The Trump administration is planning to end the conservatorships of Fannie Mae and Freddie Mac, according to a report from MarketWatch.
Joseph Otting, who is serving as the Federal Housing Finance Agency’s acting director while Mark Calabria awaits Senate confirmation, told an “all hands gathering” on Thursday that plans to release the two government-sponsored mortgage giants from conservatorship would be announced within weeks, MarketWatch reported.
An agency spokesperson confirmed to MarketWatch that there was a discussion about ending the conservatorships but denied Otting had put a timeline on any announcement.
“Acting Director Otting held the internal meeting to meet FHFA staff and establish open lines of communication,” the FHFA said in a statement to MarketWatch. “He mentioned, as he previously has, that Treasury and the White House are expected to release a plan for housing that will include details about reform and will likely include a recommendation for ending Fannie Mae and Freddie Mac conservatorships. [Treasury] Secretary Mnuchin has said that the goal of the [Trump] administration is to take the GSEs out of conservatorship. Acting Director Otting said that he and FHFA will work to advance that plan.”
A History of Deception, Manipulation, Financial Domination, and Collapse
Fannie and Freddie do not make mortgage loans. They buy loans made by banks and other lenders, package them as mortgage-backed securities, and guarantee payments on those securities. This provides mortgage lenders with cash and relieves them from having to meet capital requirements on those loans. In addition, when banks make mortgages that can be sold to Fannie and Freddie, they get relief from a variety of regulations, including Dodd-Franks’ requirement that lenders hold 5 percent of the risk on loans they make.
Fannie and Freddie’s vast market power, together they backed around 44 percent of all new mortgages last year, means they exercise an enormous influence on what kind of loans lenders make and which borrowers receive loans. Conservative critics say this played a role in fueling the housing bubble as both companies pushed lenders into taking excessive risks. Even today, many lenders seek to make loans tailored to meet Fannie and Freddie’s goals.
Both companies could borrow at extremely low costs, near the risk-free rate enjoyed by the federal government, because investors assumed they had the backing of the federal government. This so-called “implicit guarantee” arose because the companies were originally established by the U.S. government, were chartered by an act of Congress, and had numerous exemptions from taxes and regulations that marked them as pseudo-government entities.
The low funding cost boosted profits at the companies and allowed them to accumulate vast portfolios of mortgage-backed securities. These portfolios were highly profitable but also vastly increased the risks the companies were taking. They did not require much financial acumen to make money, however, because all the companies had to do was borrow at low interest rates and use that money to buy securities packed with mortgages that paid higher rates.
At the height of their power, Fannie and Freddie also exercised vast political influence. The companies used this influence to control the Office of Federal Housing Enterprise Oversight, the agency charged with regulating them before it was replaced by the FHFA, and to lobby Congress to keep their capital requirements dangerously low and fend off attempts to impose more stringent regulation.
“Fannie Mae management expected to write the rules that applied to the Enterprise and to impede efforts at effective safety and soundness regulation,” a 2006 report by government examiners concluded.
That report found:
A combination of factors led Fannie Mae senior management, through their actions and inactions, to commit or tolerate a wide variety of unsafe and unsound practices and conditions. Those factors included the Enterprise’s enormous financial resources and political influence, the expectation that senior management could write the rules that applied to Fannie Mae, financial rewards tied to a measure of profits that management could easily manipulate, and the relative disinterest of senior executives in adhering to standards of prudent business operations.
The report concluded that although Fannie Mae’s senior management promoted an image of the company as one of the lowest-risk financial institutions in the world, its true risks were “greatly understated and that the image was false.” Its seemingly smooth and reliable earnings were “illusions deliberately and systematically created by the Enterprise’s senior management with the aid of inappropriate accounting and improper earnings management.”
The companies and their executives vigorously denied the charges. Some of their defenders, including then-Congressman Barney Frank, insisted there was no implicit guarantee covering the companies–a position that would prove embarrassing when the companies were in fact rescued by the government.
