Washington Post Editorial On Fannie And Freddie Is Based On Two Profoundly False Assumptions

In 2011, The Washington Post published "The Big Lie goes viral," by Barry Ritholtz, who refuted the popular myth that affordable housing goals imposed on Fannie Mae and Freddie Mac were a central cause of the financial crisis. But, like an ever-tenacious virus, a Big Lie keeps mutating, as evidenced by a Post editorial, "This Fannie-Freddie resurrection needs to die." 

The editorial dealt with a government decision in 2012 to drain Fannie and Freddie of all equity in perpetuity. A revised Senior Preferred Stock Purchase Agreement dictated that the government sponsored enterprises, which were undercapitalized, shall henceforth distribute to the Department of Treasury every last dollar of earnings as cash dividends forever. So far, the government has drained over a quarter trillion dollars in equity out of both companies, leaving a nominal capital cushion to offset any possibility of quarterly losses. (Anyone who ever completed an accounting course or a course in corporate law would immediately recognize the idiocy and illegality of such a move.)

The Post editorial board vigorously opposes any effort to halt that cash drain and anything else that might allow the GSEs to emerge out of conservatorship. Like so many "reform proposals" that seek to abolish both companies, the editorial board predicates its argument on a false history of the GSEs and a conflation of conservatorship with nationalization. In other words, it shows a contempt for the facts and the rule of law.

Though the editorial board never pushed the most familiar Big Lie meme, that the GSEs caused the crisis, it embraced several corollaries to that falsehood, most notably that the GSEs have an “old, failed business model," which exploits a "private gain, public risk conflict." Let's demolish those shopworn talking points with the metrics of capitalism. 

(I counted 17 different prevarications or verbal sleights of hand, which were used to develop a phony argument that is utterly disconnected from basic concepts of law and the reality of today’s $10 trillion mortgage market. I may walk though each  and every one of them later.)

The GSE Business Model 

Business Model Versus Management: As is common among the Very Serious Persons of Washington, the Post editorial board simply presumes that the, “old, failed business model," and, "private gain, public risk conflict," are self-evident because they are talking points used by both Republicans and Democrats, most notably, the Obama White House. But outside the Beltway in the business world, money talks and actions speak louder than words.

First, a few basics with which, I fear, the Post editorial team may be unacquainted. It’s important to differentiate a business model from management. Blockbuster Video may have been managed superbly, but its  business model had a very brief shelf life. AIG’s business model, a conglomerate of regulated insurance companies, was perfectly fine. But a handful of incompetent managers at an AIG trading subsidiary threatened to bring down the entire empire. The GSEs’ management teams have been criticized for lowering their credit standards after 2004, when they lost market share to private label securitizations. That issue is open debate. But those management decisions do not invalidate the underlying business model.

It’s important to remember that everything in finance, every business decision, is framed around some kind of breakeven analysis.  The GSEs’ breakeven for continuous solvency, during the worst housing crash in 80 years, was about 5% capital. The GSEs’ pre-crash capital was closer to 3%. Why? The GSEs had sized their capital based on an unprecedented downside scenario of a 10% nationwide decline in housing prices. They had not anticipated 30% declines in major markets. A failure to anticipate such an unprecedented fall, which was caused primarily by an epidemic of mortgage fraud, does not invalidate the business model. It indicates the GSEs needed more capital.

It’s about loan recovery, stupid: Capitalism is all about getting your money back plus something extra.  Which is why the lending business is all about recovering principal, plus interest and fees. Everything else is fairly inconsequential. And in business, success and failure is always relative.

And since the dawn of modern credit markets, which followed the dismantling of Bretton Woods, no mortgage lender has ever come close to matching the stunning success of Fannie Mae and Freddie Mac. Fannie and Freddie’s loan performance has always been exponentially superior to any other segment of the residential mortgage market. To state otherwise is to lie. Which explains a vast conspiracy of silence among GSE critics who refuse to discuss comparative loan performance. Here’s a glimpse of Fannie and Freddie’s loan performance through the decades. Try and find any mortgage lender with a comparable track record of success,

The Big Lie, which trashes the GSEs’ underwriting standards, is based on smoke and mirrors, class bigotry and race-baiting. It was never based on the criteria that really matters, loan performance. 

