Fannie Mae and Freddie Mac's Critical Role in Protecting Black America

President Obama is Letting Fannie and Freddie Slip Away, and it will Destroy Opportunities for African American Borrowers

Trevor Thompson [email protected] June 8, 2015

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Trevor Thompson [email protected] June 8, 2015 Page 1

Executive Summary

1. America has a long history of racial discrimination in housing. It began with exclusionary policies, but has shifted to a trend of exploitation.

African Americans have been the target of discrimination in housing for as long as we've had housing. It started with racial zoning restrictions (banned in 1917), then progressed to exclusionary covenants in titles and deeds banning blacks from ever purchasing specific properties (partially banned in the late 1940s, fully banned in 1968), then led to real estate agents “steering” blacks away from white neighborhoods, a practice their licenses sometimes depended upon (also banned in 1968). These things all led to a distinct segregation of African Americans into specific neighborhoods, and these neighborhoods were discriminated against as a matter of both public and institutional policy, a practice known as redlining.

There is a raft of evidence that proves banks are still discriminating against African Americans, though now they are targeting them instead of excluding them. African Americans were three times more likely to get a subprime (high cost) loan than whites. African Americans are 45% more likely to lose the ability to be a homeowner. African Americans were foreclosed on at 2.5 times the rate of whites.

Many of the largest banks in the country have been sued for these practices and either lost or settled. PNC had to pay $35 million. Wells Fargo had to pay $175 million. Bank of America had to pay $335 million. In addition, there are more than 15 lawsuits ongoing.

2: Fannie Mae and Freddie Mac (the GSEs) fight the banks to restore balance to the market and prevent discrimination, as required by law.

Fannie and Freddie provide a number of incredibly important benefits to low income and minority borrowers:

First, GSEs are required to provide at least 55% of their business to low-to-moderate income Americans and minorities in “underserved areas.” They are required to do this by law, not just corporate policy.

Second, the GSEs are required by law to give a portion of their profits, a sum expected to be greater than a billion dollars a year, to the Housing Trust Fund, an organization exclusively devoted to helping “ultra-low income” individuals get the housing they need.

Finally, the GSEs also force banks to follow their underwriting standards, which disallow predatory lending. The stronger the GSEs, the more power they have to enforce this.



3: Republicans strongly oppose affordable housing and the GSEs. Due to President Obama’s delays, if the Republicans win the 2016 presidential election, they will be in a perfect position to eliminate them.

In 2008, President George W. Bush, a person who “despised” the GSEs, agreed to have the companies put into conservatorship, giving up control of the company to the FHFA, an arm of the government run by a presidential appointee. The companies were then forced into a large loan with a 10% interest rate on any money borrowed. Under the original agreement, Fannie and Freddie have paid back the loan in full, but in 2012 Obama allowed the terms to be changed. Under the new terms, instead of the 10% interest rate, the companies now had to give every penny they earned to the government, even if it far exceeded the former dividend payment. While GSEs were poised to exit their conservatorship in 2012, they are now unable to do so because of the weakness created by Obama’s decision.

Statements from Jeb Bush, Rand Paul, and leading Republican Congressmen demonstrate that they are anxious for a chance to gut Fannie and Freddie. If a Republican wins the presidential election in 2016, it is a certainty that everything the GSEs do for minorities will be immediately stripped away.

4: Obama has the power to end the policies that are keeping Fannie and Freddie weak and vulnerable, but he has chosen not to. If he fails to do so, the demise of affordable housing and the protection of African American borrowers will fall squarely on his shoulders.

Obama has the power to release the companies right now, heading off the inevitable attacks on the GSEs and their affordable housing goals. By delaying this decision, he is gambling with the future of affordable housing in America. Obama needs to release these companies, and it is imperative to minorities and low-income borrowers that he do so quickly.

To remedy this, we strongly recommend that President Obama initiate a “reformed release”, whereby he re-amends the terms of the bailout loan, and then releases the companies from conservatorship, allowing them to regain the strength they need to ward off partisan attacks.



