By Tara Helfman, Yale Law School Graduate / Syracuse Law Professor
August 24, 2015
Imagine this. The owner of a small business facing a financially challenging period is forced to take out a loan from her local bank. She makes her monthly repayments on time and with interest in accordance with the loan agreement. But when the borrower’s business becomes profitable, the bank is no longer content with the original terms of the loan. Instead, it wants a larger piece of the business’s profits. So the bank decides unilaterally that it is going to undertake a “profit sweep.” Now, instead of making monthly payments at an agreed-upon rate of interest, the lender will have to give every dollar of profit she earns to the bank. She is not allowed to retain any of her profits or discharge her debt to the bank.
If this sounds outrageous to you, that’s because it is. And it is essentially what the federal government has done to Fannie Mae and Freddie Mac’s investors.
As government sponsored entities (GSEs), Fannie Mae and Freddie Mac are unique enterprises. They are federally chartered private corporations that serve the public interest by making the dream of homeownership a reality for millions of Americans.
From 1968 to 2010, these GSEs were the ultimate public-private partnerships. The companies were publicly traded and privately owned, they were capitalized by private investors, and they operated under ordinary corporate by-laws. They came to guarantee more than half the mortgages on new homes in America, all while turning a profit. Private shareholders, the federal government, and society at large had a stake in their success. But now the public-private partnership has become categorically one-sided in favor of the government.
The trouble started in 2007, when the Office of Federal Housing Enterprise Oversight pressured Fannie Mae and Freddie Mac to buy up to $40 billion of sub-prime mortgage-backed securities, mortgages that did not have a high likelihood of repayment. Notwithstanding these high-risk assets, the GSEs remained profitable. But the following year, the national market for sub-prime mortgages reached a point of crisis as financial institutions that the government deemed “too big to fail” found themselves on the verge of collapse. The federal government stepped in once again with a sophisticated maneuver.
Congress effectively made the GSEs an offer they could not refuse. In exchange for $1 billion of interest-bearing preferred stock, the government would advance each GSE up to $100 billion – totaling $187 billion. To seal the deal, Congress passed a law that put the companies in conservatorship under their new regulator, the Federal Housing and Finance Agency.
But in 2012, with the GSEs growing increasingly profitable, Treasury unilaterally rewrote the terms of the agreement, amending the original agreement in such a way as to turn Fannie Mae and Freddie Mac into the government’s own ATM. Under the new terms, also known as the third amendment, the federal government would keep its preferred shares in the companies, but instead of collecting interest, the U.S. Treasury would help itself to “a quarterly sweep of every dollar of profit that each firm earn[ed] going forward.”
This may be a boon for the federal government, but it is highway robbery for the companies’ investors and continues to keep taxpayers hostage to another bailout. As of this April, Fannie Mae and Freddie Mac have paid over $220 billion to the Treasury, $40 billion more than the companies had borrowed in the first place. Other holders of the companies’ preferred shares – shareholders that range from institutional investors to insurance companies to pension funds – have not seen a penny.
Some of these shareholders are now challenging the government’s actions in the courts. One of their most compelling claims is a constitutional no-brainer: the government cannot confiscate private property without paying for it. This safeguard is so essential to liberty that it is enshrined in the Fifth Amendment of the Bill of Rights, which provides that “private property shall [not] be taken for public use without just compensation.”
The Treasury has been benefiting from the profit sweep to the tune of billions of dollars. But the cost of that bonanza is being borne by shareholders, whose legitimate expectations were pulled out from under them, and by individuals whose pensions are reliant on investments in Fannie Mae and Freddie Mac.
If the courts deny the plaintiffs compensation for the property the government has taken, they would set a dangerous and self-defeating precedent. They would deter prospective investors from taking a risk on GSEs, making it impossible for the government to marshal the energy and ingenuity of the private sector to serve the public interest. Moreover, by allowing the government to keep its thumb on the scales in its dealings with private investors, the courts would hollow out a key constitutional safeguard of private property rights.
The Department of Treasury could resolve this problem in the same way it created it: by fiat. Revoking the profit sweep would allow Fannie and Freddie to proceed under the original terms of their agreements with the government. The time for having government-backed housing finance should be over, but before we can move to that end, the Treasury must follow the rule of law.
Moreover, reverting to the initial terms of the agreement would take the taxpayers off the hook for the extraordinary risk created by the profit sweep. As long as the government is helping itself to 100% of Fannie and Freddie’s profits, it is impossible for the companies to build a surplus sufficient to weather any future financial storms. And when hard times hit, as they always do, the taxpayers will bear the burden.
Denying Fannie Mae and Freddie Mac’s preferred shareholders compensation for the government’s profit sweep would be a gross injustice in the short term and a profound blow to liberty in the long term. But the political fix is quite simple, and requires nothing more than a commitment to free-market principles and the rule of law. Until that happens, time – and the courts – will tell what the fate of property rights will be.