Obama’s GSE Options: Band-Aid, Stitches or Amputation

Much of the multifamily sector’s relative outperformance and stability—at least, as compared with other property sectors—has been due to the availability of capital through Fannie Mae and Freddie Mac. Yet there have been numerous discussions on the Hill and controversy in real estate circles over the enterprises’ role in the capital markets system and the current housing crisis, and their relationship with the government.

Right now, government is considering a handful of proposals to reform the GSEs, and it’s expected that the Obama Administration will release its decision on the GSEs in February as part of its fiscal year 2011 budget proposal. Yet given the size of the enterprises and the complications involved with making changes to them, it’s likely that any actions will not be taken for another couple of years, at least.

The options, which have been narrowed down to three dominant proposals, have their fair share of supporters and detractors, and it’s tough to say what the right solution will be.

As background, the Washington, DC-based Federal National Mortgage Association (Fannie Mae) was established in 1938, after the Great Depression and collapse of the housing market, as part of President Franklin D. Roosevelt’s New Deal program. Essentially, Fannie acted as a national savings and loan, which allowed banks—wary at the time of investing in home mortgages—to provide loans at low interest rates. This system is believed to be the root of the secondary mortgage market.

In 1968, financial pressures from the Vietnam War spurred Congress and President Lyndon B. Johnson to privatize the company, excluding it from the national budget. Fannie began operating a government-sponsored enterprise, a firm privately owned and operated by shareholders but backed by the Fed. Particularly, it was exempt from SEC oversight and income taxes, and it had access to the line of credit through the US Treasury.

By then, Fannie’s business accounted for most of the secondary mortgage market. Concerns over monopolization led to the creation of the McLean, VA-based Federal Home Mortgage Corp. (Freddie Mac) as part of the Emergency Home Finance Act of 1970. Acting in the same capacity as Fannie, though much smaller, Freddie would not only compete against Fannie, but it would also increase the availability of funds to finance mortgages.

At their inception, the companies’ missions were to provide stability in the secondary residential mortgage market and serve the mortgage credit needs of targeted groups, including low-income borrowers. They function by issuing debt and stock and using the proceeds to acquire loans from lenders, and either hold the mortgages on their own books or pool them into MBS that are sold to investors. Though neither Freddie nor Fannie were given any formal backing or insurance by the government, investors relied on their implied guarantee of financial fitness.

That model worked well for years, until the start of the new century. Then the walls came tumbling down and Fannie Mae and Freddie Mac started bleeding green.

In 2003, Freddie Mac revealed it misstated earnings by nearly $5 billion and was fined $125 million. President Bush proposed a regulatory overhaul of the housing finance system, but his suggestion was met with opposition from Democrats over concerns that this would limit the capital available for low-income housing. A few years later another bill—the Federal Housing Enterprise Regulatory Reform Act of 2005—was proposed by several high-ranking Congressmen, but it too was met with opposition from both parties and died before coming to the floor.

In 2004, the Office of Federal Housing Enterprise Oversight started an investigation of Fannie’s accounting practices. After audits, the company ended up restating its earnings in 2006 by more than $6 billion. US regulators also filed civil charges against Fannie’s management, accusing them of manipulating the company’s earnings. Also in 2006, Freddie was fined a then-record $3.8 million for illegal campaign contributions.

Government kept a careful watch on the GSEs, which continued to lose money—to the tune of nearly $15 billion total by 2008. While a significant percentage of their loans were being paid on time in 2008 and their net worth was positive, the companies’ sheer size left them vulnerable to the impact of the subprime mortgage crash, which was coming to a head around the same time.

As fears that the GSEs didn’t have enough liquidity to handle rising delinquency rates grew, and observers became increasingly apprehensive about the companies’ ability to raise capital and debt. This ultimately led the Federal Housing Finance Agency (the product of the Housing and Economic Recovery Act of 2008, which merged OFHEO, the Federal Housing Finance Board and the US Department of Housing and Urban Development GSE mission team) to place the enterprises into conservatorship in September 2008 due to concerns over the “systemic risk” the behemoths posed to the overall financial system. The move was said to be “one of the most sweeping government interventions in private financial markets in decades.”

It was also criticized as potentially being one of the largest and most expensive government bailouts ever of private companies. And with reason—at the time, Treasury committed to invest up to $200 billion in preferred stock in the agencies and extend credit through 2009 to keep them solvent.

At the time they were placed under conservatorship, Fannie and Freddie owned or guaranteed about half of the $12-trillion national mortgage market.

