion. Quarterly draws needed to maintain solvency in 2010, 2011, and 2012 would no longer count against the GSEs’ $200 billion caps. The $200 billion caps would adjust upwards by the amount of the draws throughout those three years minus any positive net worth of the GSEs at the end of 2012. The poor financial performance throughout those three years resulted in the commitment expanding from $400 billion in 2009 to $445.5 billion by the end of 2012. As of the second quarter of 2019, the GSEs have drawn $191.4 billion of this $445.5 billion commitment, leaving more than $250 billion in credit available.
- At the end of 2011, the combined liquidation preference was more than $187 billion. The required 10 percent senior preferred stock dividends of nearly $19 billion annually exceeded the net income ever earned by the GSEs in a single year. It had become obvious that the GSEs might become unable meet their obligations to the Treasury: From December 2008 through December 2011, the GSEs borrowed $36 billion from the Treasury in order to pay preferred dividends to the Treasury. In August 2012, the Treasury changed the dividend formula in order to prevent the GSEs from drawing on the Treasury commitment in order to pay the dividends they owed the Treasury. Specifically, the Treasury amended the agreement in August 2012, so that beginning in August 2013 dividends would be set equal to the GSEs’ net worth at the end of the prior quarter. In effect, the Treasury would sweep the GSEs’ profits each quarter to satisfy the dividend payments. As FHFA Director Edward DeMarco explained, “The continued payment of a fixed dividend could have called into question the adequacy of the financial commitment contained in the PSPAs.”
In addition to these bailouts, the Treasury and Federal Reserve purchased more than $3 trillion in MBSs and GSE bonds, staving off further losses that would have required even more bailouts. From September 2008 through December 2009, the Treasury purchased more than $220 billion of GSE MBSs. In November 2008, the Federal Reserve announced plans to purchase trillions of dollars of GSE bonds and MBSs over an extended time frame. The Fed then purchased $134.5 billion of GSE bonds and more than $1.1 trillion of GSE MBSs from December 2008 through March 2010, and an additional $2.2 trillion in MBSs from October 2011 through June 2019.
Only because of these bailouts and the continued credit lines are the GSEs still operating today. Collectively, they owe approximately $200 billion to the Treasury and suffer from an even larger capital deficit.
III. 10 Years After the First Bailout, Both GSEs Remain Undercapitalized
As with any company, the GSEs’ capital acts as a cushion against insolvency and helps to absorb losses. The law imposes two capital requirements on the GSEs. The first is a risk-based total capital requirement set by the FHFA Director and designed to keep the GSEs solvent through a “stress period.” The second is a core capital requirement determined according to a statutory formula. The FHFA waived capital classifications and capital requirements for the duration of the conservatorships, but these will be reinstated upon release. Significantly, based on the success in meeting these two capital requirements, the FHFA Director classifies each GSE into one of the following four categories: (1) adequately capitalized, (2) undercapitalized, (3) significantly undercapitalized, or (4) critically undercapitalized.
The authority of the FHFA Director to intervene in GSE operations widens as capital classification levels deteriorate, culminating with the discretionary power to place the GSEs into receivership and liquidate their assets if they are classified as critically undercapitalized. The HERA states that the FHFA director shall classify the GSEs as critically undercapitalized if they (1) fail to maintain an amount of total capital that is equal to or exceeds the risk-based capital level established by the FHFA and (2) fail to maintain an amount of core capital that is equal to or exceeds its critical capital level. The current negative capital balances of both GSEs would certainly result in classification as critically undercapitalized if the standards are reinstated. Although the FHFA has yet to establish the risk-based capital requirements, the severity of the GSEs’ capital deficit—how much needs to be raised to avoid being classified as critically undercapitalized—can be estimated with a statutory formula and the FHFA’s Conservatorship Capital Framework (CCF).
