Time to Fix Fannie and Freddie

How tax reform could hasten housing‐​finance reform.
April 10, 2017 • Commentary
This article appeared on The Weekly Standard on April 10, 2017.

Comprehensive tax reform, done right, would accomplish many things: It should boost investment, productivity, and employment, and along with these economic growth. That is the intent, anyway.

But tax reform could affect the housing market as well, in a way that may prompt Congress to address that market’s current stasis. It isn’t clear whether that would be a good thing.

To understand the connection between tax reform and the housing market you have to understand how U.S. mortgage financing works. Most mortgages issued by banks or mortgage companies do not remain with the issuer. Instead the bank sells them (more precisely, it sells the right to receive monthly payments from the borrower, with the house as collateral) to either Fannie Mae and Freddie Mac, two government‐​sponsored enterprises (GSE).

Fannie and Freddie bundle mortgages together and sell the bundles to investors in the form of mortgage‐​backed securities. The value added by Fannie and Freddie is that they do due diligence on the mortgages to ensure they meet certain standards and then offer a guarantee to the buyers of the securities that the borrowers won’t default.

But the GSEs have an unfortunate history of not being as diligent as advertised. When the housing collapse hit in 2008, the GSEs held hundreds of billions of dollars of mortgages of dubious value. The government declared Fannie and Freddie insolvent and placed them into what it labeled a conservatorship. It injected over $100 billion of capital into the two and assumed ownership of just under 80 percent of each entity. In exchange for the capital it put into them it also assigned itself an annual dividend equal to 10 percent of its investment in each. The existing shareholders retained their interest in the remaining 20 percent of the company, at least theoretically.

After a few years the housing market recovered, and the assets held by the GSEs recovered their value. Suddenly, Fannie and Freddie began making enormous profits: In 2012 alone, their combined profits exceeded $130 billion.

Those profits gave the Obama administration an idea—why not use that money to reduce the reported government deficit before the election? In 2012 the Treasury issued the “third amendment” to the legislation that created the conservatorship, sweeping the entire net worth of each entity into the Treasury’s coffers at the end of each quarter. The owners of the other 20 percent of the GSEs effectively saw their investments wiped out. The government has thereby recovered its entire investment in the GSEs and earned a tidy profit to boot.

The “sweep” created two problems. The first is that it is not clear that the maneuver is legal, a question currently being litigated. The second, and more immediate, problem is that the sweep leaves the two GSEs undercapitalized. The undercapitalization is problematic because it could hasten another day of reckoning.

And this is where tax reform comes in.

Fannie and Freddie reported sizable losses in the years before the sweep, totaling just over $150 billion. Those losses have been carried forward to reduce tax obligations in future years, whenever they are allowed to keep their profits. Under the current corporate tax rate of 35 percent, these will reduce future tax bills by $53 billion.

However, a reduction in the corporate tax rate to 20 percent—the rate specified in the Paul Ryan/​Kevin Brady “Better Way” tax reform plan—would reduce the value of these “deferred tax assets” to $30 billion.

While losing $23 billion in future tax relief might seem like nothing more than an accounting issue, its implications are anything but: Unless the GSEs’ profits exceed the reduction in the value of the deferred tax assets in the quarter that tax reform passes (which isn’t likely), then the GSEs will need money from the Treasury—i.e., taxpayers—to keep operating.

The optics of such an outcome are terrible. The Obama administration ignored the problems inherent in the current status of the GSEs because of the enormous profits they were pouring into Treasury’s coffers (and because Obamaites were busy telling Americans they had fixed the financial markets). When voters see that Fannie and Freddie are again costing the government money, the political urgency to remedy their status may grow exponentially.

The worry is that this easily foreseeable occurrence may nonetheless trigger an urgent effort by Congress and the Treasury to “fix” the undercapitalized GSEs immediately, and in their haste they may arrive at an inferior solution.

Fannie Mae and Freddie Mac’s status should be resolved as soon as possible: Keeping them in a state of limbo has contributed to a moribund housing market that has been a drag on the U.S. economy for years. Annual housing starts from 2009–2016 were a fraction of what they had been in the years before the Great Recession. One must hark back to the Johnson administration, when there were half as many households in the United States as there are today, to find a period when housing starts outside of a recession were as low as they have been in the last seven years.

Much better would be for Treasury and Congress to make reforming the housing finance system a priority and come up with some long‐​run solutions that would help fix the stagnant housing market. This may be wishful thinking—a sage politician once remarked that there is no political gain in solving a problem until everyone realizes that it is a problem, and few people perceive the current status of the GSEs as a problem.

Consider this an attempt to clarify that perception. Fannie Mae and Freddie Mac’s constrained, ambiguous status contributes to a growing housing shortage while putting the brakes on economic growth. It needs to be resolved as soon as possible.

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