Introduction

America has a long history of restricting African American’s access to mortgage financing. Though there have been many efforts to end the practice, banks have adapted their policies to continue their racially-biased lending. Current data clearly demonstrates that there is an enormous disparity between access to credit for Caucasians, and access to credit for African Americans. In fact, the difference is so pronounced that between 2004 and 2006 African American borrowers were 3.3 times more likely to receive a high-cost “subprime loan” than white borrowers, even after accounting for differences in incomes.1

The effort to combat these discriminatory practices has reached an important crossroad. Fannie Mae and Freddie Mac, the two Government Sponsored Enterprises (“GSEs”) that are required by law to support low-income borrowers, underserved communities, and minorities, as well as fund the Housing Trust Fund program that will provide billions for those who are most vulnerable, are at risk of being phased out. These two companies have done more to enforce fair lending and affordable housing than any other institution in the last hundred years, yet the Obama administration has put them in a perilous position where all of the capital that they need to continue supporting the housing market is instead being given to the Treasury. They’re limping along for now, but if a Republican wins the presidency in 2016, it is certain that the critical protections they have provided to all American homebuyers, especially minorities, will be quickly stripped away. It needs to be made clear to the President that risking these protections by keeping the GSEs starved of their capital is not acceptable.

This paper will cover the four key topics needed to understand this issue:

I. A brief history of racial discrimination in housing finance, its impact, and the proof that banks continue this discrimination to maximize profits;

II. A brief history of the GSEs, and the crucial role they play in ensuring fair lending; III. How the Republicans plan to dismantle these protections, and what the future will look like

without Fannie Mae and Freddie Mac; and finally IV. What President Obama can do to prevent this outcome.



I. Racial Discrimination in Housing

A brief history

Up until 1917, cities and states, especially in the Mid-Atlantic region, created racially based zoning laws to prevent blacks from moving into predominantly white neighborhoods. This policy was eventually brought to the Supreme Court in Buchanan v. Warley, and was ended when the Court ruled that it violated the Fourteenth Amendment.2

The Court’s decision only applied to legal statutes though, not private agreements between individuals. In response to this, communities began inserting racially restrictive covenants into their titles and deeds, banning the sale of homes to non-whites. The covenants became so widespread that, for example, African Americans were barred from 80% of the land in Los Angeles and Chicago3, causing serious segregation throughout the country. Exacerbating the split, real estate agents were pressured to steer African Americans away from white neighborhoods, and into the black neighborhoods created by these restrictions4. The pressure was so intense that, in some cities, agents could lose their licenses for non-compliance. Such clear delineations allowed institutions such as banks to focus on avoiding entire geographical areas with high minority inhabitance, as opposed to individual properties, skirting the eventual Supreme Court rulings on the issue the covenants.

This practice was institutionalized in 1935 when, with the country reeling from the great depression, the Federal Home Loan Bank Board commissioned a study of 239 cities to map out “residential security” at the neighborhood level. These maps, based on subjective assumptions about the community, including their racial make-up, were used by banks to deny traditional mortgage financing to African Americans, causing further segregation and economic harm. The use of these maps, which outlined the riskiest neighborhoods in red (giving rise to the term “redlining”), was crystalized by the FHA, a federal government agency that insures mortgage loans. In the FHA’s underwriting manual, it was stated that they would not insure loans in areas with “inharmonious racial groups,” and banks therefore duly avoided redlined areas5. Policies such as these were legal until the passage of the Civil Rights Act of 1968, which contained a provision known as the Fair Housing Act that banned racial discrimination in mortgage lending.

Discrimination and unequal opportunity today

Sadly, even with the passage of the Civil Rights Act and the Equal Credit Opportunity Act (1974), evidence shows that discrimination has continued to plague the industry over the last 15 years, mostly in the segments of the market where private banks have the largest market share (and the GSEs have the least).



Redlining – Banks refuse to lend in many African American communities

Though they now have to be more discreet, banks still often refuse to lend to even well-qualified African Americans. Though they will not acknowledge it, there is an overwhelming amount of evidence that this practice persists. Since the passage of the Home Mortgage Disclosure Act of 1975 (HMDA), Congress has required banks to report a variety of information on every loan that they make, including the borrower’s race or ethnicity. This has provided researchers with a robust dataset, which has allowed them to prove, beyond a doubt, that African American borrowers are being discriminated against.

Using the HMDA data, Virginia Commonwealth University examined loan denial rates for the Commonwealth of Virginia for 2011 and 2012. What they found is that blacks were denied a loan more than twice as often as whites. This alone is shocking, but even worse is the fact that this trend persisted even when accounting for debt-to-income ratio, the value of the home relative to the size of the loan, credit history, and employment history. The banks gave no reason at all for the denials of loans to African Americans in 43% of cases6.

