Phillip Swagel was Assistant Secretary of the Treasury for Economic Policy from 2006 to 2009. Mr. Swagel wrote for the Bookings Institution in 2009 that provided insight on the US Department of the Treasury’s takeover of Fannie Mae and Freddie Mac.
A few highlights on the section that discusses the GSEs are as follows:
“…the GSEs could have fought (Conservatorship) and might well have won, since their regulator had said as recently as July that the two firms were adequately capitalized.”
“…many people expressed to me directly their misgivings about what looked like a bailout, in which GSE bondholders and shareholders won and taxpayers lost. It was hard to disagree. It turned out that Secretary Paulson had the same misgivings.”
“It was also necessary to convince the management of Fannie and Freddie to acquiesce without a legal fight. …Ultimately, Secretary Paulson had a trump card: he could say in public that he could not in good conscience invest taxpayer money in these firms, and that would doubtless spark their demise. But in the end he did not have to play this card. In well-publicized meetings with Secretary Paulson, Chairman Bernanke, and FHFA Director James Lockhart, both firms acceded to conservatorship, which was announced on Sunday, September 7, 2008.”
“The U.S. government ended up as 79.9 percent owner of the GSEs, receiving preferred stock on terms that essentially crushed the existing shareholders.”
Brookings Papers on Economic Activity, Spring 2009
PHILLIP SWAGEL Georgetown University
The Financial Crisis: An Inside View
VII. Rescuing the GSEs
The relative quiet was to hold until early summer, when the effects of the housing collapse manifested themselves in the collapse of IndyMac and severe pressures on the GSEs, in the form of declining stock prices and widening spreads on Fannie and Freddie securities, and thus on mortgage interest rates for potential homebuyers. The FDIC took over IndyMac and turned the firm into a laboratory for its foreclosure prevention ideas, but the problems of the GSEs fell squarely in the Treasury’s court. The Treasury was in a difficult position. GSE debt and MBSs with GSE guarantees were held throughout the financial system, and a failure of the firms would have meant chaos in financial markets. As commentators such as Peter Wallison of the American Enterprise Institute had long warned, (see, for example, Wallison, Stanton, and Ely 2004), the GSEs were holding the financial system and taxpayers hostage—and in mid-July 2008 it seemed they would win the standoff.
The options were all unpleasant, and all required congressional action:
to provide the GSEs with more liquidity by raising their line of credit with the Treasury from $2.25 billion each to something much larger; to inject capital; or to ask Congress to put the two firms into conservatorship, with the government running the companies on behalf of their shareholders (which would eventually be mainly the government). This last option could be done under existing legislative authority but still required congressional approval, and the GSEs could have fought this and might well have won, since their regulator had said as recently as July that the two firms were adequately capitalized. (This statement referred to statutory definitions of capital, which included tax assets that could only be monetized in the future when the firms became profitable again, but it nonetheless carried weight.) Moreover, even putting the GSEs into conservatorship raised questions about whether their $5 trillion in liabilities would be added to the public balance sheet. This did not seem to Treasury economists to be a meaningful issue, since the liabilities had always been implicitly on the balance sheet—and in any case were matched by about the same amount of assets. But the prospect that rating agencies might respond by downgrading U.S. sovereign debt was unappealing. A fourth option, receivership, would involve liquidating the companies and was deemed off the table because it would have required winding down the GSE portfolios.
These portfolios were the source of the systemic risk arising from the GSEs’ activities, but the GSEs’ purchases of MBSs were important for ensuring the availability of financing to potential homebuyers. Addressing the portfolios would have to wait for a longer-term reform. In the end, Secretary Paulson went to the steps of the Treasury building on Sunday, July 13, and proposed “all of the above”: the power to give the GSEs both liquidity and capital in amounts that would make clear to market participants that the U.S. government stood behind the obligations of these companies. He asked Congress to raise the GSEs’ lines of credit; to authorize unlimited (subject to the statutory debt ceiling) direct Treasury purchases of GSE securities, including both their MBSs and their common stock, through the end of 2009, to ensure that the firms could fulfill their missions with respect to housing markets; and to give their regulator, OFHEO, the power of conservatorship and other authorities that the administration had long sought. The Treasury would insist on terms and conditions to protect the taxpayer if public money were ever put into the firms. These powers were requested with the idea that the firms’ liquidity crunch reflected a lack of market confidence that a show of Treasury support could assuage—that standing behind the firms would calm market fears and avoid the need for a bailout. (The secretary’s unfortunate phrasing, at a July 15 congressional hearing, about having a “bazooka” in terms of the financial ability to stand behind the firms was to be repeated constantly in the media in the months to come.)