Estimated Capital Shortfall: $203 Billion Critically Undercapitalized. Based on the CCF, Freddie Mac estimates its risk-based total capital requirement to be 2.44 percent of its reported assets. Using this percentage for both GSEs at year end 2018, the estimated risk-based total capital requirements—if the FHFA were to reinstate capital requirements—would be approximately $84 billion for Fannie Mae and $50 billion for Freddie Mac ($134 billion total). Based on the negative core capital levels reported at the end of 2018 (approximately $115 billion for Fannie Mae and $68 billion for Freddie Mac), the GSEs have a combined $317 billion risk-based total capital deficit (for Fannie Mae, $115 billion + $84 billion = $199 billion; for Freddie Mac, $68 billion + 50 billion = $118 billion).
Separately, the GSEs’ core capital must exceed the critical capital level, essentially a statutory formula. As seen in Table 1, Fannie Mae has a critical core capital deficit of $127 billion, and Freddie Mac has a critical core capital deficit of $76 billion.
Thus, upon release from conservatorship, in order to avoid the “critically undercapitalized” classification, Fannie Mae must meet the lower of this core capital deficit of $127 billion or the estimated risk-based total capital deficit of $199 billion. Similarly, Freddie must meet the lower of the $76 billion core capital deficit or the estimated $118 billion risk-based capital deficit in order to avoid the “critically undercapitalized” classification. Just as important, given the current negative capitalization of the GSEs, a major downturn in the near future could require another capital infusion from the Treasury. In fact, the FHFA recently conducted stress tests that estimate losses from $18 billion to $43.3 billion in a “severely adverse” economic scenario.
Naturally, meeting these capital requirements far from guarantees future solvency. In the year prior to the 2008 housing collapse, the GSEs maintained risk-based total capital nearly double the statutory requirements. The FHFA’s annual report to Congress released in June 2019 even warned that a reversion from the current low-interest-rate environment could lead to negative net worth of Fannie Mae and Freddie Mac. Regardless, the GSEs are critically undercapitalized by more than $200 billion.
Critics of closing down the GSEs argue that the companies are now profitable and that they would not be undercapitalized if the Treasury had not started taking all of the GSE’s profits. They also claim that Fannie and Freddie should be released because they have paid back more than the Treasury disbursed. A main problem with these arguments is that they ignore that Fannie Mae and Freddie Mac would not exist today without the aid of four successive taxpayer bailouts and continued government support. The claims also ignore the GSEs’ existing obligations to the Treasury under the PSPAs, obligations that were supposed to ensure that taxpayers were compensated for their risk under the bailouts. Finally, the notion that all should be forgiven because the GSEs paid back more in dividends than the amount they borrowed focuses strictly on cash-flow accounting while ignoring the ongoing risks borne by the taxpayers, as well as the opportunity costs associated with the cash infusions. Using a fair-value accounting approach to incorporate these economic costs into the equation suggests that the bailout was not a profitable endeavor for the taxpayers—it cost them more than $300 billion.
IV. At the Crossroads Again: Liquidation or Another, Larger, Bailout?
The task of raising at least $200 billion to exit conservatorship is daunting, but the true financial hurdle is roughly twice as high because of the nearly $200 billion liquidation preference under the existing taxpayer bailout agreements. In spite of the recent changes to the PSPAs, the GSEs will have to raise most of the needed capital entirely from private investors instead of using retained profits to contribute to the total needed. Even ignoring the obligations under the existing agreements, such a capital raise in the equities market would dwarf the largest initial public offerings in history, such as Alibaba’s $25 billion in 2014, Facebook’s $16 billion in 2012, General Motors’ $18.1 billion in 2010 (after emergence from bankruptcy in 2009), and Uber’s $9 billion in 2019.
To surmount the challenge of raising approximately $400 billion in capital ($200 billion to meet capital requirements and another $200 billion to satisfy obligations under the existing PSPAs), shareholders and industry interest groups are lobbying for two one-sided changes to the bailout agreement: (1) forgiveness in part or in full of the $200 billion liquidation preference and (2) dividend formula revision in order to enable the GSEs to build capital. If the federal government enacts either of these changes, existing common stock shareholders, junior preferred shareholders, and purchasers of newly issued common shares would benefit at taxpayer expense in what amounts to yet another GSE bailout.