In 2006, Fannie had to restate its reported earnings by $6.3 billion to correct several years of accounting problems in what was then one of the biggest financial scandals in U.S. history. Freddie also restated earnings by billions of dollars for multi-year accounting problems.
Two years after the special examiner’s report, both companies were on the verge of collapse.
After a Bailout, Hedge Funds Sue Seeking Windfall
Fannie and Freddie were bailed out at the height of the financial crisis and put into conservatorship by the FHFA. Over the next few years, the government injected $187.5 billion of new capital to keep the companies solvent. In exchange, the government received warrants for a 79.9 percent stake in the companies and senior preferred stock that initially paid a 10 percent dividend. In 2012, the dividend was changed from fixed to floating, requiring the companies to pay all of their profits to the government but relieving them of the burden to pay in quarters that result in financial losses. That arrangement has come to be known as the “net worth sweep” because the companies pay all of their positive net worth to Treasury.
When the companies were first put into conservatorship, many in the government underestimated the size of their financial losses and assumed they would be rehabilitated and released. Others believed Congress would pass legislation that would create a replacement for the liquidity and guarantee roles played by Fannie and Freddie.
Congress has attempted several times over the years to enact housing finance reform legislation but those efforts have failed due to conflicting views about the government’s role in the mortgage market. Conservative and libertarian lawmakers would like to see the government step back from supporting such a large portion of the market for home loans, with some advocating no government backstop at all. Liberals and self-styled affordable housing advocates insist that some sort of government support is necessary to promote home ownership and keep mortgages affordable and available for lower-income Americans.
Several hedge funds and other institutional investors bought up shares of Fannie and Freddie in hopes that they would be released from conservatorship and allowed to return to control by shareholders. Many of these investors purchased junior preferred shares that were trading at deep discounts to their face value. Others purchased common shares. Those that bought before the net worth sweep was introduced in 2012 have done very well. Shares that once traded at less than 25 cents were trading at above $1.80 on Thursday, a 640 percent rise, before they jumped higher when the MarketWatch story broke.
Despite these gains, some of the investors have sued the government seeking to end the conservatorships and have the courts strike down the net worth sweep. At first, the fund managers described their lawsuits as surefire winners, calling the net worth sweep “clearly illegal.” Some investors were so confident that they bought shares after the sweep was implemented. Bill Ackman’s Pershing Square became the largest holder of common stock years after the sweep was introduced.
The federal courts have not agreed with the investors. Nearly all of the many lawsuits filed by investors have been dismissed by courts, with many of those dismissals surviving challenges in appeals courts. A few cases remain outstanding, including one in the Federal Court of Claims where investors have said the sweep amounts to an unconstitutional “taking” of their property without compensation.
A Dark Money Campaign Waged by Hedge Funds
But hedge funds have not relied solely on the courts in pursuit of a Fannie and Freddie windfall. Behind the scenes, they have deployed a shadowy campaign to influence various Washington D.C. groups to take their side. This has included donations to civil rights groups, affordable housing advocates, and a campaign to convince conservatives that the net worth sweep is an affront to property rights. At one point, advocates for overturning the net worth sweep resorted to falsely claiming that profits from Fannie and Freddie were being illegally used to fill a budget hole created by Obamacare.
Mark Calabria, now serving as an advisor to Vice President Mike Pence and awaiting Senate confirmation for the job of running the FHFA, co-wrote a paper in 2015 arguing that the government’s treatment of Fannie and Freddie was not in keeping with the Housing and Economic Recovery Act of 2008. Calabria, then a policy expert at the libertarian Cato Institute, had served as a staffer on the Senate Banking Committee and had a hand in drafting that law. His co-author, Michael, Krimminger, is an attorney who had served in policy leadership positions with the FDIC. When their paper was released, they presented their analysis on a media teleconference sponsored by Investors Unite, a group formed to advocate for shareholders of Fannie and Freddie.