This sad fact is confirmed by a number of other studies as well. A Dayton Daily News examination of 2008 Home Mortgage Disclosure Act data found significant racial disparities exist at every income level. A nationwide analysis of mortgage lending performed by Zillow in 2013 showed that African Americans were almost three times as likely to be denied a loan. Even the bank’s regulator found that “black and Hispanic white applicants experienced higher denial rates than non-Hispanic white applicants.”7

An Ohio real estate agent observed, “It’s like redlining is being made legal again… Am I dreaming? This seems like something from the ’70s.”8

The difficulty in getting loans has a two-fold effect. First, it pushes low-income African Americans into lower priced homes, often in depressed neighborhoods, which perpetuates the cycle of poverty. Second, because they’ve got nowhere else to get a loan, it has forced many African American borrowers at all income levels to take high-cost subprime loans with severely predatory terms.

Reverse-redlining – African Americans are being targeted for predatory lending

Especially since 2000, banks have recognized that the African American neighborhoods, created by the segregation of the previous century, are willing to swallow much steeper and harsher loan terms than any other segment of the population. This has become so prevalent that it is the subject of more than a dozen major lawsuits by cities, counties, and even the U.S. Department of Justice. Figure 1 shows a partial list of those suits, including suits against most of the largest banks in the country.



Figure 1

Plaintiff Defendant Year Court

Birmingham Citigroup 2009 Northern D. of Alabama

Baltimore Wells Fargo 2010 D. of Maryland

Memphis Wells Fargo 2011 Western D. of Tennessee

United States Countrywide 2011 Central D. of California

Miami Bank of America 2013 Southern D. of Florida

DeKalb County HSBC 2013 Northern D. of Georgia

Los Angeles J.P. Morgan 2014 Central D. of California

Los Angeles Citigroup 2014 Central D. of California

Los Angeles J.P. Morgan 2014 Central D. of California

Los Angeles Wells Fargo 2014 Central D. of California

United States PNC 2014 Western D. of Pennsylvania

Cook County Bank of America 2015 Northern D. of Illinois

Los Angeles Bank of America 2015 Central D. of California

Some of these suits have already been settled. PNC settled for $35 million9. Bank of America settled for $335 million10. Wells Fargo had to pay $175 million11. Others are still winding through the court system, at least for now, as Disparate Impact is still available. For the purposes of understanding though, it is clear that regardless of the legal tools available to fight it, predatory lending is rampant.

This phenomenon has also been proven academically. The University of Minnesota Law School recently demonstrated the effect in the Twin Cities. Between 2004 and 2006, fully half of African American borrowers received a high-cost subprime loan, compared to just 10% of whites12. Figure 2 Map 1 shows the concentration of subprime loans in the Twin Cities geographically, and Map 2, the concentration of African Americans in those areas. As you can see, subprime lending perfectly corresponds to areas of high minority ownership.

Figure 2



It is beneficial to consider what is happening on an individual level in addition to the broad statistical picture. In Illinois, the Cook County suit alleges a variety of mistreatments to borrowers. These include:

Targeted marketing of mortgage loans on unfavorable terms to vulnerable borrowers who are unsophisticated or without access to traditional credit sources;

Steering credit-worthy borrowers to more costly loans;

Incorporating into mortgage loans unreasonable terms, excessive fees, pre-payment penalties, and/or yield spread premiums to the loan broker (i.e., kick-backs);

Basing loan values on inflated or fraudulent appraisals;

Repeated refinancing of loans that does not benefit the borrower and often jeopardizes the property (loan flipping);

Lending based on the value of the real estate asset collateralizing the loan, not the borrowers’ ability to repay (“equity-stripping”); and

Inclusion of other loan terms and conditions that make it difficult or impossible for a borrower to reduce their indebtedness.

The DeKalb County v. HSBC case details the lengths to which the banks went to seek out minority borrowers. Using an algorithm designed to “identify individuals who would respond well” to the marketing of their high cost lending arm, one that combed through a database filled with customers’ personal information, they convinced huge numbers of African Americans to enter into deceitful mortgage loans that robbed them of their equity, often causing them to lose their homes altogether.

