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TREASURY, THE CONSERVATORSHIPS AND MORTGAGE REFORMBy Timothy HowardThere are two competing approaches to setting up a secondary mortgage marketmechanism to succeed the one in place prior to the 2008 financial crisis: (a)legislative reform that would replace Fannie Mae and Freddie Mac with a de novosystem, such as the one proposed by Senators Johnson and Crapo, and (b)administrative reform that would make structural and regulatory changes to FannieMae and Freddie Mac but keep them as the centerpieces of conventional secondarymortgage market financing.The main argument for legislative mortgage reform is that Fannie Mae and FreddieMac are a “failed business model” that needs to be replaced with a more reliablemechanism. But many proponents of this alternative, in defending it, badly distortthe history of the financial crisis. In this paper we briefly discuss three importantissues that are widely misunderstood or mischaracterized in the reform debate:
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Treasury’s actions to place Fannie Mae and Freddie Mac into conservatorshipwere fundamentally different from Treasury and Federal Reserve interventionsin support of commercial and investment banks during the financial crisis.Intervention in support of banks was done in response to sudden anduncontrollable liquidity crises that required immediate government assistanceto keep the companies from failing, and involved actions and tools intended toachieve that result (not always successfully). The act of placing Fannie Mae andFreddie Mac into conservatorship was not a response to any imminent threat offailure but rather a policy decision initiated at a time of Treasury’s choosing, andinvolved actions and tools intended to make and keep the companies insolvent.
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Convincing evidence exists that the conservatorships of Fannie Mae and FreddieMac were planned well in advance, and that they were intended to remove thecompanies permanently from private ownership. There also is clear priorhistory of OFHEO and its successor agency FHFA following the dictates ofTreasury in its dealings with Fannie Mae and Freddie Mac.
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The motive behind the third amendment to the Treasury-FHFA senior preferredstock agreement was made evident by its timing, coming as it did just ten daysafter Fannie Mae announced sufficient second quarter 2012 earnings not only topay its $2.9 billion quarterly senior preferred stock dividend but also to add $2.5billion to its capital. Coupled with strong and growing revenues, rising homeprices in the first half of 2012 meant that the pessimistic assumptions that haddriven earlier decisions to write down assets, add huge amounts to the lossreserve, and establish a valuation reserve for deferred taxes no longer weresupportable. Treasury and FHFA entered into to the third amendment to ensure
that when many of these write-downs were reversed it would be thegovernment, and not Fannie Mae’s shareholders, that would benefit.The Fannie Mae takeover was unlike any other financial institution rescueAll of the individual financial institution rescues (or failures) during the 2008crisis—including that of AIG—had similar profiles: market perceptions of a sharpdecline in the value of a company’s mortgage-related assets led to rapid outflows ofconsumer deposits or an inability to roll over maturing short-term obligations.Depressed asset prices made it impossible for these highly leveraged companies toreplace lost deposits or maturing short-term debt by selling assets without takinglosses that would have exhausted their capital. The Federal Reserve and Treasurywere faced with the need either to take immediate steps to save them—whetherthrough assisted mergers, massive provisions of liquidity, asset guarantees or othermeasures—or to allow them to fail.In their respective books,
On the Brink
and
Stress Test
, then-Treasury secretaryPaulson and then-New York Federal Reserve president Geithner both discuss howthe Fed and Treasury evaluated a financial institution in the throes of a liquiditycrisis. If the long-term value of that company’s assets was too low to allow it torepay its outstanding debts, the company was insolvent and could not be savedwithout a permanent infusion of capital (typically by the government). If, on theother hand, the Fed and Treasury judged that the values of the company’s assetswere only temporarily depressed—because, for example, markets had becomeilliquid—the Fed or Treasury could maintain its solvency by providing short-termloans or guarantying a floor value for their assets until their prices could recover.Fannie Mae’s situation was totally different. In the winter of 2000, it had agreedwith Treasury, and pledged publicly, to maintain sufficient liquidity to enable it tosurvive at least three months without access to the debt markets. As a consequenceof this pledge—to which it had adhered—unlike all of the other companies rescuedby the Fed or the Treasury during the crisis, Fannie Mae never experienced a threatto its solvency because of difficulty rolling over its maturing debt, nor did it need tosell assets at depressed prices to survive. The company never experienced a marketcrisis. At the time it was put into conservatorship, Fannie Mae’s capital significantlyexceeded its regulatory minimum. Fannie Mae’s “rescue” was a policy choice byTreasury, with its timing determined by Paulson. As he said in
On The Brink,
hewanted to put Fannie Mae and Freddie Mac in conservatorship before LehmanBrothers announced a “dreadful loss” for the second quarter of 2008.After the companies were placed in conservatorship, the mechanism Treasury usedto extend credit to them—“draws” of non-repayable senior preferred stock to makeup for book capital shortfalls—was one developed specifically for Fannie Mae andFreddie Mac. No other regulator in the world, at any time or under any set ofcircumstances, ever had used non-repayable senior preferred stock, paid with after- 2
