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Nov4, 2019,04:07pm EST|4,175 views

Forbes: The Government Should
Have Shut Down Fannie and
Freddie In 2008 – They Still Can

Norbert Michel Contributor
Policy

I follow the evolution and devolution of monetary and financial policy

WASHINGTON, DC – SEPTEMBER 10: U.S. Treasury Secretary Steven

Mnuchin (L), U.S. Housing and Urban … [+] GETTY IMAGES

https://www.forbes.com/sites/norbertmichel/

https://www.forbes.com/policy

1
Our nation’s housing finance system was at the center of the 2008 financial

crisis. Yet our elected officials have done nothing to fix the problem—until

now. Credit Mark Calabria, the new director of the Federal Housing Finance

Agency (FHFA), for giving it an honest effort.

2
Despite all the hype claiming that the Dodd-Frank Act would fix the financial

system and make everyone safer, Fannie Mae and Freddie Mac are essentially

just as weak today – and just as dangerously leveraged – as they were in 2008.

3
Calabria and his new team at the FHFA can’t be expected to solve this

problem overnight, but it looks like they are on the right path.

4
On the heels of reiterating that the federal government should have wiped

out Fannie and Freddie’s shareholders in 2008, Calabria recently warned

members of the Mortgage Bankers Association that “Today’s status quo poses

significant risk to taxpayers, homeowners, renters, and the entire financial

system.”

5
Last week, the agency released its new Strategic Plan for the

Conservatorships of Fannie Mae And Freddie Mac, emphasizing that the

FHFA wants a competitive mortgage market where nobody – even Fannie and

Freddie – has a set of special rules. That sort of market would be a major

break from the past, but it is now the goal:

https://thehill.com/blogs/pundits-blog/finance/343084-7-years-in-dodd-frank-still-protects-main-street-from-excessive

https://www.fhfa.gov/Media/PublicAffairs/Pages/Prepared-Remarks-of-Dr-Mark-A-Calabria-at-MBA-2019-Annual-Convention-and-Expo.aspx

Calabria says he’s willing to wipe out Fannie Mae, Freddie Mac shareholders

https://www.fhfa.gov/Media/PublicAffairs/Pages/Prepared-Remarks-of-Dr-Mark-A-Calabria-at-MBA-2019-Annual-Convention-and-Expo.aspx

https://www.fhfa.gov/AboutUs/Reports/ReportDocuments/2019-Strategic-Plan

https://www.aei.org/wp-content/uploads/2019/06/The-Housing-Lobbys-APOR-Solution-is-fatally-flawed-final

“compared to the duopoly of Fannie Mae and Freddie Mac, moving

toward a more competitive secondary mortgage market – in which the

same rules and regulations apply equally to all – would better serve

borrowers and renters. Competition more effectively delivers

market-affordable prices with customer satisfaction and continual

innovation to improve product quality.”

6
Given that Calabria unabashedly wants to work with Congress to create “a

competitive mortgage market with a limited government role,” Americans

should be optimistic that things are heading in the right direction.

7
Unfortunately, Calabria and his team will face continuous pressure from all

corners of the housing finance lobby to upset the status quo as little as

possible. That pressure, of course, is the main reason that so little has changed

since the 2008 crisis, and that Fannie and Freddie remain so highly leveraged.

8
Many people balk at this suggestion and argue that Fannie and Freddie

remain so highly levered because the U.S. Treasury has been taking all of their

profits, thus preventing the companies from building capital.

9
But this narrative omits crucial context, especially the part about how Fannie

and Freddie would not exist today without hundreds of billions in taxpayer

support.

https://www.forbes.com/sites/steveforbes/2021/02/09/how-covid-19-will-change-public-school-education-forever/

https://www.fhfa.gov/Media/PublicAffairs/Pages/Statement-of-FHFA-Director-Mark-Calabria-on-the-Administrations-Plans-for-Housing-Finance-Reform.aspx

https://www.fhfa.gov/Media/PublicAffairs/Pages/Prepared-Remarks-of-Dr-Mark-A-Calabria-at-MBA-2019-Annual-Convention-and-Expo.aspx

https://www.forbes.com/sites/norbertmichel/2019/01/14/bipartisan-housing-finance-reform-a-blatant-giveaway-to-special-interests/#462c223225f4

https://www.heritage.org/article/new-housing-reform-package-naked-giveaway-special-interests

https://www.jchs.harvard.edu/blog/temporarily-ending-the-gse-net-worth-sweep-a-limited-but-important-step-towards-gse-reform/

https://www.forbes.com/sites/norbertmichel/2019/07/15/the-best-housing-finance-reform-options-for-the-trump-administration/#414c62f87d3f

10
Here’s a quick rundown of the multiple taxpayer bailouts that helped

Fannie and Freddie get to where they are today. (More detail is available in

this new Heritage Foundation Backgrounder.)

