Plan C: A simple fix for Fannie and Freddie

Everybody talks about fixing the problem of Fannie Mae and Freddie Mac, but it is hard to make anything actually happen.  Current legislative grand plans for housing finance restructuring are complex, full of untried ideas, and seem unlikely to be enacted.

We have a reform bill in the House, the “PATH  Act,” which would transition U.S. housing finance to one based on private markets.  In my opinion, it ought to be enacted, but everybody agrees that it won’t be.  I call this Plan A.

We now have a Senate bill, “Johnson-Crapo,” which is getting a lot of attention.  It is bipartisan, which means it gives every constituency in the real estate political complex something. Let us call it Plan B.  It has a lot very debatable about it, both on the merits and from the viewpoint of the majority in the House.

Suppose that neither Plan A nor Plan B can get enacted.  What then?

Do we want to live indefinitely with the Fannie and Freddie status quo?  No.  Nobody is supporting an indefinite continuation of Fannie and Freddie in conservatorship, run as a ward of the state, with no capital, enjoying even more subsidies and market share than ever before.  That would indeed be a bad idea.

Therefore, we need a Plan C—one which is simple and direct.

The Plan C I propose for immediate action, until fundamental housing finance reform can be achieved someday, is easy to understand.  It is in essence:

Treat Fannie and Freddie exactly like a Too Big To Fail (TBTF) bank.  We already know what this means.  It would include recognizing them as the Systemically Important Financial Institutions (SIFIs) they indubitably are.

Are Fannie and Freddie Too Big To Fail?  Nothing could be more obvious.

Are Fannie and Freddie systemically important?  Nothing could be more obvious.

Thus what we need is a simple, clear, a-partisan act to immediately reduce the distortions, systemic risk, capital arbitrage, taxpayer exposure and utter dependence on the government, of Fannie and Freddie.  We have already worked out with great efforts over the past several years how to address TBTF banks:  Just apply this to Fannie and Freddie!

Specifically, Plan C has seven steps:

1.        Give Fannie and Freddie the same leverage capital requirement as every TBTF bank holding company, namely, minimum equity capital of 5 percent of total assets.

2.       Formally designate Fannie and Freddie as SIFIs, just like every TBTF bank.  Fannie has assets of $3.3 trillion, bigger than JPMorgan and Bank of America.  Freddie has $2 trillion in assets, bigger than Citigroup and Wells Fargo.  Both are running with close to infinite leverage.  It is undeniable that they are in fact SIFIs.

3.       Make Fannie and Freddie explicitly pay for their proven guaranty from the government, just like TBTF banks have to pay deposit insurance premiums assessed on their total liabilities.  Fannie and Freddie should likewise pay an “offset fee,” also assessed on their total liabilities-- all of which are guaranteed by the government.

I propose this offset fee to the Treasury be set at 0.17% per year. Consider that Fannie and Freddie with essentially zero capital are critically undercapitalized.  The base FDIC assessment fee of the government’s deposit insurance guaranty for an undercapitalized bank is 0.23 percent to 0.35 percent.  The total premiums paid by all banks to the FDIC were about 0.17 percent in 2012 and 0.16 percent in 2013 of estimated insured deposits.   This fee proposal is certainly moderate.

4.       Apply all consumer protection rules in full force to Fannie and Freddie, just like to every TBTF bank. Fannie and Freddie now have a free pass to avoid regulations intended to protect mortgage borrowers--that is ridiculous.

5.       Remove all special treatment of Fannie and Freddie from all banking regulations.  The limits on credit exposure to one borrower, the risk-based capital requirements on such exposure, and in every other respect, Fannie and Freddie should be treated in banking regulations exactly as any other TBTF bank.

6.       Eliminate Fannie and Freddie’s exemption from state and local income taxes.  Treat them in this respect, too, just like every other TBTF bank.

7.       Finally, when steps 1-6 are in place, we can settle the issue of how to treat the bailout senior preferred stock of Fannie and Freddie.  I propose that its dividend should be set in statute at its original 10 percent per year, it being understood that paying dividends of course does not reduce the principal of preferred stock.  Fannie and Freddie must first pay their offset fee, then the dividends on the taxpayers’ senior preferred, then build up their capital until it reaches 5 percent of total assets.  After that, all excess cash must go to retiring the remaining principal of the senior preferred stock at par until it is fully paid.  There must be no dividends on the old junior preferred stock or common stock until the capital requirement is met and the taxpayers’ forced investment is completely retired at par.

After all that is done, the old junior preferred and common stock could again receive dividends out of profits Fannie and Freddie might make while competing on a level basis with all other TBTF banks.

We should immediately preempt the danger the pernicious status quo by implementing Plan C.  Then continue working on Plans A and B.

Pollock is a resident fellow at the American Enterprise Institute in Washington, DC.

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