"If the GSEs suffer a big loss and need to go back to taxpayers, there will be a political furor."

Are Fannie Mae and Freddie Mac an antidote to the influence of big banks in the mortgage market, and, by extension, in the economy?

That’s what Bethany McLean thinks.

In her crisp examination of the two mortgage giants, Shaky Ground, the best-selling author lays out the risks posed by their current limbo-like state, a conservatorship they were put into by the government in September 2008 as their losses mounted amid the subprime mortgage implosion.

But she also recognizes the merits of keeping these government sponsored enterprises (GSEs)—two of the largest financial institutions in the world—alive.

The argument that Fannie and Freddie have value as big-bank buffers is a persuasive one. After all, a core rationale for bailing out banks during the financial crisis was that they were too big to fail; eliminating the GSEs would only allow the biggest banks to become even bigger.

There are, of course, other justifications for the GSEs: if they stopped buying loans from banks, mortgages would be less affordable and disparities in access to home financing—by region or socio-economic strata, for instance—would be more acute.  

Right now, though, Fannie and Freddie are in a state that many observers, McLean too, find untenable.

Since Aug. 17, 2012, they’ve been required to send all their profits to the government. Sure, it’s enabled them to pay off not only the $187.5 billion Treasury has injected into the GSEs since the conservatorship began but an additional $50.5 billion.

But that same rule has also left them sharply undercapitalized.

Even a “blip” in performance, McLean says, could send them back to taxpayers, hat in hand.  They are, in her words, “the last major institutions to remain in post-crisis uncertainty.”

McLean took some time to discuss the difficult terrain the GSEs are now navigating, the obstacles to reform, and how the continued viability of Fannie and Freddie is important if still very fraught.


ASR: Have there been any changes made to the housing finance system since the crisis that would prevent taxpayers from footing the bill for another collapse in housing prices?

McLean: In short, no. Government policy has actually been at best schizophrenic…While the administration has said repeatedly they want private capital in front of any taxpayer money that are exposed [to Fannie Mae and Freddie Mac] they’ve actually done a lot of things to discourage the private market from getting re-engaged in financing home mortgages and at the same time, they’ve done nothing to reform Fannie and Freddie.

Let’s talk about efforts to get private capital back into the market. One way the GSE’s are doing this is through risk-sharing. They have used various kinds of transactions to share the credit risk in mortgages that they insure with capital market investors, insurers and others. What’s your view on these?

It should be said that Fannie and Freddie’s regulator [the FHFA] and the companies themselves are doing a lot more to reform the housing market than anybody in the administration. There are pros and cons to that. This risk-sharing thing is real, they are definitely working to get people to take risk. But thus far, the problem with that is that [this market] could dry up. It isn’t a permanent structure and whenever there’ve been any wrinkles in the market, any blips, they’ve been unable to sell those deals. So it’s not really clear how sustainable or meaningful what they’ve done so far is.

We’re now the eighth year of the conservatorship. This wasn’t intended to be permanent.

I’m enough of a capitalist to believe that nationalizing the mortgage market is not the way to go. The idea of any administration having its thumb on the scale of mortgage credit is frightening to me. I want there to be some level of independence in that. I also don’t think the two companies can survive healthily in conservatorship forever. How would you feel if you were an employee who didn’t know if you were going to have a job in a year? And to listen to your company constantly be vilified? It’s not a healthy situation.

If substantial reform isn’t in the cards then what are the options here?

Two things could force a revolution; I’m not sure either one is great for American citizens. If the GSEs suffer a big loss and need to go back to taxpayers, there will be a political furor, and I’m not sure what will ensue from that. And the second thing could be that big investors that are suing the government. If these hedge funds and other investors win one of their lawsuits, it’s not clear that the court would force a restitution, but that could be a big problem.

Let’s talk about this litigation In a nutshell, these investors held stock in Fannie and Freddie, and feel they’re victims of an expropriation that took place Aug. 17 2012. That’s when the Treasury and FHFA changed the rules so they would receive all the GSE profits.

This has angered a lot of people. What’s your take on what happened to these investors?

I’m not sure what’s left for the investors, I’m not sure what that 20% stake in the preferred stock should be worth but I’m quite sure that what happened with the third amendment is wrong. [The shift in 2012 from 10% dividend to all profits flowing to the government is known as the “Third Amendment Sweep.”] I just don’t see how you could leave stock outstanding, tell those stockholders that their shares might have value someday, and come along and sweep all the profits. People in the administration have tried defending it to me and thus far I’ve heard nothing that changes my mind about that.

