GSEs Have Been Ill-Served by Balance Sheet Equity 'Experiment'

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"Why are the GSEs functioning institutions and not hollowed-out buildings with smashed glass, like the factories in Youngstown, Ohio, where I grew up?" asks Michael Bright, a director at the Milken Institute's Center for Financial Markets. His answer: "Because the Treasury stood behind them."

The same could be said about Bank of America, Citigroup and General Motors, with one important caveat. Had the government-sponsored enterprises not liquefied mortgage markets in the wake of the housing crash, Bank of America, Citigroup and GM would most likely have ended up like the hollowed-out buildings with smashed glass like the factories in Youngstown.

One inconvenient truth — consistently ignored by those calling themselves reformers who seek to replace the GSEs — is that America recovered from the financial crisis because Fannie Mae and Freddie Mac performed their public mission. The two companies kept on financing new mortgages when other bailout recipients, faced with the prospect of falling home prices, turned off their credit spigots. The economic benefits derived from the GSEs' business model far exceeded the dollar amount of any temporary support extended by the U.S. Department of the Treasury. Over the past few decades, the GSEs have remained a bulwark of stability in housing finance; no other company had ever come close to matching their standards of underwriting excellence, as measured by credit losses.

Today, the benefit of hindsight tells us Treasury's support of the GSEs was structured in a way that proved to be counterproductive. Fannie and Freddie's needs were unlike those of the Wall Street banks; the GSEs never needed taxpayer dollars to fund cash shortfalls and operating expenses. Today, we know that the GSEs relied on bailout funds to offset massive "losses" for fiscal years 2008-2011, which proved to be ephemeral, if not illusory. Those initial losses were driven by non-cash accounting provisions, timing differences under Generally Accepted Accounting Principles, which, as any banker knows, are subject to dramatic change. The non-cash provisions were largely reversed in fiscal years 2012 and 2013. In the absence of those subsequently reversed accounting provisions, the GSEs' bailout draws would have been much closer to zero.

And with the benefit of hindsight, we know with absolute certainty why the GSEs' balance sheet capital remains close zero. The Federal Housing Finance Agency engineered it that way. It chose to reduce Fannie and Freddie's equity by $250 billion in order to fund cash dividends to the Treasury. Irrespective of what Bright or anyone else thinks, the FHFA's decision-making could never be described as normal. It is never normal for an undercapitalized, regulated financial institution to pay cash dividends. It is never normal for a conservator to authorize any cash dividends prior to the company's emergence out of conservatorship.

In the annals of modern corporate and insolvency law, there is no precedent for a conservator to dictate, to the detriment of the companies' ability to become self-sustaining, that now and forever in the future, every last dollar of GSE earnings shall be distributed as dividends to one class of shareholders. Former General Counsel to the Federal Deposit Insurance Corp. Michael Krimminger put it this way: "The continuation of the sweeps through the conservatorships is a violation of every principle established in bankruptcy and in the more than 80 years of FDIC bank resolutions. And it has no support in [the Housing Economic Recovery Act]" of 2008.

Like the FHFA, Bright is dismissive of arguments that the GSEs should rebuild equity on their balance sheets. He says, "These arguments fall into two camps. One stems from a political concern. The other is more transparently self-serving."

He describes the political concern as fear of any fallout if, in the future, taxpayer dollars were needed to raise a GSE's net worth from a negative number back to zero. Bright doesn't think that should be problem because there was little uproar in 2013, when the Treasury transferred $1.7 billion into the Federal Housing Administration's mutual mortgage insurance fund. Of course the FHA has always been government-owned; it never had any private shareholders.

Bright says the other argument is self-serving because the GSEs' private shareholders might benefit from recapitalization. He says this is unfair because a, "taxpayer-funded bailout of Fannie and Freddie should not reward legacy private shareholders with profits made possible by new taxpayer equity." But if you follow the flow of funds, you see that the taxpayers haven't provided any new equity since fiscal year 2011. Taxpayers extended $187 billion in bailout funds to both companies, whereas the GSEs returned $250 billion in cash dividends to Treasury, leaving the GSEs with balance sheet equity nearing zero — which is why it difficult, if not impossible, to attribute prospective GSE income to new taxpayer equity.

Bright describes the push to recapitalize the GSEs as a, "sideshow," predicated on "dangerous misinformation." Perhaps recapitalization does pose a danger to those committed to the belief that GSE conservatorship is no different from GSE nationalization.

David Fiderer has previously worked in energy banking for more than 20 years. He has written extensively about the financial crisis and is currently working on several projects concerning housing finance.