Last week, the non-partisan Congressional Budget Office published an analysis which concluded letting Fannie and Freddie retain some of the earnings and build capital would make it less likely the government sponsored enterprises (GSEs) would need to turn to taxpayers during an economic downturn.
This makes perfect sense and serves as a reminder of the absurdity of the Net Worth Sweep underway since 2012. Treasury says the Sweep was needed to protect taxpayers from exposure to another bailout if the market suffered a major setback. However, with the GSEs’ capital dwindling away, many experts, including Federal Housing Finance Agency Director Mel Watt, have raised the idea that the Sweep itself exposes taxpayers.
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At the request of Senate Banking Committee Chairman Richard Shelby (R-AL), the CBO looked at a scenario in which the GSEs could keep $5 billion in earnings annually for ten years. If the GSEs were able to create even a small capital buffer, there would be little more stability in the mortgage market and less of a chance of new draws on Treasury funds. This could reduce the cost of loans and lead to more lending.
The analysis is a little complicated but basically Fannie and Freddie would be a bit more self-reliant but the government would continue to provide a backstop should market downturns lead to losses for the companies. While Fannie and Freddie could keep $5 billion in earnings annually, the government’s commitment to purchase more of Fannie and Freddie senior preferred stock in a market downturn would remain in place. In addition, the GSEs would invest retained profits in Treasury securities and the returns on those bonds would mean more income for the GSEs. At the same time, by continuing to hold the GSEs’ senior preferred stock, the government would continue to have a claim to the GSEs’ net worth ahead of other stockholders.
The CBO figures that taxpayers could be exposed to greater potential losses in the case of another major crisis. This assumes taxpayers’ exposure to the $258 billion line of credit established at the Treasury for the two companies – a credit line the companies neither wanted nor needed. Plus, if Fannie and Freddie keep $100 billion in earnings over ten years instead of having Treasury sweep up the money, then taxpayers would forgo that money too.
The CBO figures that taxpayers could be exposed to greater potential losses in the case of another major crisis. The CBO’s calculations assume the following: One, taxpayers would continue to be exposed to the $258 billion line of credit established at the Treasury for the two companies – a credit line the companies neither wanted nor needed. Two, if Fannie and Freddie keep $100 billion in earnings over ten years instead of having Treasury sweep up the money, then taxpayers would forgo that money too.
It is worth noting that the budget impact of this arrangement would be roughly $85 billion over ten years using the Administration’s assumption that Fannie and Freddie are private companies, rather than part of the government. This is ironic considering that the Net Worth Sweep, which was engineered by Treasury in 2012, uses these private companies as piggy banks to feed the government’s revenue stream.
For its part, the CBO regards Fannie and Freddie as federal entities and therefore treats transactions in its scenario as intragovernmental transfers that have no net impact on the deficit. Its $10 billion budget cost is based on the estimated market value of the increase in the government’s exposure to losses on the GSEs’ mortgage guarantees and investments.
The scenario the CBO considered was narrowly defined and not a comprehensive reform proposal. However, working within this particular scenario, the CBO’s analysis demonstrates that fully privatizing Fannie and Freddie could be a bad idea for shareholders and disruptive to the mortgage market. The guarantee fees Fannie and Freddie charge when selling the mortgage-backed securities they create are held down somewhat with the implied government backstop. Take the government backstop away and Fannie and Freddie’s value would decrease significantly.
This might explain why there has been no consensus on a plan to dismantle and privatize the GSEs. They play too important a role in preserving market stability and access to homeownership. The financial crisis in 2008 revealed the need to revise aspects of housing finance policy. Had the conservatorship of Fannie and Freddie been run as required by the Housing and Economic Recovery Act and the companies were again sound and solvent, policymakers could have agreed on needed reforms. Instead, the Sweep introduced an unnecessary and destabilizing variable into the mix and lawmakers need to ask CBO if there is a way out of the mess created by the Net Worth Sweep.
The CBO’s analysis simply reinforces the need to get back to basics: Allow the companies to retain their capital, preserve a government role in helping to ensure a liquid and stable housing finance market, and implement reforms needed to avoid a repetition of practices that led up to the financial crisis. And last but not least, stop robbing Fannie and Freddie’s shareholders.