The Fed authorized bridge lending to Fannie and Freddie while Congress worked on the legislation, which was enacted on July 30, 2008 (and which included the Hope for Homeowners program). Some market participants complained that the rescue did not distinguish between senior and subordinated debt but instead made both of them whole, whereas many participants had expected the subordinated debt not to be included within the rubric of a guarantee. However, the view at the Treasury was that simplicity and clarity were paramount (although, of course, clarity is sometimes in the eye of the beholder).
This effective hardening of the heretofore-implicit guarantee of the GSEs left mixed feelings among Treasury staff. A crisis had been forestalled with a flurry of weekend activity (soon to become a regular part of the Treasury workweek), but the outcome seemed to cement in place the awkward status of the GSEs and their ability to privatize gains and socialize risk by borrowing at advantageous terms under the shelter of a now-explicit government guarantee. Past Treasury departments across administrations had sought to remove the implicit guarantee, not to harden it. At a dinner in Cambridge, Massachusetts, on Thursday, July 24, 2008, to honor Martin Feldstein, outgoing president of the National Bureau of Economic Research, many people expressed to me directly their misgivings about what looked like a bailout, in which GSE bondholders and shareholders won and taxpayers lost. It was hard to disagree. It turned out that Secretary Paulson had the same misgivings. The following Monday, July 28, he instructed Treasury staff to analyze the capital situations of the GSEs. To protect taxpayers in the case that an actual investment was needed in the future, he wanted to know first if these firms were solvent. The Treasury’s Office of Domestic Finance engaged a topnotch team from Morgan Stanley to dig into Fannie and Freddie’s books and assess their financial condition. While this was happening, it became apparent that the July 13 announcement and subsequent legislation had left markets uncertain about the status of the enterprises. The GSEs had access to private sector debt funding, although with increased costs, as the spreads on five-year Fannie benchmark agency debt above Treasuries rose from about 65 basis points in early June to 94 basis points on September 5, just before the firms were put into conservatorship. But the common stocks of the two firms continued to decline. Market participants were in effect saying that they (mostly) believed that the government stood behind the debt and guarantees on the MBSs, but were not confident that the firms were solvent. This was not Secretary Paulson’s intent—he did not deliberately set up the GSEs to fail and get them into conservatorship. The weeks in July and August were tense ones within the Treasury, as markets deteriorated while waiting for more clarity on Fannie and Freddie. It looked to market participants as if there was no guidance, but this was because we were busy working—and Secretary Paulson was willing to suffer for a few weeks in order to have his next step come out right. The Morgan Stanley team came back several weeks later in August with a bleak analysis: both Fannie and Freddie looked to be deeply insolvent, with Freddie the worse of the two. In light of the firms’ well-publicized accounting irregularities of previous years, Treasury staff were especially amazed that the GSEs appeared to have made accounting decisions that obscured their problems. With receivership still an undesirable outcome because it would imply prematurely winding down the retained portfolio, the Treasury worked with the GSEs’ regulator (formerly OFHEO, the July legislation having merged it with the Federal Housing Finance Board to create the Federal Housing Finance Agency, or FHFA) to set out an airtight case of insolvency that warranted putting the firms into conservatorship. The July legislation allowed FHFA to do this without consulting Congress, although no one had contemplated actually using that power so rapidly. Even though the analysis from Morgan Stanley was clear, it took some time to bring the FHFA examiners on board—it seemed difficult for them to acknowledge that the firms they had long overseen had gone so wrong, and it would have been awkward for the head of FHFA to decide on the conservatorship over the objection of his senior career staff. It was also necessary to convince the management of Fannie and Freddie to acquiesce without a legal fight. There was no expectation of a problem with Freddie’s management—the CEO had publicly expressed his fatigue with the whole situation—but Fannie appeared then to be in somewhat better financial shape and might reasonably have expected to be treated differently than Freddie. Ultimately, Secretary Paulson had a trump card: he could say in public that he could not in good conscience invest taxpayer money in these firms, and that would doubtless spark their demise. But in the end he did not have to play this card. In well-publicized meetings with Secretary Paulson, Chairman Bernanke, and FHFA Director James Lockhart, both firms acceded to conservatorship, which was announced on Sunday, September 7, 2008.
