President-elect Trump’s selection of a former mortgage banker as Treasury secretary signals the incoming administration’s intention to finally settle the status of Fannie Mae and Freddie Mac, the two government-sponsored housing finance behemoths that were bailed out and brought under federal conservatorship in 2008.
Secretary-designate Steve Mnuchin told Fox Business that Fannie and Freddie should be freed from government conservatorship, causing shares in the two entities to soar and enriching hedge fund managers Bill Ackman, John Paulson and other speculators betting on such an outcome. While privatization is warranted, it needs to be done in a way that serves the interests of taxpayers rather than those of well-connected hedge fund investors.
An especially bad outcome would be a return to the pre-2008 status quo when investors and executives at Fannie and Freddie shared the spoils during the good times, leaving taxpayers with the bill when the party ended. To avoid bungling the privatization of the government-sponsored enterprises, it is worth taking a moment to review the history of these institutions and the muddled thinking that has led us to the current mess.
The Federal National Mortgage Association (FNMA) was established by the Roosevelt administration in 1938 as a government agency that made a market in government-insured mortgages. It was one of several Depression-era agencies created to support cratering home values by improving access to mortgage finance. While homeowners and real estate brokers hate low home prices, it is not at all clear that they are a social evil. By inflating home values, the government ultimately encouraged speculation by residential real estate investors: Home ownership seemed like a safe bet until prices finally reached unsustainable levels during the last decade.
In 1968, the Johnson administration and a Democratic Congress converted Fannie Mae to a for-profit, shareholder-owned company. At the time, the word “privatization” had barely entered the English language; it would not become a popular term until the 1980s, when Margaret Thatcher began selling England’s state-owned corporations. So why would liberal Democrats steal a page from the right-wing playbook a dozen years before that page was even written?
Back in Johnson’s day, people still worried about relatively small deficits. In the mid-1960s, annual deficits averaged less than 1 percent of GDP. But increased spending on the Vietnam War as well as Great Society programs were threatening to increase the flow of red ink later in the decade. In his January 1968 budget message (for the 1969 fiscal year), Johnson proposed to limit the growth of government debt by, among other things, shifting the cost of buying mortgages to the private sector.
Fannie Mae and its younger sibling, Freddie Mac (officially the Federal Home Loan Mortgage Corporation, created by the federal government in 1970), bought mortgages with borrowed money, in the form of proceeds from the bonds they issued. There was always the risk that mortgages purchased by the GSEs would fail to perform. In that case, Fannie Mae and Freddie Mac — which both maintained very thin layers of capital — would default on their bonds. Because of this risk, bond investors would demand hefty interest rates on mortgage-backed bonds. But in the case of the GSEs, they assumed that the federal government would back the bonds in the event of a default. As a result, GSE bonds carried interest rates only slightly higher than Treasury securities.
Although the federal government did not explicitly back the GSEs’ bonds, it did nothing to dissuade investors from thinking that a guarantee existed. Instead, the government signaled its support by providing the GSEs a line of credit from the Treasury and other special privileges. With the implicit federal guarantee, GSEs could buy large volumes of mortgages with cheap capital. After the Community Reinvestment Act was enacted in 1977, banks began meeting the law’s mandate to lend more in disadvantaged areas by originating and then offloading risky mortgages to Fannie and Freddie. The GSEs thus had a large supply of mortgages to buy with their bond proceeds.
Between 1982 and 2001, Fannie Mae’s share price grew by a factor of 100 on a split-adjusted basis. Meanwhile, company executives received lavish compensation packages. Between 1991 and 1998, Fannie Mae CEO James Johnson earned roughly $100 million, while his successor, Franklin Raines, pulled down $90 million over the five subsequent years. Only later did we learn that Raines presided over a massive accounting fraud designed to pad executive bonuses.
While the accounting scandal depressed Fannie Mae’s stock, the existential crisis for GSEs really began when the housing bubble burst in 2006 and 2007. By the summer 2008, both Fannie and Freddie faced insolvency. Amidst pressure from foreign holders of GSE debt to fulfill the implicit guarantee, Treasury Secretary Hank Paulson (like Mnuchin, a Goldman Sachs veteran) obliged, injecting capital into the GSEs and taking them into conservatorship.
This conservatorship was short of an outright nationalization, but stockholders were given little reason for hope. Paulson’s plan included a stated intention to shrink the GSEs assets by 10 percent annually. Further, the government took an option to buy 79.9 percent of each GSE at a price of $0.00001 per share. Effectively, Fannie and Freddie were now under government control.
An outright takeover would have obliged the federal government to count the $5 trillion of GSE bonds then outstanding as part of the national debt — representing a roughly 50 percent increase from the $10 trillion the federal government owed at the time. Even though such a reclassification would have made no difference in reality, the optics would have been terrible: a Republican administration adding 50 percent to the national debt during an election year. It’s hard to imagine the debt ceiling increase needed to facilitate such a reclassification could have made it through Congress. So, in order to pretend that taxpayers were not on the hook for trillions of dollars of mortgage-backed bonds, we maintained the fiction that the GSEs are private.
Eight years later, the conservatorship remains in place and the GSEs are nearly as large as they were before the financial crisis. While Washington remained gridlocked, Fannie and Freddie became profitable again. In 2012, the Obama administration began sweeping nearly all GSE profits into the federal Treasury. Having recouped the entire $187.5 billion of capital that taxpayers injected into Fannie and Freddie, it was time for the public to share in the upside of GSE operations.
This, however, was not the view of hedge fund investors who bought Fannie and Freddie stock at pennies per share. They have sued the federal government, arguing that the profit sweep amounts to an illegal taking. This conveniently ignores the fact that GSE profits are attributable to their ability to borrow at rock bottom interest rates with a minimal capital cushion by virtue of government support. Now speculators are hoping for good news from the Trump administration and a Republican Congress. But while a return to the pre-2008 world might enrich private investors and future GSE executives, it does nothing to protect the taxpayer from the risk of a future bailout.
If we’re going to try privatizing the GSEs again, we need to make sure that they are really private. This means that lawmakers must make clear that the entities will never receive taxpayer support under any circumstances. They should also be subject to the same stringent capital requirements that are applied to private banks in today’s post-crisis world. Without special government privileges, Fannie and Freddie may not be very profitable, but that should be a problem for their executives and owners — not the taxpayer.