The GSEs never lacked for liquidity: Financial institutions almost never collapse because they release financials with a negative net worth. They fail because of a sudden loss of liquidity, which is access to immediate cash, usually in the form of deposits or unsecured credit. That’s what happened to  Bear Stems, Lehman Brothers and a litany of others.

Contrary to myth, the GSEs never "collapsed." Period. They never faced a moment when they lacked unfettered access to the unsecured corporate debt markets. Anyone who says otherwise is either misinformed or lying.  “Fannie Mae, Freddie Mac debt funding smooth,” said the Reuters headline on September 3, 2008. "Fannie Mae FNM.N and Freddie Mac FRE.N drew solid demand for $5 billion of new securities on Wednesday...The [GSE’s] latest sales underscored their continued access to debt funding that is key to running their businesses and supporting the U.S. housing market." Alan Zibel of the Associated Press reported pretty much the same thing. "The companies' ability to sell debt has diminished expectations that a government rescue is imminent,” he wrote on September 3, 2008. “Investors are demanding a smaller premium for Freddie Mac's debt than last month.” Two days later, the GSEs were notified of the imminent government takeover.

 Moreover, the suggestion that any GSE failure to roll over unsecured debt would have precipitated a liquidity crisis is patently absurd. Both companies were required to maintain 90-days liquidity at all times. For Fannie, 90-days liquidity—which is cash, cash from operations, and assets instantly convertible into cash to pay all maturing debt—totaled about $450 billion. 

Though the GSEs never had direct access to the discount window of the Fed, it is false to characterize them as part of the Shadow Banking System, because, unlike, say, Lehman Brothers, the GSEs holdings in short-term, highly liquid investments always exceeded their short-term debt obligations.

Unlike the big banks, which need lots of liquidity to support their trading operations and funding of Libor rollovers, the GSEs didn’t consume much liquidity, since most of their credit exposure involves non-cash guarantees on loan portfolios that deteriorate, if at all, gradually. Finally, the GSEs were never required to post collateral on their out-of-the-money derivatives, in sharp distinction to, say, AIG, which collapsed because it faced collateral calls on derivatives.

THIS IS IMPORTANT: GSE critics, such as Ben Bernanke, like to say that Fannie and Freddie cannot operate without an express government guarantee. These critics have zero empirical evidence to support their claim, and four decades of evidence strongly refute it.  It’s also worth noting that right up until the takeover, there was never a moment when the markets for GSE corporate debt or GSE securitizations were illiquid.

Executive Summary of the Crisis: The financial crisis was caused by a succession of liquidity crises at financial institutions and in structured finance markets. All of those liquidity crises were tied to the collapsing values of private label mortgage-backed securities, which were toxic because of their severe subordination and because of fraud. The financial shock was caused by the sudden wipeouts of private mortgage securities, not by mortgage loans, which have values that deteriorate gradually over time. To state otherwise is to lie.   The GSEs had nothing, zero, to do with any of the aforementioned liquidity crises. And, because the GSEs’ underwriting has always been a exemplary, it is a Big Lie to characterize the GSEs as a primary cause of the crisis.

The GSEs’ big “losses” were illusory.  The massive GSE losses recognized in 2008 through 2011, which ostensibly triggered the need for a "bailout," proved to be illusory. After the government takeover of the GSEs, the Federal Housing Finance Agency, acting as conservator, mandated that the GSEs shall recognize massive non-cash loan loss provisions, guesstimates of future cash shortfalls when loans are eventually  liquidated and removed from the books. Those provisions proved to be vastly over inflated, which is why the GSEs earned $135 billion in 2013, when the provisions were substantially reversed, and when all earnings were drained out of the companies as dividends to Treasury. Those reversals of provisions continued into 2014 and onward, which is why in most fiscal quarters credit expenses increase net income rather than reduce it.