 tax dollars, as a vehicle for rescuing a financial institution in crisis (or for any otherpurpose). The goal of this instrument was not to aid the two companies, but to pushthem into insolvency and keep them there.The contrast between Treasury’s treatment of Fannie Mae and the banks during thefinancial crisis could not have been more striking. At the exact time the Fed andTreasury were making extraordinary efforts to overcome banks’ lack of liquidity byproviding them with virtually unlimited assistance to bridge what they claimed wasa period of temporarily depressed asset prices, Treasury was working with FHFA tomake Fannie Mae’s superior liquidity irrelevant, by forcing it to mark down almostall of its assets, and change its accounting policies, to levels that reflected the sametemporarily depressed values it was seeking to help the banks ride out throughgovernment assistance. Treasury then effectively made Fannie Mae’s temporarilydepressed values permanent—foreclosing any chance of recovery, at any time—byrequiring it to take draws of non-repayable senior preferred stock, at a 10 percentafter-tax dividend, to fill the hole that Treasury and FHFA themselves had created.It is difficult to look objectively at how Treasury responded to the real liquiditycrises of the banks (and AIG) and at the same time created both the problems FannieMae (and Freddie Mac) faced and the unique “solution” to those problems, andconclude anything other than that Treasury took advantage of the 2008 financialcrisis to advance their long-held policy objective of removing the two companies asthe centerpieces of the U.S. mortgage finance system.Treasury’s September 7, 2008 nationalization of Fannie Mae and Freddie Mac wasplanned well in advanceTreasury Secretary Paulson has said repeatedly that Treasury made its decision toplace Fannie Mae and Freddie Mac under government control after the Housing andEconomic Recovery Act (HERA) was signed on July 29, 2008, and only shortly beforetheir conservatorships were announced. The facts, however, do not support thatcontention.In late 2007, private-label securitization—which Treasury and the Federal Reservehad promoted aggressively since the early 2000s as superior to securitization byFannie Mae and Freddie Mac for financing single-family mortgages—collapsedamidst an explosion of delinquencies and defaults. The result was in a huge fall-offin the supply of mortgage credit, to which Congress responded in February of 2008by nearly doubling the Fannie Mae-Freddie Mac loan limit. That gave the companiesaccess to the largest share of new residential mortgage loans in their history.Within a month, in early March of 2008,
a paper titled “Fannie Mae Insolvency andIts Consequences” was circulating among senior officials at the National EconomicCouncil and the Treasury. This paper, which was provided to
Barron’s
as the basisfor a negative article on Fannie Mae published on March 8, claimed that because of3
 risky loan acquisitions and four accounting treatments it questioned—for deferredtax assets, low-income housing tax credits, and the valuation of both the company’sprivate-label security holdings and its guaranty obligations for mortgage-backedsecurities—Fannie Mae was in danger of failing and might have to be nationalized.Whatever one might have thought about the merits of the paper’s analysis, itsprescription for Fannie Mae insolvency—writing down many of the company’sassets and greatly boosting its loss reserves—was a blueprint for what Treasury andFHFA would do six months later.Barely a week after the
Barron’s
article, and on the eve of the announcement of thegovernment-assisted acquisition of Bear Stearns by JP Morgan, Paulson overrodethe strong objections of FHFA director Lockhart and agreed to allow Fannie Mae andFreddie Mac to reduce their surplus capital percentage with no firm commitmentfrom either company to raise additional capital. This was significant on two levels—first as a clear example of Treasury’s dominance of FHFA, and second as a strongindication that Paulson at that early date already was thinking of Fannie Mae andFreddie Mac as instruments of the federal government. (Two years later, Paulsonwould tell the Financial Crisis Inquiry Commission, “[Fannie Mae and Freddie Mac],more than anyone, were the engine
we
needed to get through the problem.”[Emphasis added])On July 11, the
New York Times
published a front-page article saying, “Senior Bushadministration officials are considering a plan to have the government take over oneor both of [Fannie Mae and Freddie Mac] and place them in a conservatorship iftheir problems worsen.” Shares of the companies plunged, and in response Paulsonpublicly pledged support for them on July 13, saying, “Fannie Mae and Freddie Macplay a central role in our housing finance system and must continue to do so in theircurrent form as shareholder-owned companies.” Yet he had a very different privatemessage for Wall Street insiders. As reported by Bloomberg in November of 2011,Paulson met with a select group of hedge fund managers at Eaton Park CapitalManagement on July 21, where he told them that Treasury was considering a plan toput Fannie Mae and Freddie Mac into conservatorship, which would effectively wipeout common and preferred shareholders. This, of course, is precisely whathappened six weeks later.When HERA was signed into law on July 29, it created a new regulator for FannieMae and Freddie Mac, FHFA (effectively, OFHEO renamed), and gave it expandedpowers to put both companies into receivership or conservatorship. HERA alsocontained a clause not present in any other regulatory statute: “The members of theboard of directors of a regulated entity shall not be liable to the shareholders orcreditors of the regulated entity for acquiescing in or consenting in good faith to theappointment of the agency [FHFA] as conservator or receiver for that regulatedentity.” The rationale for this clause became evident within a matter of weeks.When Paulson met with the directors of Fannie Mae and Freddie Mac to informthem of his intent to take over their companies, neither entity met any of the twelveconditions for conservatorship spelled out in the newly passed HERA legislation.4
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