The Treasury announced three measures jointly with the conservatorship decision: so-called keepwells, under which the Treasury committed to inject up to $100 billion of capital each into Fannie and Freddie as needed to ensure their positive net worth; a Treasury lending facility if needed; and a program under which the Treasury would purchase the GSEs’ MBSs in the open market. This last program was mainly symbolic—a demonstration by the Treasury that the obligations of the GSEs were “good enough for us” and should be seen as secure by the rest of the world. The U.S. government ended up as 79.9 percent owner of the GSEs, receiving preferred stock on terms that essentially crushed the existing shareholders. (The precise level of ownership was chosen in light of accounting rules that would have brought GSE assets and liabilities onto the government balance sheet at 80 percent ownership.)
The real action here was the two $100 billion keepwells, which were meant to effectuate the now-explicit guarantee of GSE debt and MBS coverage—they would provide just-in-time capital injections as losses were realized and ensure that Fannie and Freddie had the financial ability to service their debt and insurance obligations. The Treasury could not by law make GSE debts full-faith-and-credit obligations of the U.S. government—this could only happen through an act of Congress that changed the GSE charters. Unfortunately, the keepwells were not well explained by the Treasury, and it took some time for market participants to understand that they were the explicit guarantee—and even then, some observers questioned whether $100 billion was enough to cover possible losses at either firm. As with many decisions made quickly at the Treasury in this period, the figure of $100 billion did not receive considered discussion across the building and was eventually revised upward by the Obama administration. The conservatorship arrangement left unanswered the question of the long-term status of Fannie and Freddie. This was by necessity, since any such decision required congressional action to amend the firms’ charters. An unfortunate consequence, however, was that borrowing costs for the GSEs remained above those for Treasury debt. Even though the public balance sheet was effectively behind the firms, this could change in the future, and the spread over Treasuries seemed to reflect this uncertainty. The confusion over what the Treasury could and could not do was evident in the writings of outside observers. In his blog on November 25, 2008, for example, New York Times columnist Paul Krugman wrote, “the Bush administration, weirdly, has refused to declare that GSE debt is backed by the full faith and credit of the US government.” Krugman wondered whether this reflected politics. No politics were involved: the Treasury did not do this because it was not legal. Although the criticism of the Bush administration was off target, the Treasury had not explained the situation clearly. The long-term status of the GSEs remains at this writing to be decided by Congress. Each of the GSEs before conservatorship could be thought of as two related entities under one roof: a securitizer and monoline insurer that packaged and guaranteed mortgages with relatively good underwriting standards, and a hedge fund that leveraged the funding advantage from its implicit guarantee. Their retained portfolios were the embodiment of this positive carry and the source of the systemic risk, since scaling up the balance sheet with MBS purchases had driven the GSEs’ massive borrowing.
It was clear that the desired long-term outcome for the GSEs was to wind down the portfolios. Indeed, the agreements struck at the time of the conservatorship explicitly committed the firms to do so over time, starting in 2010. In the meantime, however, the portfolios were a tool with which to support the housing market, and the Treasury wanted there to be upward room for more MBS purchases so that homebuyers would not face higher interest rates. As a result, Treasury officials, including the secretary, did not talk directly about winding down the portfolios, out of fear that this would fluster markets and cause a spike in interest rates paid by the GSEs. This tension was not resolved until later in the year, with the November 25, 2008, announcement by the Fed that it would fund the GSEs directly by purchasing their debt and MBSs.
Treasury staff did draw up sketches of long-run plans for the GSEs, and Secretary Paulson spoke publicly on this topic in early January 2009. He favored turning the GSEs into a utility-like company, with private shareholders but government regulation. This preference seemed to be driven by a view that there would be substantial waste from the duplication involved with multiple GSEs, which was an approach favored by some at the Fed. A possible alternative would combine the two, with one or two GSEs running the automated networks by which banks originating mortgages sold conforming loans to the GSEs, and then a multitude of financial institutions competing with each other to securitize those loans into MBSs that would receive a government-backed guarantee. Such a restructuring would be along the lines of the present credit card market, which consists of a few large networks such as Visa and MasterCard but many credit card issuers in fierce competition.
The agreements struck with the GSEs took one small step in the direction of fostering future competition, in that the companies would have to pay a fee to the government for the explicit backing of the securities they issued starting in 2009. The details remain to be determined, but one could imagine over time allowing banks to pay such a fee and receive government backing on their securitizations of conforming loans. This would allow entry, which, one hopes, would drive innovation for the benefit of American homebuyers. Eventually the GSEs could become boutique financial firms rather than behemoths, or they might even one day acquire banks and become normal financial services firms. All of this, however, is for the future.