In stark contrast to all of the other bailouts, taxpayer funds applied to the GSEs were never used to support corporate liquidity or operating expenses. Virtually all of it was used to offset non-cash accounting provisions, which were reversed, and cash dividends paid to the government.

Shareholders have sued the GSEs’ auditors, Deloitte & Touche and PriceWarehouse Coopers, precisely because Fannie and Freddie violated GAAP by failing to restate earnings for the 2008 – 2011 period. The rules require the companies to correct the wildly inaccurate loss provisions initially posted. It’s hard to overstate the extent to which GSE critics demonstrate, or exploit, a failure to grasp timing differences under GAAP.

GSE Operations Have Never Scaled Back: Whoever heard of a “failed business model” that expands its operations while facing the specter of insolvency? Beginning in 2007 and continuing right to today, the GSEs have financed the vast majority of residential mortgages in the United States, whereas as banks substantially withdrew from the market until the housing recovery, which began in 2012.

After 2007, private label deals have never exceeded 1% of mortgage originations because institutional investors aren’t stupid. They have become well aware of the pervasiveness of fraud, their grossly inadequate legal protections, and the brutal fact that the math doesn’t work. The Big Lie is an effort to reassign blame for the failures of the Wall Street’s originate-to-distribute model for private securitizations on to the GSEs.

The GSEs filled the vacuum left by private securitizations, which is why the people who hawked those fatally flawed securities now want to abolish the GSEs in order to try out a new, untested scheme, substantially similar to this one.

The So-called Private Gain, Public Loss “Conflict" 

Money talks. It says taxpayers laid out $187 billion in cash to support the GSEs, and they received over $251 billion in cash in return. In the land of capitalism, that is not a public loss.

(Of course, in the land of capitalism, a company does not “pay back” an investor holding preferred shares. It pays the originally contacted coupon. And if the shareholder wants to recover his initial principal, he must sell his shares. Companies only pay back debt, which is then extinguished. Which is why the government’s defense of the Third Amendment is a bottomless pit of fatuousness.)

Moreover, there’s a common meme, promoted by adherents to The Big Lie, that GSE management acted recklessly out of the belief that, no matter what, the government would bail them out for their mistakes. It’s hard to make a case for recklessness if GSE loan performance is vastly superior to everyone else’s. Moreover, an abundance of evidence shows that the GSEs’ credit losses, which only began to seriously accelerate in 2008, two years after the bubble began to deflate, were caused by crashing home prices in markets that had been dominated by reckless and fraudulent private label securitizations.

The Big Lie That Minimizes Public Benefit. This cannot be emphasized strongly enough. Anyone who dismisses the public benefits of GSEs is engaged in a form of willful blindness on the scale of climate change denial. Over the last four decades, the GSEs repeatedly saved the mortgage markets from collapse and continuously offered a time-tested loan product that stabilizes one of the largest credit markets in the world.

Only someone living under a rock could dispute the public benefit of the GSEs during the last decade.  When home prices started falling, other private players exited the market. The GSEs were the only private players that kept lending during the crash, and thereby helped stabilize the housing and mortgage markets. That has always been their public mission, and only the GSEs, with their dominant market shares, have the business incentive to stabilize the market to benefit their existing credit books, the mortgage markets in general, and the American economy. The value of those benefits far exceeded the $187 billion “bailout” temporarily extended by the Department of Treasury.  To dispute the public benefits brought by the GSEs during the crisis is to lie.

A major reason why the GSEs’ loans perform so much better than anyone else’s is because of there GSEs' competitive advantage in financing 30-year and 15-year fixed rate mortgages, which have stood the test of time. Investors in GSE securitizations willingly assume interest rate risk, because they benefit from a corporate guarantee.

People forget that during the savings and loan crisis in the early 1980s, the during second savings & loan crisis in the early 1990s, as well as during the recent housing  crash., the GSEs stepped in to fill the void left by private market failures. 

This only touches the surface of what was wrong with the editorial. More to come.

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