11
In September 2008 Treasury bailed out Fannie and Freddie, promising to

shore up each with as much as $100 billion. In return, they forced the

companies to give Treasury 1 million shares of preferred stock, worth a total of

$1 billion. These shares required the companies to pay quarterly cash

dividends to the Treasury, and they included a protection device called a

liquidation preference. This device means that the companies cannot raise

new equity capital without first paying back the liquidation preference (now

approximately $200 billion).

12
In May of 2009, the companies were still struggling, so Treasury promised

to provide each with up to $200 billion.

13
In December 2009 the companies were still struggling, so Treasury changed

its commitment formula, allowing it to provide more than $200 billion.

14
Even after these three bailouts, Fannie and Freddie were still struggling in

2012—so much, that they faced the prospect of borrowing from Treasury just

to pay the dividends they owed Treasury.

https://www.heritage.org/markets-and-finance/report/revising-the-preferred-stock-purchase-agreements-fannie-mae-and-freddie

https://www.fhfa.gov/Conservatorship/Documents/Senior-Preferred-Stock-Agree/2008-9-26_SPSPA_FreddieMac_RestatedAgreement_508

https://www.fhfa.gov/Conservatorship/Documents/Senior-Preferred-Stock-Agree/2009-5-6_SPSPA_FannieMae_Amendment_508

https://www.fhfa.gov/Conservatorship/Documents/Senior-Preferred-Stock-Agree/2009-12-24_SPSPA_FreddieMac_Amendment2_N508

15
Papering over this problem, Treasury amended the agreement once again,

this time taking any profit that Fannie and Freddie managed to earn in order

to satisfy the dividend payments.

16
It is true that, between 2008 and 2018, Fannie and Freddie paid back about

$300 billion to Treasury, roughly $100 billion more in dividends than they

received from Treasury. But this fact merely addresses the cash flows. It

overlooks that Fannie and Freddie were able to pay these dividends only with

the aid of successive bailouts, and it also ignores the risk that taxpayers were

forced to take on through these bailouts.

17
Of course, these four bailouts are separate from the additional help that

Fannie and Freddie received when the Fed and Treasury purchased trillions of

dollars of Fannie’s and Freddie’s bonds and mortgage backed securities, thus

staving off further losses that could have required even more bailouts.

18
Despite all of these bailouts, the federal government chose to place Fannie

and Freddie into conservatorship (to preserve their assets) rather than

receivership (to liquidate their assets and shut them down). Conservatorship

was a bad choice in 2008 because Fannie and Freddie had blown through

their capital buffer and had no prospects for building capital without

additional support from taxpayers.

https://www.fhfa.gov/Conservatorship/Documents/Senior-Preferred-Stock-Agree/2012-8-17_SPSPA_FreddieMac_Amendment3_N508

https://www.fhfa.gov/DataTools/Downloads/Documents/Market-Data/Table_2

https://www.fhfa.gov/DataTools/Downloads/Documents/Market-Data/Table_1

http://gcfp.mit.edu/wp-content/uploads/2018/11/Lucas-Bailouts-Nov2018

https://www.federalreserve.gov/newsevents/pressreleases/monetary20081125b.htm

https://www.fhfa.gov/DataTools/Downloads/Documents/Market-Data/Table_3

https://www.fhfa.gov/DataTools/Downloads/Documents/Market-Data/Current_Market_Data-2016-02-19

https://www.fhfa.gov/DataTools/Downloads/Documents/Market-Data/Table_4b

19
Now that the FHFA is taking its job seriously and trying to get Fannie and

Freddie out of conservatorship, lack of capital is a major hurdle to a smooth

exit. Before they can exit, Fannie and Freddie will have to meet their capital

requirements (which were suspended throughout the conservatorship), and

the FHFA director will have to classify them as either: (1) adequately

capitalized, (2) undercapitalized, (3) significantly undercapitalized, or (4)

critically undercapitalized.

