Reform of U.S. housing finance is essential to avoiding another financial crisis. Since the U.S. placed Freddie Mac and Fannie Mae into conservatorships in 2008 under the Housing and Economic Recovery Act, the contours of this reform have been much debated but repeatedly deferred. Today, these companies remain wards of the state.
Most parties should be able to agree that the government-sponsored entities' current state of limbo is untenable. At best, the arrangement reinforces continued government dominance of the housing market. At worst, it distorts our housing finance system, preserves incentives to misprice mortgages and creates the potential for a future housing crisis.
Unfortunately, real reform seems more unlikely by the day. Policy views remain divided. And the government may see limited benefits to changing the status quo. In 2012, the Treasury Department unilaterally decided to change the terms of the agencies' conservatorships and sweep 100% of Fannie and Freddie's profits to Treasury as dividends in perpetuity. This sweep continues to this day, despite the fact that Fannie and Freddie have now paid back almost $40 billion more than they were originally loaned. This prevents Fannie and Freddie from accumulating any cushion against future losses — potentially putting the taxpayers at further risk.
Investors in Fannie and Freddie have sued Treasury and the Federal Housing Finance Agency to challenge the continued conservatorships and profit sweeps. In September, the D.C. federal trial court rejected those challenges. While that decision is on appeal, there are even more fundamental problems with Treasury's actions.
The perpetual conservatorships and Treasury sweeps are a violation of every principle of insolvency law. I do not make this statement lightly. After more than twenty years at the Federal Deposit Insurance Corp., and frequent participation in domestic and international efforts to improve insolvency laws, I provided technical advice to Congress on HERA.
My primary model — and an internationally recognized standard — was the Federal Deposit Insurance Act. It has served this country well for more than 80 years by closing insolvent banks, protecting insured depositors, and recycling the failed bank’s loans back to sound banks. In fact, HERA parallels the FDIA in virtually all of its provisions.
HERA was never meant to authorize permanent government control over the housing sector. Under HERA, the FHFA and Treasury have the clear statutory authority to begin reform by ending the conservatorships of Fannie and Freddie. FHFA director Mel Watt recently acknowledged this authority in a hearing before the Senate Banking Committee. Many, including Senate Banking Committee chairman Tim Johnson, have called on Watt to exercise that power.
The FHFA's statutory authority to end the conservatorship isn’t a question of interpretation or policy debate. Like the FDIA, the law provides for conservatorships and receiverships to give the FHFA some flexibility to decide how best to resolve a failing Freddie or Fannie. However, this discretion is limited. In fact, HERA requires termination of the conservatorships and appointment of the FHFA as receiver if Freddie and Fannie remain insolvent. The FHFA director is required to make periodic findings on this point precisely to provide discipline to the process.
Not only does HERA provide this discipline, it also imposes duties on the FHFA as conservator. In this role, the FHFA is instructed to return Freddie and Fannie to "a sound and solvent condition" and to "preserve and conserve the assets and property" of the companies. The FDIA includes the same instructions. The FDIC has always treated conservatorships as short-term solutions leading to the recapitalization and return of the failing bank to full private control, or to a receivership and payment of creditors and stockholders.
The continued diversion of Freddie and Fannie's profits to Treasury misuses HERA as well as ignores the international standards underpinning all insolvency frameworks. This is important because one foundation of corporate finance, and our system of commercial laws, is that insolvency law assures creditors that the remaining value of the company will be paid out under defined priorities. If this standard is ignored, as it has been through the Treasury sweeps, it will undoubtedly affect future investment in housing finance and the financing costs for businesses.
The FHFA is ignoring the basic duty of a trustee: to protect the interests of all creditors. By keeping the companies in conservatorships and diverting their cash to Treasury, the FHFA effectively prefers one creditor over all others. While Treasury provided critical up-front funding to the GSEs, it has now been well-compensated under the original agreements. It cannot simply strip the companies of cash in perpetuity.
Every sound insolvency process, including HERA and the FDIA, repays the funding provided but then pays all creditors the remaining value. In bank resolutions, once the FDIC's cash outlay is repaid, the FDIC receives no more money. The continuation of the sweeps through the conservatorships is a violation of every principle established in bankruptcy and in the more than 80 years of FDIC bank resolutions. And it has no support in HERA.
Michael Krimminger is a partner at Cleary Gottlieb in Washington and a former general counsel to the FDIC.