Fannie and Freddie, an alternative to the profit centered banks

The banks are refusing to lend to many African Americans, and then using their weakened position to force high cost, highly profitable loans on them. In an amoral world, this makes great financial sense. Subprime loans are the engine that drove banks to be the most profitable industry in the entire economy in 2005 and 2006. And because of the banks’ profitability goals, that is the only way executives can see things, or they will get replaced.

Public companies, including the banks, are specifically designed to maximize profits. No matter what they claim in their marketing materials and PR campaigns, that is their sole purpose. You can’t expect an institution, motivated by nothing but money, to keep the welfare of their customers in mind unless doing so will have a positive effect on the bottom line. The banks can’t have demonstrated this more clearly; they’ve done everything that they could to squeeze as much money as possible out of African American borrowers, even going so far that they broke laws in the process.

If the country wants anything other than this profit-maximizing exploitation, the only answer is to create a different kind of institution. If the country wants to ensure that the mortgage market is there for average Americans, providing the numerous benefits that homeownership confers, then



we need a company that has this public policy goal built into its DNA. Fortunately for us, we’ve already got two companies like that: Fannie Mae and Freddie Mac.

Many of the opponents of the GSEs claim that we do not need them; that the banks will police themselves, and that we already have laws in place that ban discrimination. Consider the banks’ recent history. Does the evidence suggest that they will police themselves? Does the foreclosure crisis that has destroyed countless African American families suggest that they will police themselves?

Furthermore, one of the most important legal tools, used in every major case that has been brought against the banks, is at risk of being revoked. Disparate Impact Theory allows groups affected by racial discrimination to sue a company without proving that they intended to discriminate on the basis of race, but rather that their policies did in fact lead to a discriminatory outcome. In regards to housing finance, it would be nearly impossible to prove that the network of brokers the banks used to make loans actually intended to discriminate, but cities, counties, and the U.S. government have been successful in proving that the banks did give more onerous terms to African American borrowers compared to white borrowers. The people’s ability to use Disparate Impact Theory in housing discrimination cases is being challenged in the Supreme Court13, and if the challenge is successful, it will completely gut the legal protections that are in place. This would allow a Republican president to look the other way and not be held responsible for failing to enforce the discrimination laws.

President Obama can prevent this fate. He can lock in the protections that Fannie Mae and Freddie Mac provide forever, because it would take a formidable act of Congress to overturn them. We have seen numerous African Americans politicians and civil rights groups call for the reformed release of the GSEs. To date, Obama has ignored their pleas. Inexplicably, Obama has been hesitant to do anything that could be construed as being overly helpful to African Americans. Now is the time for black America to come together and collectively demand that President Obama preserve Fannie Mae and Freddie Mac.



How Fannie Mae and Freddie Mac Protect Borrowers

A brief history of the GSEs

Fannie Mae was created in the 1930’s as part of FDR’s New Deal in order to purchase home loans from banks, creating a marketplace where lenders sell their loans for cash, thereby increasing the amount of money available to lend to prospective home buyers. For the first 30 years of its existence, it was fully owned and operated by the government, and had a monopoly over this secondary mortgage market. In 1968 though, it was converted into a shareholder company (though still bound by a government charter, hence the designation of “Government Sponsored Entity” or GSE), and in 1970 it was listed on the New York Stock Exchange along with its newly created competitor, Freddie Mac.14

Though they originally retained ownership of the loans they purchased, the two companies shifted their business model in 1981. They began packaging the loans into “mortgage backed securities” – essentially a bond wherein the yield is paid out of the stream of mortgage payments – and selling them to investors, charging a small fee to guarantee that the payments would be made. This now constitutes a majority of the companies’ business. Figure 3 demonstrates how a mortgage flows through this system.

Figure 3

A lender makes a loan to a prospective

homeowner Loan is sold to a GSE

A pool of loans is turned into a bond-like security

(an MBS), guaranteed by the GSE

MBS is sold to investors

Income from the loans is now paid to investors

Lender GSE Investor

Manages payments Bears credit riskSecuritizes

Deals with foreclosure

Invests the capitalReceives loan payments

How the GSEs protect low-to-moderate income Americans

It is clear that banks, even when subjected to regulatory scrutiny, will operate in a way that is detrimental to the financing needs of low-income borrowers, especially minorities. In stark contrast, Fannie Mae and Freddie Mac have stepped in to serve as the entities responsible for ensuring that all citizens, not just wealthy ones in white neighborhoods, can achieve the American Dream. They do this with three primary tools, detailed below.