As justification for writing down the liquidation preference, some proponents contend that the Treasury’s senior preferred stock “has been repaid with interest.” The $306 billion in dividends paid by the GSEs to the Treasury exceed the $191.5 billion in Treasury cash infusions by more than $116 billion. As discussed previously, though, this argument merely relies on cash-flow accounting and ignores all of the economic risks associated with the bailout, an error that understates the true cost by approximately $200 billion. And, of course, the return on an investment (preferred dividends) is distinct from the investment itself (the credit commitment). At issue is the $123 billion in additional dividends paid since the start of 2013 (the date the net worth sweep went into effect) through the third quarter (Q3) of 2019 relative to the original fixed 10 percent dividend formula.
These statistics in isolation present an incomplete view of reality. The Treasury made this change in the dividend formula because the GSEs were in such bad shape that they were borrowing from the Treasury simply to make the promised dividend payments. Furthermore, this net worth sweep did not result in exorbitant Treasury profits. More than 80 percent of the $123 billion in excess dividends was due to an anomalous surge in net income during a brief stretch in 2013 and 2014. In 11 of the past 19 quarters (since the start of 2015), dividends based on net worth have fallen short of what the payout would have been under the prior fixed rate. In fact, since the start of 2015, dividends under the sweep relative to the 10 percent fixed rate have resulted in $9.2 billion less in dividends. Retroactively reclassifying dividends paid as repayment of the principal balance is yet another bailout.
Massive shareholder dilution and the likelihood of dismally small returns on the shareholder equity also create significant hurdles to raising the entirety of this needed capital in a share offering. First, a $400 billion capital raise would massively dilute the ownership stake of existing common stock shares by more than 95 percent. Second, unlike typical capital raises, the proceeds will not be directed to investment in the expansion of business operations intended to increase net income. Instead, the capital raise will be earmarked for paying down the liquidation preference and restoring the required capital buffer. Over the past 30 years, the average annual return on equity for all U.S. banks is approximately 12 percent. Obtaining this return on $400 billion of newly raised capital would require more than $47 billion in combined GSE net income, a feat achieved only once in their history. For the five years from 2014 to 2018, Fannie Mae earned $11.2 billion annually, and Freddie Mac earned $7.3 billion annually. The combined $18.5 billion in net income represents just a 4.6 percent annual return on the $400 billion of newly raised equity.
V. There Is an Alternative to Another Bailout or the Status Quo
An alternative does exist to another series of bailouts, a continuation of the status quo of conservatorship, or a recapitalization of the government-guaranteed GSEs. The HERA gives the FHFA the authority to place the GSEs into receivership and liquidate the companies, provided that certain conditions are met. Under the terms of the PSPAs, capital from asset sales in such a wind-up of the GSEs would first go to pay down the liquidation preference—thus compensating the taxpayers—and then flow to other debt holders and shareholders of the GSES.
The FHFA Has the Administrative Authority to Liquidate the GSEs. Shutting down the GSEs requires first removing the GSEs from conservatorship and placing them into receivership (with the goal of liquidation). In order to place the GSEs into receivership, the FHFA must reinstate the suspended capitalization requirements and classify the GSEs as critically undercapitalized. The negative capitalization levels elicit such a classification. Upon this classification, the FHFA Director can then place the GSEs under receivership, which immediately terminates the pre-existing conservatorship.
Once the GSEs enter receivership, the FHFA Director may begin the liquidation process, including the transfer of GSE assets and liabilities into newly chartered limited-life regulated entities (LLREs) with a board of directors appointed entirely by the FHFA. The GSE charters are immediately transferred to the LLREs upon their creation, and each LLRE assumes the powers and attributes of the GSE being liquidated during its temporary period of operation. The remaining assets and liabilities of the GSEs can be transferred to the respective LLREs in one or more transfers which need no “further approval under Federal or State law.”
The FHFA has just two years to wind up all the affairs of the LLRE, unless granted an extension by the Director. Only three additional one-year periods may be granted by the Director. As such, the maximum wind-up time is five years.
