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Salvaging Housing Finance Reform | Commentary

Housing finance legislation has stalled in the Senate but reform is not dead yet. Secretary Jack Lew recently announced a new initiative to incentivize private capital in the housing market, yet to date, the administration has implemented housing policy that does the complete opposite.

As director of the Federal Housing Finance Agency, Melvin Watt can push forward without Congress, while complementing the administration’s new goal of making sure private capital sustains the housing market.

“The housing market accounts for nearly 20 percent of the American economy, so it is critical that we have a strong and stable housing finance system that is built to last,” declares the Senate Banking Committee Leaders’ Bipartisan Housing Finance Reform Draft. But so far, Congress has been unable to reach a broad enough consensus to make headway towards this laudable goal.

During the financial crisis of 2008, the U.S. mortgage giants Fannie Mae and Freddie Mac (highly successful in the past) joined a long list of distressed financial institutions. Even though these two companies never became insolvent, Congress passed the Housing and Economic Recovery Act of 2008 to take control over Fannie and Freddie, placing them under the FHFA.

Fannie and Freddie recovered and returned to profitability in 2012 and are currently generating cash — enough cash, in fact, to more than repay the $187.5 billion in emergency funding received from the government during the downturn. But instead of fulfilling its fiduciary obligation as conservator to marshal these assets for the benefit of shareholders, the FHFA worked with the Treasury (without the approval of either Congress or of Fannie and Freddie shareholders) to enact new regulations requiring the companies to turn over 100 percent of profits they earn to the Treasury.

As one analyst recently observed, “in this case the debt that was once $187.5B is now considered infinite. That is to say that with the way things currently are, it is impossible to ever pay back what they have borrowed because the Treasury said so.” By sweeping 100 percent of Fannie and Freddie’s income, the government has left the two private companies undercapitalized despite the large amount of cash they have been generating.
Just as the FHFA worked previously without Congress, it can do so again — but this time, it can help correct its path. Under HERA, Mr. Watt has the statutory authority to develop and set capital standards for Fannie and Freddie. Mr. Watt may use this authority to require the companies to begin rebuilding capital.

How might this look? The FHFA could suspend dividends and retain earnings in order to build an adequate capital cushion. FHFA could legally override the requirement that Fannie and Freddie sweep all profits to the government and instead require the two private companies to build their capital to better absorb future economic shocks. With $5.2 trillion in combined liabilities, Fannie and Freddie would have a long way to go to build up an adequate cushion without other efficiency measures, but reversing the sweep would be a move in the right direction. By ceasing the government’s constant removal of all of Fannie and Freddie’s cash, the FHFA would also remedy its prior dereliction of its fiduciary duties and shift to an appropriate role as conservator. In this way, the FHFA could work to build stronger companies that are better able to provide liquidity to the housing market and can be transitioned from government control.

Investors have filed more than a dozen lawsuits to challenge the government’s income sweep, and the Perry Capital LLC suit is scheduled for argument later this month. With Congress unable to move forward, it is time for Mr. Watt to take at least the initial steps towards reforming Fannie and Freddie into more efficient enterprises that operate at lower risk to taxpayers.

Jonathan R. Macey is the Sam Harris Professor of corporate law, corporate finance, and securities law at Yale Law School. Logan Beirne is an Olin Scholar at Yale Law School and author of Blood of Tyrants.