GSE 'Recap' Experiment Is Just a Sideshow

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"Large financial institutions need to have more capital," say many policymakers in Washington. But in the case of Fannie Mae and Freddie Mac, this statement is not so simple. With these two institutions sitting in conservatorship, the type of capital and where it comes from matters. On this point, there is quite a bit of dangerous misinformation.

First, some fundamentals. Fannie and Freddie have capital today. Lots of it – $256 billion, in fact. This does not change in 2018, as some have argued. They will absolutely still have this capital.

That is because of the terms of the Senior Preferred Stock Purchase Agreements (or "PSPAs") that the two government-sponsored enterprises entered into with Treasury in 2008, when they were put into conservatorship. The PSPAs promised that at all times the U.S. Treasury Department – e.g. the taxpayers - would keep the GSEs solvent and functional no matter what.

Think about that for a minute. In perpetuity, unless or until Congress undertakes GSE reform, the United States government must keep the GSEs solvent by adding capital to their balance sheets if the value of either firm goes below zero. A legally binding promise like this from Uncle Sam has to be the single most robust source of capital in existence.

Now if Fannie and Freddie already have capital, what do people mean when they say the GSEs "should be allowed to rebuild capital"? Well, these arguments fall into two camps. One stems from a political concern. The other is more transparently self-serving.

Let's start with the political argument. This line of thinking says that a "draw," meaning a quarter where the GSEs lose money and need to have the Treasury Department make good (again) on its promise to keep them solvent, would cause a political backlash. And so, this argument goes, allowing the GSEs to retain earnings on their books lessens the risk of a bad headline and poor public policymaking.

Maybe, but I doubt it. For evidence, look no further than the Federal Housing Administration. The FHA recently suffered balance-sheet insolvency and needed Treasury support for a short period of time. There were bad headlines, yes. But what laws were passed to irresponsibly torch FHA? None.

The other argument says the GSEs should follow a corporate restructuring process that begins by allowing them to retain earnings. But this presents very important challenges.

This reasoning ignores a big part of how those earnings are possible. Why are the GSEs functioning institutions and not hollowed out buildings with smashed glass, like the factories in Youngstown, Ohio where I grew up? Because the Treasury stood behind them via the aforementioned PSPA's in 2008, and still does today.

Such a recapitalization could potentially benefit investors in the two GSEs, who have been arguing for the reinstatement of their shares. But the taxpayer-funded bailout of Fannie and Freddie should not reward legacy private shareholders with profits made possible by new taxpayer equity.

More importantly, though, the impact on the housing market of a recap could be quite negative. We are not discussing this risk enough, but it exists. The illusion of moving the GSEs towards being "recapitalized" companies without any legislative reform could very well disrupt the market for mortgage-backed securities. The Federal Reserve, for example, which is currently the largest investor in GSE mortgage-backed securities, likely won't buy any debt that a private company issues.

Treasury has spent eight years saying the MBS issued by Fannie and Freddie have government backing. This promise is why central banks and pension funds across the globe have purchased these securities, thus keeping interest rates low. It is also what makes their to-be-announced ("TBA") futures market function. This, in turn, allows prospective homebuyers the ability to lock in a rate before closing.

I am not opining here on the wisdom of having such a government role in the mortgage market over the long run. I am, however, saying that this arrangement objectively exists today. If the enterprises are instantly treated like private companies, this backing could be questioned. We need to recognize this.

And so we face a fundamental question: are Fannie and Freddie private companies, as the shareholders argue? Or are they government agencies, like their MBS investors believe? This is a legitimate debate. Do we really want to find out inadvertently by trying this "recap" experiment?

It would take over a decade for the GSEs to recapitalize themselves using retained earnings to the point of being anywhere near safe. And that's while letting the taxpayers provide an equity-like investment for at least the next 30 years for no additional return. Are investors who purchased their delisted shares really planning to sit tight for over a decade? Maybe. And some of them seem to really believe in their position. The more thoughtful ones also admit that they'd need to make an additional equity injection as well for the plan to work.

The problem, though, is that some of these investors simply want to find a new set of marginal buyers so that they can sell right now. Hence, the "recap" push. For these investors, it's not about systemic risk. It's not about helping policymakers sort through challenging questions. It's about letting them sell their stake immediately at a small gain.

I am all for increased privatization and competition in the mortgage market over time. But simply recapitalizing the GSEs without legislative reform would be a policy decision coming at the expense of homebuyers, future taxpayers, and the economy. That is not a good trade.

There is simply no easy way around it: America needs comprehensive and, more importantly, honest housing finance reform. We need a real debate on the right role of government, competition, market forces and housing subsidies. That debate – not some recap sideshow argument – is the debate our country deserves.

Michael Bright is a director at the Milken Institute's Center for Financial Markets. He has previously at worked Blackrock, the office of Sen. Bob Corker, R-Tenn., and the Office of the Comptroller of the Currency.

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