The law also specifies an expedited time frame for complete wind up, depending on how quickly the FHFA sells at least 80 percent of the LLRE’s capital stock to third parties. Once this threshold is met, the LLRE terminates automatically. The FHFA must then divest any remaining capital stock of the former LLRE within one year unless the Director extends the deadline. The entire span from reaching the 80 percent liquidation threshold to complete disposal of all the GSEs’ assets may not exceed three years.
Prior to the end of the statutory deadline for liquidation of the GSEs assets, Congress would need to revoke the GSE charters in order to prevent them from being re-released into the marketplace. Although the HERA prohibits the FHFA from terminating these charters, the FHFA could choose to issue new charters for companies to operate in the secondary mortgage market rather than immediately release the current charters of the GSEs into the marketplace to other enterprises. Unlike the existing GSEs, these charters could specify higher capital requirements akin to banks. The new charters could also be issued without any Treasury credit lines and with neither explicit nor implicit federal guarantees. In this open system, investors who would have provided capital to the GSEs for secondary market operations may form their own companies to securitize mortgages. These actions will reduce taxpayer risk, end the economic distortions caused by the government domination of the market, and gradually restore housing affordability.
Without the commitment by the Treasury to extend up to $445 billion in credit to the GSEs, both would have long since dissolved. From 2008 through 2011, the GSEs relied heavily on this commitment to remain in business and to make timely payments to their debt holders and MBS investors. Though the GSEs drew less frequently on the line of credit after 2011, they could not continue operating without the continuing Treasury commitment.
Understandably, shareholders desire a release from conservatorship in order to enjoy a resumption of dividends and long-term growth in shareholder value. Yet release from conservatorship in accordance with the current PSPAs and reinstated capitalization standards would require a capital raise of more than $400 billion. The burden of the senior preferred stock dividends—whether in the form of a fixed payment or a net worth sweep—makes it nearly impossible for the GSEs to retain net income and enhance shareholder value. Given the combined market cap of the GSEs of under $8 billion, acquiring this capital through an equity offering would substantially dilute common stock shareholders and likely deliver inadequate returns on investment.
To reduce the amount of capital needed, special interests are proposing forgiveness of at least a portion of the nearly $200 billion liquidation preference on the senior preferred stock. Such a write-down on the credit extended by the Treasury to the GSEs would be a blatant taxpayer-funded bailout. In addition, more changes to the dividend formula in order to enable the GSEs to retain added capital is coming closer to realization. If done improperly, such a change could deprive taxpayers of proper compensation for the risks undertaken over the past 11 years for the GSE bailouts.
The dominance of the federal government in the housing finance market through the GSE conservatorships stifles private competition and is re-inflating the housing bubble. Americans are in poorer financial condition as a result of the extreme leverage encouraged and made possible by the GSEs.
The best approach is to completely wind up the affairs of the GSEs through receivership, a process that the FHFA should have undertaken in 2008. Although the FHFA cannot revoke the GSEs’ charters, the agency can issue new charters for companies with bank-like capital requirements and no credit lines with the Treasury. Rather than invest in the GSEs, investors can provide capital to new companies that do not have either implicit or explicit taxpayer backing, thus reducing taxpayer risk, ending the economic distortions caused by the government domination of the market, and gradually restoring housing affordability.
Robust homeownership existed in the U.S. long before the government became heavily involved in the housing market, and a competitive, private market is not possible if the current government-guaranteed duopoly is allowed to continue. Liquidation of the GSEs—rather than recapitalization and release—is the most prudent way to create this competitive marketplace.
In the absence of liquidation, any recapitalization plan must ensure that taxpayers remain compensated for the prior bailouts and ongoing credit risk. The liquidation preference should be paid in full before a resumption of dividends to private shareholders. Any dividend formula revisions should be constructed in a manner that respects taxpayer interests.
Joel Griffith is Research Fellow for Financial Regulations in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom, at The Heritage Foundation. Norbert J. Michel, PhD, is the Director of the Center for Data Analysis, of the Institute for Economic Freedom.