GSEs: As Sleazy as 1-2-3

When the Jackson Five (featuring a very young Michael Jackson) appeared on American Bandstand on February 21, 1970, they sang about love being as easy as learning the ABCs.  But childhood crushes pale in comparison to a truly nefarious coupling:  the marriage of private gains and taxpayer losses.

Those who saw or heard about The Big Short, a 2015 motion picture based on real-life investors who predicted the disastrous housing market collapse of 2007 and profited handsomely from it, may have thought they learned everything about what occurred during that time.  There were a lot of sleazy characters in the movie, and plenty of blame to go around, but two of the guilty parties were hardly mentioned in the Hollywood production:  Fannie Mae and Freddie Mac.  Fannie and Freddie, the more common names respectively associated with the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), are the two housing-related government-sponsored enterprises (GSEs) whose recklessness contributed directly to the mortgage market catastrophe and the ensuing Great Recession.

The GSEs, with their government charters and implied guarantees that their investments are backed by the full faith and credit of the U.S. Government, have the best of both worlds:  They enjoy privatized profits (where only the shareholders benefit), while all losses are socialized (meaning that taxpayers pick up the tab).

As noted in its September 2013 WasteWatcher, Citizens Against Government Waste (CAGW) has long inveighed against the excesses of the GSEs.  Indeed, on June 25, 2003, CAGW President Tom Schatz testified before the House Subcommittee on Capital Markets and Government Sponsored Enterprises, sounding a prescient (and tragically Cassandra-like) warning:  “It is clear that because of their size and market concentration, Fannie Mae and Freddie Mac are too big to fail. … no matter how many times the GSEs say that they are private companies, independent of the government, everyone knows that is not the case.  The American taxpayer is on the hook if anything goes wrong with the GSEs, and therefore, effective regulation and accountability must be of paramount importance.”

While the eventual train wreck played out in slow motion, relative to the 2003 admonition, the housing market finally collapsed in 2007, and the financial crisis from which the U.S. economy still struggles to emerge ensued shortly thereafter in 2008.  The resulting $189 billion bailout is the largest taxpayer bailout in American history.

After the bailout, Congress created the Federal Housing Finance Agency (FHFA), a regulator that put the GSEs into conservatorship.  And the intent of conservatives who wanted to ensure that taxpayers would never again be on the hook for such staggering losses was for the next step, beyond conservatorship, to be a complete “wind down”; essentially, true privatization, severing all ties to government guarantees.  No more government charter, no more presidential appointees, and no more liberal line of credit from the U.S. Treasury.  It is essential that taxpayer exposure be significantly reduced by ensuring that private capital take on virtually all the risk.

But the GSEs count on memories being short.

Hedge fund investors, who paid pennies on the dollar for common stock in Fannie and Freddie, are hoping to get the GSEs re-capitalized, so that the latter can (theoretically) emerge from conservatorship unscathed.  This concept is being referred to by the seemingly innocuous phrase “recap and release.”

Unfortunately, this type of rhetoric may potentially corrupt conservative thinking.  Experience teaches that reforms will not occur unless Fannie and Freddie are kept in a box, beyond which they cannot run roughshod over the mortgage market with their reckless policies.  At the same time, any “profits” that they generate are regularly swept by the Treasury (rather than retained as operating capital) into a general “slush fund” that is used to fund the administration’s pet projects or to mask larger deficits.  This frustrates fiscal conservatives, prompting many of them to believe that the funds would be better off held in reserve by the GSEs themselves.

However, to do so would create a false impression that Fannie and Freddie might somehow be on the path to fiscal recovery, making their privatization less pressing of an imperative.  In turn, such a misleading capitalization would feed the perception that they should be able to resume their earlier business practices (i.e., controlling the overwhelming majority of mortgage loans, with the taxpayers’ continued backing).  In other words, rather than taking bullets out an unsecured revolver (i.e., removing the temptation to use the weapon in some extreme circumstance), re-capitalization is more akin to reloading the weapon, with little (if any) supervision over who might try to use it.

The GSEs have not demonstrated any serious interest in significant reforms.  They continue to impose guarantee fees and price adjustments far in excess of actual credit risk.  Since any profits (after expenses) go straight to the Treasury, the GSEs have no incentive to control costs.  To the contrary, expenses have increased by 36 percent (more than $1.1 billion) since 2012.  Under the preferred stock agreement that mandated a downward glide path for retained capital ($1.2 billion in 2016, $600 million in 2017, and zero in 2018), the GSEs have spent wildly.  They have sought to reconstitute their political influence machine, hiring more than 1,000 people over that period and sending teams to conferences and events throughout the country, spreading the gospel that the GSEs are serving the market just fine.  By their narrative, all is well.

To further underscore both the lack of restraint to spend wildly and the disincentives for reforms, FHFA Director Mel Watt approved the ability of Fannie and Freddie to pay their CEOs a combined $6 million.  Fortunately, Congress stalled this boondoggle by passing the Equity in Government Compensation Act of 2015.

There is a better way.  Require that the private market take on the credit risk of mortgages from the first dollar of loss before any government guarantee is applied.  The goal, of course, is to eliminate the need for any government guarantee.  Until then, the government should only be in a catastrophic backstop position, with the guarantee fee reduced to match its significantly reduced exposure.

In the meantime, the GSEs bide their time, certain that memories will continue to fade.  Unless and until their advantageous government guarantees are withdrawn, they have nothing to lose.  For them, it’s as easy as 1,2,3.  For taxpayers, it’s just plain sleazy.