Since then, the future of the GSEs and stronger government regulation of the enterprises have been top-of-mind concerns for both those on the Hill and on the ground. And with the companies still bleeding—in November Fannie Mae requested $15 billion in emergency Treasury aid for the fourth time since it entered conservatorship—it’s become clear that a solution to the GSEs’ financial troubles is just as important as keeping them solvent and operating.

And so we come to the latest chapter in Fannie and Freddie’s saga. There are three leading options being considered in terms of reforming the agencies:

• Reconstituting the enterprises as for-profit corporations with government sponsorship while placing additional restrictions on them. Basically, things would remain status quo, but with more controls to minimize risk, such as eliminating or reducing mortgage portfolios, establishing executive compensation limits or converting the companies from shareholder-owned corporations to lender-owned associations.
• Establish the enterprises as government corporations or agencies. This would eliminate the Fannie and Freddie’s mortgage portfolios and the firms would focus instead on buying qualifying mortgages and issuing MBS. FHA would step in to fill the void left by this move.
• Privatizing or terminating the enterprises altogether. Fannie and Freddie would be gone, and the lending business and risk management would be dispersed throughout the private sector. Some have suggested creating a federal mortgage insurer to help protect lenders against catastrophic mortgage losses.

A breakdown of the three dominant GSE reform proposals and their implications. Courtesy of the Government Accountability Office's September 2009 report to Congressional Committees, “FANNIE MAE AND FREDDIE MAC: Analysis of Options for Revising the Housing Enterprises’ Long-term Structures.”

I, for one, believe Fannie and Freddie, in some form or another, are necessary to the multifamily business. Most of the trouble is on the single-family residential side, but the GSEs are a major—and today, arguably the only reliable—source of financing for those in apartments. Many would agree that the multifamily industry would be in a lot worse shape if they weren’t around; just look at its counterparts in the property market.

If Fannie and Freddie were to be privatized, the companies would be split into smaller entities with no federal backing. The Government Accountability Office, which issued a comprehensive report on the GSEs and the implications of the various proposals, pointed out that private companies might not be able to support today’s complex mortgage market and even if they could, the cost of capital for borrowers would likely be prohibitive. The move could also lead to higher interest rates and lenders’ unwillingness to make long-term loans that they would have to hold in their portfolios. So that negates door #3.

Nationalizing the companies carries similar risks; the government would just have to absorb the enterprises’ liabilities, further adding to national debt—like we really need that. There goes door #1.

Unfortunately, door #2 is as undesirable as the alternatives. A combination of the nationalization and privatization, this proposal aims to turn Fannie and Freddie into private-sector mortgage guarantors overseen by a commission, much like with public utilities. Again, the GAO pointed out the downsides to this option—regulation of public utilities has been seen as inefficient. So much so, in fact, that several states have deregulated those industries. Also, the number of players in the financial market¬ make it difficult for one company to hold a monopoly. And this structure would also bring to the surface the issue the GSEs were having before they entered conservatorship, which was balancing shareholder expectations with their public mission.

Although all three proposals could result in a big, fat FAIL, it’s undeniable that the GSEs could use more oversight and controls. I’m actually surprised this issue didn’t come to the forefront sooner; the rate of growth both Fannie and Freddie have experienced over the past few years is in itself somewhat suspect, although the same could be said of many companies in the US that experienced rapid growth over the same period.

In fact, it’s gotten to the point where a good segment of the public has come to view the enterprises as no different from the “too-big-to-fail” institutions that have received millions of dollars in federal bailout money. In September 2009, Treasury decided to abolish the cap on federal aid to the GSEs; President Obama had raised it from the initial $200 billion to $400 billion earlier that year. As of the end of Q3, Fannie Mae had received $60 billion in Freddie Mac got $51 billion in funds under the conservatorship.

There’s no doubt Fannie and Freddie’s accounting practices were questionable. But I don’t think they’re the only ones to blame when it comes to the country’s overall housing crisis. Sure, there’s an awful lot of finger-pointing now that we’re feeling the effects of the downturn, but the enterprises were viewed by many through rose-tinted glasses during the halcyon days of the housing boom.

If we are to turn our attention to the GSEs and move toward reform measures, I think it’s just as important to enact similar measures in the overall finance industry. The aggressive brokers and intermediaries, as well as the countless overeager borrowers, are as much to blame for our current turmoil as the lenders that provided the questionable loans.

I would hope that we have learned a lesson from this latest catastrophe, but history shows us that, well, history repeats itself. And if I were to give you my honest opinion, it would be this: I don’t think much is going to come of this latest effort at all.

Go ahead, call me cynical.