Affordable Housing Goals – ensuring all who need a loan can get one

In the 1990’s, the charters of Fannie and Freddie were modified to include “affordable housing goals.” These goals, set annually by the Department of Housing and Urban Development (now by the Federal Housing Finance Agency (FHFA)) and approved by Congress, were created to ensure that low to moderate income borrowers had sufficient access to mortgage financing15. When first introduced, they required the GSEs to make 30% of their business directed to low-moderate income borrowers. By 2008, this number increased to 55%, based on the actual proportions represented by these borrowers16.

Because so many of the loans existing in America flow through Fannie and Freddie – nearly 50% of the outstanding residential mortgage debt was owned or securitized by the GSEs as of 201017 – the companies have been able to use their influence to bring loan supply into balance with loan demand across the income spectrum without turning to predatory lending practices, as the banks did.

Housing Trust Fund – billions in grants for ultra-low income housing

In the Housing and Economic Recovery Act, passed in 2008 to stabilize the housing system, the GSE charters were changed to require payments into a trust fund for low-income housing. The fund “Is intended to provide grants to States to increase and preserve the supply of rental housing for extremely low- and very low‐income families, including homeless families, and to increase homeownership for extremely low- and very low‐income families. The National Housing Trust Fund (HTF) funds will be used to produce or preserve affordable housing through the acquisition, new construction, reconstruction, and/or rehabilitation of non-luxury housing with suitable amenities.”18

Funding for the HTF was swiftly revoked after the GSEs were put into conservatorship, only to be brought back in late 2014 when Mel Watt, director of the FHFA, announced that he would resume the program. The funding from the companies is expected to exceed $1 billion per year, and distributions are expected to begin in early 201619.

Enforcement of Underwriting Standards – the prevention of predatory lending:

Underwriting standards fell precipitously in the years from 2003 through 2007 and beyond, so much so that lenders were even accepting loans with no documentation and specifically targeting the sale of unnecessarily high cost loans to minority borrowers. The GSEs, by setting requirements for the loans that they purchase, combat this practice.

As long as the GSEs are guaranteeing a majority of the mortgage market, the standards they set are followed by almost everyone in the business. Lenders that do not follow them are subject to higher costs and more intense scrutiny. Because the GSEs do not engage in anything close to predatory lending practices, their standards become de facto industry regulation.



III. If a Republican is elected president, the GSEs will be dismantled

Most all of the powerful Republican figures have come out in opposition to Fannie Mae and Freddie Mac, stating that they are clearly broken and need to be reformed. Here are some quotes from these prominent conservatives:

Jeb Bush, candidate for president: “We’re creating the same bubble that got us in this mess beforehand… I don’t think we’ll ever get back to the 30-year fixed-rate mortgage.”20 At a recent Club for Growth conference he also said that he is targeting the GSEs for phase out, and that it was such a priority that even shutting down the Export Import Bank will be a small achievement compared to eliminating Fannie and Freddie21. Obviously the GSEs are as good as dead in his mind.

Peter Wallison, codirector of the American Enterprise Institute (AEI) program on financial policy: “I would like to think that with a Republican Congress the chances of eliminating the government’s involvement in the housing finance business are much improved… Much depends then on the election of a Republican president in 2016.”22

Spencer Bachus, former House Financial Services Committee Chairman: “Republicans will continue to offer solutions that wind down the operations of Fannie Mae and Freddie Mac…”23

Bob Corker, Republican co-sponsor of a Senate GSE bill: “Congressional action is needed to wind down Fannie Mae and Freddie Mac and reform our housing finance system. The fate of these failed enterprises should be determined by Congress…”24

But what would those reforms look like? The republicans would obviously love to just wind them down, but even if that’s not possible, they will simply take the GSEs apart brick by brick. The consequences of letting this happen are dire, harming millions of African American homeowners and prospective homeowners who are still reeling from the foreclosure crisis. The three most critical changes that would take place are these:

How the Republicans will dismantle the GSEs

Funding for the Housing Trust Fund will be immediately reversed, and the fund will likely be eliminated.

Republicans are vehemently opposed to the Housing Trust Fund. Jeb Hensarling, Chairman of the House Financial Services Committee, had this25 to say after Mel Watt’s decision to begin funding the HTF:

In taking this action, Director Watt is making a grave mistake that harms hardworking taxpayers and violates both the letter and spirit of the law… Director Watt’s decision to activate the Fannie and Freddie slush fund may be an early Christmas present for Acorn-like, liberal housing activists, but it’s a lump of coal in the stocking of every American taxpayer.



