The Administration has refused to turn over over 12,000 documents in a lawsuit against how the government operated Fannie and Freddie in their conservatorship. The major bone of contention is that Treasury stripped them of all profits, which damaged the remaining private shareholders.
But the unsealing of a small batch of government records shows why the Administration is fighting to hard to keep this affair under wraps. Josh Rosner, a former GSE analyst, discusses in new report on the how the Administration implemented rules requiring Fannie and Freddie to sweep all profits to Treasury just as they were turning into huge cash cows. Aside from tapping into a source of additional funding when deficit hawkery was all the rage, depriving Fannie and Freddie of the ability to retain earnings prevented them from strengthening their equity bases. That fed into the narrative that they were beyond redemption and the best solution was to “reform” them. As we wrote when the GSE reform debate was in full swing, the proposals amounted to another form of bank looting. From a 2011 post:
As time goes on, the various Ministries of Truth just get better and better at their stock in trade. We’ve gone from artful obfuscation like “extraordinary rendition”, and “Public Private Investment Partnerships” to stress free “stress tests” (particularly the Eurozone version) designed to get bank stocks up and credit default swap spreads down, to even grosser debasement of language. What passes for the left has for the most part been dragged so far to the right that the use of once well understood terms like “liberal” and “progressive” virtually call for definition. And the word “reform” has virtually been turned on its head. Financial services reform was so weak as to be the equivalent of a jaywalking ticket; health care reform was a Trojan horse for even large subsidies to Big Pharma and the health care insurers. But GSE reform takes NewSpeak one step further by turning the “reform” concept on its head and using the label to describe an effort to institutionalize even bigger subsidies to the mortgage industrial complex.
While Team Obama appears to have backed down from the trial balloon floated by the Center for American Progress (note that press reports give another rationale) and is expected to offer a menu of choices for “reform” in its overdue white paper on Friday, don’t be fooled. The proposals coming from the lobbyists expected to have real influence on which ideas get the green light are virtually without exception serving up such a narrow menu of choices as to constitute unanimity. We offered our take as of the release of the CAP report; a subsequent proposal by Moody’s Mark Zandi (see details here) is more of the same.
It’s as if a population suffering from a toxic reaction to mustard was now offered options ranging from Dijon to pommery to spicy brown as meaningful improvements. And this is not an exaggeration. The new GSEs (and let us not kid ourselves that that this is where the Powers That Be are driving this effort) would have an explicit government guarantee, be larger in number, and supposedly have higher capital buffers.
The problem is that any government sector guarantee for a private sector entity is a terrible idea absent very tough constraints on operations, which is the still-unlearned lesson of the financial crisis. And the idea that any higher capital standards will hold over time is dubious. Fannie and Freddie were enormously powerful lobbying forces, a de facto mainly Democrat slush fund; any new GSEs will have similar collective clout and will press for their agenda on a unified basis, which is certain to include waivers that will amount to lower equity requirements. Increasing leverage is one of the easiest ways to improve performance in a financial firm.
Now the Administration is also allegedly presenting some elements of securitization reform on Friday. We’d be glad to be proven wrong, but we anticipate any proposals will be cosmetic and/or insufficient in scope. The real problem is that the coming staged fight over GSE reform will serve as a useful distraction for what is really needed, which is much broader mortgage market reform. Pursing the GSE question largely in isolation is sure to produce bad outcomes.
Our subsequent posts, Our Response to the Center for American Progress Objection to Our Post on Its GSE Reform Proposal, The 7 Things Really Wrong with the Treasury’s GSE Reform Plan, and GSE 2.0 Scare Tactics: False Claim That No Government Guarantee = No Thirty-Year Mortgage showed that our initial take was correct. From the GSE 2.0 Scare Tactics post:
So let us be VERY clear about this: this is GSE non-reform. It’s merely reconstituting the GSEs with better capital cushions but also a full faith and credit guarantee on their mortgages, which is a better backstop than Fannie and Freddie enjoy now. And the only compelling reason for continuing to offer government guaranteed mortgages is to escape exposing and cleaning up mortgage and securitization industry abuses.
Rosner, as usual, does a fine job of presenting the legal and political issues. A key section of his analysis, which we’ve embedded at the end of the post:
The documents demonstrate that former Obama Administration officials violated the intent and purpose of HERA [Housing and Economic Recovery Act of 2008]. The goal of HERA was to rectify shortcomings in the oversight of Fannie Mae while choosing a path not provided for in that statute or any other. In 2012, as the GSEs were on the verge of massive and sustainable profitability, the Administration rushed to change the terms of the Preferred Stock Purchase Agreement (“PSPA”) which governed Treasury’s financial support to the GSEs in conservatorship.
That agreement was originally put into place in 2008 and amended twice in 2009. The 2012 changes, referred to as the “Net Worth Sweep,” demanded terms that forced the GSEs to “sweep” any future profits directly into Treasury’s coffers in perpetuity. Rather than retaining earnings and building capital in accordance with the goal of rehabilitation (as required in a conservatorship pursuant to HERA, and as was demanded of every other financial institution after the crisis), the Third Amendment ensured that the GSEs could never rebuild capital nor – no matter how much money they returned to the Treasury – be allowed to ever repay the government. These actions clearly violate the most basic requirement of HERA that instruct the Director of FHFAiii “to oversee the prudential operations of each regulated entity and to ensure that … each regulated entity operates in a safe and sound manner, including maintenance of adequate capital and internal controls.”
The newly-released documents also show the actions of these former senior officials were premeditated and defended with false public statements which falsely articulated there was an imminent risk the GSEs would need more financial assistance.
GSE reform was one of the few post-crisis bank-enrichment programs that the Administration failed to bring to fruition. While it appears to be a dead letter now, don’t underestimate the odds that a Clinton or Trump administration would seek to revive it. But if the Administration is forced to cough up some of the documents is it keeping from the court, the stench of corruption may be rank enough to keep the banks from creating yet another source of enrichment at public expense.