20
As this new paper explains, the authority of the FHFA director to intervene

in Fannie’s and Freddie’s operations widens as the capital classification

deteriorates. Ultimately, the director has the discretionary power to place the

GSEs into receivership and liquidate their assets if they are classified as

critically undercapitalized.

21
As the paper also shows, Fannie and Freddie are critically undercapitalized

by (combined) approximately $200 billion. This shortfall is a major hurdle to

exiting conservatorship, so there was a great buzz when the FHFA and

Treasury recently agreed to allow Fannie and Freddie to retain some of their

profits and maintain capital reserves of $25 billion and $20 billion,

respectively.

22
If, however, retained earnings are the firms’ only source of capital, it could

take close to decade to build the required amount. And that’s if everything

goes well.

https://www.law.cornell.edu/uscode/text/12/4614

https://www.heritage.org/markets-and-finance/report/revising-the-preferred-stock-purchase-agreements-fannie-mae-and-freddie

https://www.law.cornell.edu/uscode/text/12/4614

https://www.marketwatch.com/story/fannie-freddie-can-hold-more-capital-per-treasury-fhfa-agreement-2019-09-30

23
So it would seem that the companies will have to raise capital from outside

sources, with a public offering. That option, however, also has a few major

hurdles. First, given that $200 billion dwarfs the largest public equity

offerings in history, it is not clear that the companies can pull this off even if

they build capital through retained earnings for the next several years.

24
A bigger problem is that the liquidation preference, the mechanism that is

supposed to protect taxpayers’ investment, now sits at approximately $200

billion. As the agreement with Treasury stands, to protect taxpayers, Fannie

and Freddie cannot exit conservatorship until the liquidation preference is

paid off.

25
So the companies actually need to raise about $400 billion in equity.

26
It may be argued that the most politically expedient option is to provide yet

another bailout so that the companies no longer have to pay off the liquidation

preference. There is, however, a much better solution to this problem.

● Reinstate capital standards for Fannie and Freddie.
● Place Fannie and Freddie into receivership and liquidate their

assets because they are critically undercapitalized.

27
These moves will cause a firestorm, but it doesn’t really matter: The FHFA

director has legal authority to take these steps, and it’s what should have been

done in 2008. Besides, anything the administration does to shrink Fannie and

https://www.investopedia.com/articles/investing/011215/top-10-largest-global-ipos-all-time.asp

https://www.heritage.org/markets-and-finance/report/revising-the-preferred-stock-purchase-agreements-fannie-mae-and-freddie

https://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Issues-Proposed-Rule-on-Enterprise-Capital.aspx

https://www.marketwatch.com/story/fannie-freddie-overhaul-could-mean-windfall-for-preferred-stock-analyst-says-2019-07-12

Freddie’s footprint will cause a firestorm. (The shareholders can still have

their day in court no matter what.)

28
Liquidating the two companies would have been the right thing to do in

2008, and it is still the right thing to do. This government-protected duopoly

prevents the housing finance market from being competitive and better

serving customers’ needs. As the FHFA has said, a competitive market helps

people because it “effectively delivers market-affordable prices with customer

satisfaction and continual innovation to improve product quality.”

Follow me on Twitter.
Norbert Michel
I am the Director of the Center for Data Analysis at The Heritage Foundation. I also research issues

pertaining to financial markets and monetary policy

https://www.heritage.org/housing/report/taking-stock-shareholder-lawsuits-no-barrier-gse-dissolution

https://www.fhfa.gov/AboutUs/Reports/ReportDocuments/2019-Strategic-Plan

https://www.twitter.com/@norbertjmichel

https://www.forbes.com/sites/norbertmichel/

TooBig to Fail: Journal Review #5

Read and annotate this article about Fannie Mae and Freddie Mac. Then answer the questions.

1. What are three new words you learned from this article? Write the word, part of speech
and definition below:

2. What is the author’s claim?

3. What are some pieces of support the author uses to support his claim?

4. Do you agree or disagree with the author? Why? Explain your ideas in about 3-5

sentences.

5. How is this article related to the field of business? Explain your ideas in about 3-5
sentences.

Word

Part of speech
(n, v, adj, etc)

Definition in your
own words

https://docs.google.com/document/d/1fN53yOs-aGT1iGYjyYTcXaykxNHbH7xvbM_kr3YS-LM/edit?usp=sharing

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