And he’s not alone. In April, the House Committee on Transportation, Housing, and Urban Development approved a bill that would broadly slash funding for the fund. Congresswoman Maxine Waters blasted26 Republicans for the bill:

I am disgusted with the Republican measure approved by the Appropriations subcommittee today… While this bill contains many harmful provisions, most egregious among them is the decision to rescind funding to the Housing Trust Fund, which allocates a tiny percentage of Fannie Mae and Freddie Mac’s profits to provide safe, decent and affordable housing for millions of American households where there is the greatest need.

This measure also continues the Republican attack on our public and assisted housing programs. Funding for the public housing program in this bill is at an historic low, risking the long-term viability of our public housing stock and diminishing the quality of life for countless public housing residents.

Given the current political environment, it is obvious that the HTF would not survive a Republican controlled House, Senate, and presidency.

The Affordable Housing Goals will be significantly reduced

The Affordable Housing Goals are set every one to three years by the director of the FHFA. In making this decision, the director is to consider things such as the needs of the market, demographic conditions and trends, and the size of the conventional mortgage market. The director is also told to consider “The need to maintain the sound financial condition of the enterprises” though, which opens the decision up to an enormous threat if the director were to buy into the Republican view that “affordable housing goals caused the financial crisis.”27

If a Republican president is chosen, they will be able to choose the next director of the FHFA with just a simple majority in the Senate, thanks to the changes made by Harry Reid. That means that the president would essentially be able to gut the affordable housing goals by claiming the self-inflicted weakness of the GSEs is grounds to shrink the program based on financial instability.

If it comes to pass, this would have awful ramifications on access to mortgage credit, especially in predominantly minority areas that are part of the explicit assistance that Fannie and Freddie provide in their “Moderate income families in high minority census tracts” subgoal.

Forced cost increases will prevent the GSEs from fighting predatory lending

Some Republicans, aware that they might not be able to get rid of the GSEs altogether, are setting themselves up to gut the companies’ power instead. The Cato Institute has proposed allowing the GSEs to continue operating with these new requirements28: They want the GSEs to keep 10% in capital (twice as much as was suggested by the highly stringent stress test done recently), be saddled with untenable regulations designed to reduce the size of the institution, lose the tax benefits that they pass along to borrowers, and charge increased fees.



This is just another scheme to reduce the GSEs importance, allowing the banks to take over significant portions of the business that the companies do. It also has the result of making the underwriting standards much less relevant, allowing banks to make much higher cost loans without having to worry about the loans not meeting Fannie and Freddie’s requirements. As we’ve showed, allowing the banks to police themselves doesn’t work. In the absence of strong requirements, they will lend at rates as high as they can in order to maximize profitability, at the expense of the homeowners taking out the loans.



IV. Obama can prevent this fate, but is gambling that power away

How we got here

In 2008 the economy was in dire straits. The reckless lending by the banks, the targeted equity stripping schemes, the ballooning and variable interest rates given to people with no documentation for houses with inflated values, all these things combined to threaten a collapse of the banking sector. The GSEs also were struggling, but not nearly as badly as the banks. Sensing an opportunity to step in and fix the system, Hank Paulson, Secretary of the Treasury at the time, decided to take over the GSEs altogether.

He didn’t decide to bail them out; he decided to put an end to them. Under the Housing and Economic Recovery Act of 2008 (HERA), the law that he helped push through Congress, he put the GSEs in conservatorship, giving control of their operations to their regulator. He then forced a loan on them with shockingly predatory terms not unlike the predatory loans made by the banks that trapped people in poverty with no hope of ever escaping. The way they engineered this is almost elegant, in a depressing sense. First, with the power that they now had in conservatorship, Treasury and the Bush administration required the GSEs to write down their mortgages, a sharp change in direction compared to the previous accounting rules. Then, with their balance sheets now heavily impaired, the GSEs were required to take a loan from the Treasury equal to the amount of the write downs, a loan that the Treasury wouldn’t allow to ever be paid back. On this loan, the GSEs would have to pay a 10% fixed interest rate every year. With such large losses coming from the accounting changes, those interest payments were incredibly large, and no one expected the GSEs to ever be able to cover them.

