Too Big To Bail Out: The Trouble with Johnson-Crapo
There is a theory about the naming of legislation. Some titles are straight out of George Orwell’s “double-speak” dictionary. In other words (literally), whatever word is in the title usually means exactly the opposite of what the bill will do. Remember the “Affordable Care Act” (ACA)? Despite the promises of President Obama and his administration that this milestone legislation would reduce the cost of healthcare for most Americans, the ACA is on track to explode those costs for all but the poorest Americans.
To wit: the Housing Finance Reform and Taxpayer Protection Act S. 1217, which passed the Senate Banking Committee on Thursday, May 15, by a vote of 13-9. In keeping with the title theory, this bill, referred to as “Johnson-Crapo” after the Committee Chairman Tim Johnson (D-S.D.) and Ranking Member Mike Crapo (R-Idaho), neither reforms housing finance nor protects the taxpayers. The bill collapses the current housing government-sponsored enterprises (GSEs) into a third government entity, embodying the typical Washington shell game that keeps interventionist government bureaucracies alive in perpetuity: “putting lipstick on a pig” is the adage that most immediately comes to mind. Moreover, by adding $5.2 trillion to the national debt, this bill does the exact opposite of protecting taxpayers.
Interestingly, the committee’s 12 Democrats and 10 Republicans did not vote along clear party lines. The 13 votes in favor of passing the bill were cast by strange political bedfellows, and Democrats were outnumbered by Republicans in their support of the bill. By the same token, the Republicans and Democrats who opposed the bill did so for widely divergent reasons.
Citizens Against Government Waste (CAGW) has long inveighed against the excesses of and systemic risk posed by the housing finance industry’s dysfunctional duo, the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), the GSEs known as “Fannie Mae” and “Freddie Mac.” The privatization of Fannie Mae and Freddie Mac (that is, getting American taxpayers off the hook for any more failures) is perennially listed as one CAGW’s Prime Cuts, a compendium of recommendations to reduce the waste and inefficiency of the federal government. The GSEs were endowed by Congress with special benefits not afforded to other firms in the secondary mortgage market, including lines of credit through the U.S. Treasury, exemption from income taxes, and some freedom from Securities and Exchange Commission oversight. Their biggest advantage was their implicit federal guarantee: in a crisis, Uncle Sam was assumed to be willing to step in to bail out the mortgage giants, allowing them to borrow at lower rates than would have otherwise been possible.
More than 10 years ago, 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.”
Fannie and Freddie have been in conservatorship since 2008 when they fell into financial distress and required government support to continue operating. The explicit purpose of conservatorship is to conserve and preserve the assets of the subject enterprises and to restore them to sound and solvent condition. Fannie and Freddie have worked through housing crisis losses, tightened mortgage underwriting, and reduced their investment portfolios. Their mortgage guarantee business is now generating enormous profits that can be used to build capital reserves against credit losses in the future.
Notwithstanding this progress, Fannie and Freddie are not approaching safety and soundness, the goal of conservatorship, because the Treasury is taking the profits for itself rather than letting them build capital. In August 2012, the Federal Housing Finance Agency and Treasury amended the terms of the government’s support, changing the already-high 10 percent dividend on invested capital into 100 percent of all Fannie and Freddie profits. As a result, all of the money the enterprises are now making goes straight to the Treasury Department in order to fund unrelated government spending. Therefore, the lack of capital means that no real economic value remains to back the enterprises’ financial obligations.
Supporters of the Johnson-Crapo housing finance reform bill in the Senate cite the enormous financial risk to the taxpayer presented by Fannie Mae and Freddie Mac. To address this risk, they want to wind down the enterprises, filling the market vacuum with a new government-backed mortgage system that requires $500 billion of unspecified, unidentified, and as-yet-uncommitted private capital to protect the taxpayer going forward.
The financial risk to taxpayers that is being codified in Johnson-Crapo is entirely a result of Treasury’s own actions. If the administration was serious about limiting taxpayers’ exposure, it would have declared itself whole when it received the $187 billion of invested capital plus its 10 percent return. To the contrary, the dividend payments that the Treasury has received from Fannie Mae and Freddie Mac under the “sweep” cannot be considered repayments of the funds previously drawn from the Treasury to help Fannie and Freddie. The government’s senior preferred stock can never be redeemed, the enterprises’ financial obligation to the government can never be satisfied, and the sweep will continue in perpetuity. At a time when voters want taxpayer investments in distressed companies paid back as soon as possible, Treasury’s actions are logically and politically perverse.
Senators Johnson and Crapo want to dramatically expand the government’s responsibility, converting the remaining $258 billion in Treasury’s backstop into $5.2 trillion of full faith and credit of the United States on Fannie and Freddie securities. When the national debt already stands at more than $17.5 trillion, this 30 percent increase in the debt is a huge expansion of the burden on future generations.
It would be a terrible signal to the marketplace to convert the largest implicit backstop into an explicit one. When Fannie and Freddie securities were issued and sold to investors, they contained explicit language saying that they were not the legal obligations of the U.S. government. Fannie and Freddie’s creditors should therefore get only what they bargained for, repayment based on the enterprises’ financial ability to meet their obligations without any gifts or subsidy from the U.S. government.
If the Johnson-Crapo system does not work and insufficient private capital materializes to fund loans, mortgage credit will contract and substantial losses on mortgage-related assets will result. Per the full faith and credit provision, the government will have put itself (read, taxpayers) on the hook to cover those losses, effectively dealing itself a serious self-inflicted and unnecessary financial wound.
Instead, Congress should demand that after the government is paid back, capital should be allowed to build up in reserves against future credit losses. The unfunded Treasury backstop can be replaced by funded capital reserves on a dollar-for-dollar basis, until taxpayers are off the hook altogether. The government’s goal with Fannie and Freddie should be payback, followed by long-term financial independence.
Otherwise, the earlier GSE bailout will seem like a minor leak in a rickety rowboat compared to the Titanic-scale damage that will be wrought on the American economy if taxpayers are left holding the bag for Fannie’s and Freddie’s $5.2 trillion in liabilities, as envisioned by Johnson-Crapo.