Just because the language of conservatorship can be twisted and contorted to read that the government can do whatever it wants doesn’t make it right to my view. But that’s a moral statement rather than a legal one.

If they were to win, would that usher in a new era, basically force reform?

I think it has to. I don’t think anybody knows what a settlement with the investors would look like but I don’t see how you settle with them without reforming Fannie and Freddie. If the court said they’re owed restitution, what’s going to be more palatable at that point? Restructure Fannie/Freddie or pay the [billions] directly from taxpayers, whatever the amount is.

This would be politically fraught is what you’re saying.

It is. And in a polarized Washington it’s hard to imagine anything getting done on this because you have to be pragmatic and you can’t be polarized. You can’t be ideological. So the two main qualifications of success in today’s Washington, which seem to be, being idealistic and totally unwilling to comprise are exactly opposed to what it would take to get anything done on Fannie and Freddie.

The idea of abolishing Fannie and Freddie still has fans, even though the push for reform seems to be gaining steam. What would our mortgage market look like in a world without the GSEs? Would might, for instance, happen to the fixed-rate 30-year mortgage without any government support?

The truth is we don’t know because Fannie Mae has been around since the late 1930s. Nobody knows. It’s all just theory.

I can’t see how you wouldn’t have without Fannie and Freddie a much smaller [mortgage market], credit that would be much more expensive and…much harder to come by.

And I think there’d be great disparities in the pricing of a mortgage. So the very wealthy might still be able to get a 30-year fixed-rate mortgage from a big bank. The poorer person living in a less desirable geography, maybe a 15-year mortgage with a floating rate. And there would be really big disparities in the pricing of mortgage and it would dry up in times of economic stress, instead of being constant.

Now you could argue that that would be good because if home prices decline in value they’re more affordable. You don’t have to borrow as much to buy one, right? I’m just not sure: can you really deal with the reset shock? It may be great if homes were 30% less expensive but [are] you’re going to say to everybody’s who’s a homeowner today “it’d be good for future generations if your home falls 30% in value, let’s go ahead and do this.”

Who are the other losers if Fannie and Freddie were abolished?

A broad spectrum of the American public. It’s not just very low income people who need affordable housing. And mortgage rates are pretty consistent whether you’re a very upper income person or a middle-income person even though the market wouldn’t price it that way, and that’s because Fannie and Freddie cross subsidized. So a Fannie and Freddie conforming mortgage was basically one price and that’s because Fannie and Freddie were aggregating all of that. Some people would do better. But a lot of people would do a lot worse. It’s a broader [section] of the population than you might think who’d do a lot worse. 

In the book, you also mention how small banks might get hit without the GSEs.

I think small lenders would be losers. And they’ve been a big voice in worries about any reform. If the big banks took a more prominent position in the market why would they help out their smaller competitors? Right now we still have the remnants of this two tiered banking system: these big national banks and then these small local community banks. I think, maybe it’s just a bias of mine, but I think we want to preserve that.

A GSE-free world then might then increase the importance of big banks?

That’s something I’ve thought about more since publishing the book. I used the phrase “the purported private market” because I really believe if the big banks were to be more involved in financing our mortgage market, they wouldn’t be allowed to fail in the next crisis. They were too big to fail in the last crisis. For all that the GSEs were government-supported enterprises and had to be bailed out by taxpayers, it turned out the big banks were government-supported enterprises too. They had to be bailed out by taxpayers and in fact…their bailout [was] much nicer, much friendlier. So you can ask: really who’s the preferred ward of the state? Fannie and Freddie? Or was it Citigroup? That’s easy. It was Citigroup.

There’s a big argument over whether the changes that Dodd Frank national regulation have made it possible for a big bank to fail, let’s just for the sake of argument say it has. But if that big bank controls the national mortgage market, there is no way it will be allowed to fail, in which case we’re right back where we started.

So whenever I hear plans to reform that rely more on the big banks, I think it is totally hypocritical because that turns them into GSEs as well.

So in order to have a truly private market for mortgages you would have to not involve the big banks any more than they are today, it would have to remain a portion of the business. There would have to be plenty of other sources of support for the mortgage market beyond them.

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