In short, Hank Paulson and George Bush, both strong ideological opponents to the GSEs and their affordable housing goals, took control of the two companies. With this control they forced them to take a loan that they didn’t need, that could never be repaid, effectively setting them up to go out of business. Paulson, in his book about the crisis, put it like this, “We’re going to move quickly and take them by surprise. The first sound they’ll hear is their heads hitting the floor.”29

The current state of the GSEs

Shockingly, the GSEs came back even from Paulson’s best attempts to kill them. In 2012, the companies were on the verge of profitability again, even after accounting for the usurious bailout loan interest rate. The companies were primed to rebuild their balance sheets and return to their long history of helping Americans achieve homeownership. Sadly this didn’t come to pass.

In the middle of the year, the Obama administration announced that it was now changing the terms of the bailout loan. Instead of paying the steep 10% rate, Treasury would now just take 100% of the money earned by the companies, never allowing them to build up their capital to return to their duties30. It has taken time for everyone to realize what a disastrous change this was, but people are



now beginning to realize that this means the benefits described in this paper, as well as many others, have been put in jeopardy.

There is a lot of speculation as to why President Obama did this. Why did he go along with a targeted action taken by the Republicans to kill the institutions that are the fundamental pillar of our country’s affordable housing goals? Why did Obama agree to a plan that destroyed Housing Trust Fund, a measure that Democrats fought so hard for, a measure that would provide billions of dollars to help struggling Americans, especially African Americans?

Some argue that he did it to create an opening for his own housing finance reforms, proposals that have been stricken down repeatedly in Congress since then. Others argue more cynically that Obama used the companies as a piggy bank to buy himself time in the debt ceiling government shutdown talks (recall that Treasury found a few extra months’ worth of funding right before the brink; that was largely from the accounting reversals at the GSEs). It was probably a bit of both, but regardless, it is abundantly clear now that there is no reason for Obama to continue holding the protection of our country’s borrowers hostage.

The President can fix this himself, no Congressional action needed

President Obama and others have claimed that it will take an act of Congress to change the state of the GSEs, but this is not true. This is an argument made by people who are looking to buy more time. The Republicans want more time because they are trying to wait Obama out, ending the government involvement in affordable housing once there is a Republican president. Obama wants more time so that he can take yet another bite at the ideal solution while ignoring the political reality that Democrats are outnumbered in both the House and the Senate.

No, the truth of the issue is that the only solution that can preserve these protections for African Americans and low-moderate income earners is that Obama has to change the terms of the loan, just as he did in 2012. He had the power to do it then, and he has the power to do it now. Changing the terms will allow the GSEs to begin rebuilding their capital, and will let them exit the conservatorship that will be their destruction under Republican rule. And it is entirely up to President Obama.

This has been confirmed by one of the key Treasury officials who worked on the financial crisis bailouts, Jim Millstein, the Chief Restructuring Officer during the crisis years, who said31:

The responsible path forward is not to continue to wait for new direction from a divided Congress, but rather to lay the groundwork for “administrative reform” by reversing the administrative policies that have kept the companies from rebuilding their capital. It’s not about the math. It’s about political will.

Furthermore, changing the terms absolutely doesn’t prevent Congress from continuing to negotiate reforms. Whenever they can finally come to a true bipartisan agreement, Obama’s decision to let



them rebuild capital does nothing to stop Congress from getting it passed. All it does is preserve the protections for the foreseeable future.

Recommendation

The GSEs are in conservatorship because they don’t have enough capital (money in excess of their liabilities that would be used to weather another downturn). Currently, because of the “Net Worth Sweep” agreement that Obama's administration put in place, they will never be able to rebuild their capital because they aren't allowed to retain any of their profits. To ensure the protections that the GSEs offer, there are two steps Obama would have to take:

First, he should direct the FHFA and the Treasury to once again amend the terms of the loan, considering the large payments made in 2012, 2013, and 2014 to have paid down the outstanding balance, and once again allowing the GSEs to retain earnings and build their capital.

Second, once the companies have put together a thorough recapitalization plan, they should be released from conservatorship and regain the ability to direct their own operations (though still subject to congressional oversight).

This two-step process is together known as “reform, release.”



Conclusion

For 80 years Fannie Mae and Freddie Mac have provided everyone in this country, not just the rich and the white, with the opportunity to achieve the American Dream of homeownership. In stark contrast with the private markets, the GSEs have actively fought to ensure that underserved communities, low-income borrowers, minority borrowers, and everyone else have access to affordable mortgage loans. They have stood up to the banks, enforcing underwriting standards to prevent predatory lending even when it was wildly profitable.