The arguments in the Calabria-Krimminger paper were later used by attorneys for investors as part of their legal brief.
In the absence of Congressional action, many have been urging the Trump administration to act unilaterally to release Fannie and Freddie from conservatorship. The investment banks Moelis & Co this fall re-introduced its plan to have the agencies released. It calls for the government to surrender its senior preferred shares in exchange for nothing. Instead, the government would exercise its warrants and control just under 80 percent of the company–essentially giving away the other 20 percent to the hedge funds and other shareholders. Some investors say shares could rise to as high as $20 to $40 under this plan.
In December, a group of some of the nation’s most prominent and respected housing finance experts authored an op-ed condemning the Moelis plan:
Taking advantage of this congressional impasse, several of Fannie and Freddie’s largest investors have banded together to advocate a path out of this state of limbo. Remarkably, however, the path does not lead to a new system as policymakers had intended, but back to the very system we had before the crisis. Yes, the one that nearly took down the economy.
To their credit, the investors recommend retaining some of the reforms that have taken place in conservatorship, such as limits on what Fannie and Freddie can invest in, and higher capital levels. But they would leave untouched the fundamental structural flaw that was the system’s ultimate undoing: the dominance of a duopoly that is too big and too important for the nation ever to let fail.
This makes sense from the investors’ point of view, as Fannie and Freddie’s market power will bring them more profits. But it is absurd from the nation’s point of view.
By once again standing behind the solvency of these two institutions, which taxpayers would have to do for the very reasons we could not let them fail the last time around, we would again give Fannie and Freddie the incentive to take outsized risks.
Otting, Mnuchin, Mulvaney, and Moelis
It is not clear if Otting’s plan to release the companies is modeled after the Moelis plan or if Calabria also agrees the companies should be released from conservatorship.
Otting is a former banking executive and associate of U.S. Treasury Secretary Steve Mnuchin. Sources close to the White House say he is part of the “banker/globalist/Davos” wing of the Trump administration. Prior to becoming the chief at Office of the Comptroller of the Currency and acting head of the FHFA, he was chief executive officer of OneWest, the California lender started by Mnuchin after the 2008 housing crisis. OneWest was built from the ashes of the failed California lender IndyMac. Along with Mnuchin, investors included billionaire hedge fund manager John Paulson and left-wing donor George Soros. OneWest was sold to CIT Group in 2015.
“He’s not deep state, but he’s deep Wall Street,” one Trump administration official told Breitbart News.
Wall Street certainly cheered the news that the companies could be released. Shares of Fannie and Freddie moved sharply higher on Friday, jumping 35 percent to more than $2,40.
Shares of Fannie and Freddie have moved on comments by Trump administration officials in the past. Even before the president was sworn in, Trump’s pick for Treasury Secretary Steven Mnuchin said that privatizing the two companies would be a top priority for the administration. He later clarified that the administration planned to work through Congress for comprehensive housing finance reform rather than unilaterally releasing Fannie and Freddie.
Last year, however, Mnuchin said that he expects Congress to enact housing finance reform in 2019 and that the administration could take action on its own if Congress does not act. Some inside the Trump administration feared that could wind up as a push to adopt the Moelis plan.
Mick Mulvaney, the White House’s budget director and the acting head of the Bureau of Consumer Financial Protection, is also viewed as a potential ally of those pushing the Moelis plan. As a Congressman, Mulvaney sponsored a bill that offered “a bonanza for hedge funds seeking to cash in on their investments in Fannie Mae Mae and Freddie Mac—but the cost to taxpayers would [have been] steep.” That bill died on Capitol Hill for lack of support.
The government continues to support Fannie and Freddie even though the two companies have returned to profitability. Treasury continues to promise to support the companies with over $220 billion of bailout funds should they need it. And the Federal Reserve has bought hundreds of billions of their securities, often buying more than the companies issued in a given month.
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