Capital Flows, Contributor
11/22/2013 @ 8:00AM
Fannie Mae And Freddie Mac Exemplify The Horrors Of Crony Capitalism
Fannie Mae (Photo credit: NCinDC)
By Ike Brannon
Nothing exemplifies the the cost of crony capitalism like Fannie Mae and Freddie Mac. For years these fiefdoms were run as little more than as piggy banks for connected politicians, who could count on substantial financial support for re-election, and retiring members and staffers from their committees of jurisdiction could expect a lucrative lobbying contract. Even their relatives got in on the act.
A major shareholder recently offered a reform plan that would replace them with two fully-capitalized private entities, which Treasury officials dismissed out of hand. Before anyone puts a knife in the heart of privatization efforts, it’s worth reviewing how they got into their current plight.
For a long time Fannie and Freddie had been managed by political entities rather than mere businessmen, and they had two masters–the politicians who wanted campaign contributions and increasing home ownership rates, and shareholders. Eventually, regulatory oversight went by the wayside and they chased their twin, conflicting goals with impunity.
Their collapse revealed the stark cost of this corruption for all to see-a debt of hundreds of billions of dollars on their books. Treasury placed Fannie and Freddie into a conservatorship, assuming ownership of almost 80 percent of each.
Taking them over via a conservatorship rather than receivership–whereupon it would have assumed complete ownership–allowed the government to keep the combined debt of Fannie and Freddie off the government’s books. Since this totaled well over $1 trillion at the time, this maneuver helped the government avoid any potential fiscal or political ramifications from reporting an annual deficit the over $2 trillion.
To recoup some of the government’s money, Treasury assigned itself preferred stock that paid a 10% dividend on its $188 billion capital injection. Few complained about this: taxpayers were on the hook and it was likely that a resumption of economic growth and robust financial markets would eventually return Fannie and Freddie to profitability.
With the uptick in the economy and improvement in real estate markets, Fannie and Freddie have returned to profitability, with reported profits greatly exceeding the $18.8 billion dividend owed Treasury.
Seeing a golden political opportunity,Treasury re-wrote the rules to allow it to go beyond its dividend and instead lay claim to all of the profits generated by the GSEs. Such a move allowed the federal government to report lower deficits while also allowing it to declare its GSE intervention a rousing success.
The only problem with this maneuver is that it contravenes the rule of law. Under the terms of a conservatorship the bondholders retain a stake in the company and, as a result, are entitled to be repaid. The government’s brazen maneuver shuts them out despite the fact that they still own twenty percent of the company.
While it may be tough to feel sorry for bondholders, many of whom (but far from all) purchased them knowing the inherent risk of the asset, it doesn’t take much effort to feel uneasy about the government changing the rules of the game in mid-stream to screw over investors.
The Administration has done this sort of thing before, of course, when it forced GM’s secured bondholders to take a massive haircut in deference to the UAW even though bankruptcy law gives their debt a higher priority. The ostensible excuse in 2009 was that it was the only way to garner enough political support to make their bailout work. This time they don’t even have this flimsy excuse: it’s solely for political expediency.
The rationale for Fannie and Freddie remaining as full-fledged government-sponsored enterprises evaporated long ago. The implicit backing of the federal government (which was called upon in 2008) allowed these entities to make imprudent investment decisions and ultimately squander hundreds of billions of taxpayer dollars.
There are two paths out of this morass: the first would be to end the current ownership structure of Fannie Mae and Freddie Mac but keep them as government sponsored enterprises, with strict limits placed on their portfolios and continuing the prohibition on lobbying, the two activities that led to their unraveling.
The other way would be to disentangle Fannie and Freddie from the warm bosom of the Treasury, shorn of the full faith and credit of the government, and make them go their own way in the world.
Last week one of the aggrieved GSE shareholders, Fairholme Capital, sent a letter to acting FHFA director Ed DeMarco detailing one way to go about doing such a thing. Its proposal would wind down Fannie and Freddie and introduce new private entities that would provide mortgage insurance as well as the capital necessary to perpetuate a robust housing market in the U.S. Its plan contends that the phase-out Fannie and Freddie and the capitalization of their replacements can be done so that Treasury (and their other owners) can be paid what they are owed while creating the new entities and without putting any residual debt on their balance sheet.
The administration’s reaction to the proposal has been predictably cool, with a Treasury official expressing wonder as to how housing loans could possibly be made without the government being involved in some way, which is a perfect encapsulation of the general philosophy of the current regime. It’s worth noting that the reaction from the Hill has focused more on political hurdles of doing such a thing rather than attacking the notion of privatization.
Regardless of how reforms of the mortgage market proceeds, it is clear that continuing the status quo and letting the Treasury become the effective owner of the GSEs threatens to take Fannie Mae and Freddie Mac down the same politicized path as before, with similarly disastrous results as during the financial crisis of 2008.
Ike Brannon is a Senior Fellow at the Bush Institute and President of CapitalPolicy Analytics, a DC-based consulting firm.
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