This amazing service has been put in a perilous position by President Obama though, one that threatens to ruin the companies, destroying the protections for millions of future prospective homeowners. The upper- and upper-middle-class will get by, given their already strong access to credit, but the banks have demonstrated what happens to low-to-moderate income borrowers and minorities; they are preyed upon, used as profit centers, and taken advantage of in the name of the bottom line.

We can’t allow President Obama to put this off any longer. We need to demand the reformed release of Fannie Mae and Freddie Mac.



About me

I am a senior at the University of Massachusetts Amherst, majoring in Economics. As a student at one of the top political economy programs in the country, I have studied economic policy and the impact that it has on workers, and am especially interested in the effect that policy can have on those without a strong voice in the decision making process.

I first became aware of Fannie Mae and Freddie Mac after researching the companies for an internship with a small financial company in Boston. After realizing the incredibly important role these companies play in American housing, I decided to continue my research at the University, with the help of my professors. Once I saw that no one but the people at timhoward717.com were talking about anything but the “Hedge Funds vs. the taxpayers” angle, I decided to get involved, and am now working with a number of parties to advocate for the release of Fannie and Freddie.



1 Cities and Crisis: New Critical Urban Theory by Kuniko Fujita. Page 86 2 Buchanan v. Warley, 245 US 60 - Supreme Court 1917 3 Fair Housing Center of Greater Boston 4 CivilRights.org Report: Racial Steering into Segregated Neighborhoods Most Prevalent Form of Housing Discrimination 5 The perpetuation of residential racial segregation in America: historical discrimination, modern forms of exclusion, and inclusionary remedies, Florida State University Law School 6 Racial gulf persists in who gets home loans, Virginia Commonwealth University 7 Racial disparities in home lending, Dayton Daily News 8 Racial disparities in home lending, Dayton Daily News 9 PNC Agrees to Pay $35 Million to Settle U.S. Loan Probe, Bloomberg 2013 10 Bank of America settles discrimination suit for $335M, CBS News 2011 11 Justice Department Reaches Settlement with Wells Fargo Resulting in More Than $175 Million in Relief for Homeowners to Resolve Fair Lending Claims, U.S. Department of Justice 12 Communities in Crisis: Race and Mortgage Lending in the Twin Cities, University of Minnesota Law School 13 Disparate-Impact Theory Finally Gets Its Test At Supreme Court, Forbes 2015 14 History of the Government Sponsored Enterprises, FHFA OIG 15 HUD’s Affordable Lending Goals For Fannie Mae And Freddie Mac, HUD Issue Brief 2001 16 Overview of the GSEs’ Housing Goal Performance, 2000-2007, HUD 17 Residential Mortgage Debt Outstanding – Enterprise Share, 1990 – 2010, FHFA 18 Housing Trust Fund, HUD Exchange 19 Housing Trust Fund, HUD Exchange 20 Jeb Bush: Current housing and debt situation unsustainable, Housing Wire 2015 21 Jeb Bush Pleases Conservatives by Saying Export-Import Bank ‘Should Be Phased Out’, The Daily Signal 2015 22 ‘Hidden in Plain Sight': A Q&A with Peter Wallison on the 2008 financial crisis and why it might happen again, American Enterprise Institute 2015 23 Hensarling Re-Introduces Legislation to End Taxpayer Funded Bailout of Fannie Mae and Freddie Mac, Jeb Hensarling Media Center 2011 24 Corker, Warner offer jumpstart GSE reform amendment, Bob Corker Media Center 2015 25 FHFA Director Delivers Lump of Coal to Every Taxpayer, House Financial Services 2014 26 Housing Funding Bill Harmful for Millions of Americans, Democrat’s House Financial Services 27 ‘Hidden in Plain Sight': A Q&A with Peter Wallison on the 2008 financial crisis and why it might happen again, American Enterprise Institute 2015 28 Making a Fannie and Freddie we could live with, Cato Institute 2015 29 On The Brink, Hank Paulson 2013 30 Freddie Mac Update, Freddie Mac 2015 31 It's time for administrative reform to end the GSE conservatorships, Urban Institute 2014

Documents

Fannie Mae and Freddie Mac's Critical Role in Protecting Black America