Our nation’s housing finance system was at the center of the 2008 financial crisis. Yet our elected officials have done nothing to fix the problem—until now. Credit Mark Calabria, the new director of the Federal Housing Finance Agency (FHFA), for giving it an honest effort.

Despite all the hype claiming that the Dodd-Frank Act would fix the financial system and make everyone safer, Fannie Mae and Freddie Mac are essentially just as weak today – and just as dangerously leveraged – as they were in 2008.

Calabria and his new team at the FHFA can’t be expected to solve this problem overnight, but it looks like they are on the right path.

On the heels of reiterating that the federal government should have wiped out Fannie and Freddie’s shareholders in 2008, Calabria recently warned members of the Mortgage Bankers Association that “Today’s status quo poses significant risk to taxpayers, homeowners, renters, and the entire financial system.”

Last week, the agency released its new Strategic Plan for the Conservatorships of Fannie Mae And Freddie Mac, emphasizing that the FHFA wants a competitive mortgage market where nobody – even Fannie and Freddie – has a set of special rules. That sort of market would be a major break from the past, but it is now the goal:

“compared to the duopoly of Fannie Mae and Freddie Mac, moving toward a more competitive secondary mortgage market – in which the same rules and regulations apply equally to all – would better serve borrowers and renters. Competition more effectively delivers market-affordable prices with customer satisfaction and continual innovation to improve product quality.”

Given that Calabria unabashedly wants to work with Congress to create “a competitive mortgage market with a limited government role,” Americans should be optimistic that things are heading in the right direction.

Unfortunately, Calabria and his team will face continuous pressure from all corners of the housing finance lobby to upset the status quo as little as possible. That pressure, of course, is the main reason that so little has changed since the 2008 crisis, and that Fannie and Freddie remain so highly leveraged.

Many people balk at this suggestion and argue that Fannie and Freddie remain so highly levered because the U.S. Treasury has been taking all of their profits, thus preventing the companies from building capital.

But this narrative omits crucial context, especially the part about how Fannie and Freddie would not exist today without hundreds of billions in taxpayer support.

Here’s a quick rundown of the multiple taxpayer bailouts that helped Fannie and Freddie get to where they are today. (More detail is available in this new Heritage Foundation Backgrounder.)

In September 2008 Treasury bailed out Fannie and Freddie, promising to shore up each with as much as $100 billion. In return, they forced the companies to give Treasury 1 million shares of preferred stock, worth a total of $1 billion. These shares required the companies to pay quarterly cash dividends to the Treasury, and they included a protection device called a liquidation preference. This device means that the companies cannot raise new equity capital without first paying back the liquidation preference (now approximately $200 billion).

In May of 2009, the companies were still struggling, so Treasury promised to provide each with up to $200 billion.

In December 2009 the companies were still struggling, so Treasury changed its commitment formula, allowing it to provide more than $200 billion.

Even after these three bailouts, Fannie and Freddie were still struggling in 2012—so much, that they faced the prospect of borrowing from Treasury just to pay the dividends they owed Treasury.

Papering over this problem, Treasury amended the agreement once again, this time taking any profit that Fannie and Freddie managed to earn in order to satisfy the dividend payments.

It is true that, between 2008 and 2018, Fannie and Freddie paid back about $300 billion to Treasury, roughly $100 billion more in dividends than they received from Treasury. But this fact merely addresses the cash flows. It overlooks that Fannie and Freddie were able to pay these dividends only with the aid of successive bailouts, and it also ignores the risk that taxpayers were forced to take on through these bailouts.

Of course, these four bailouts are separate from the additional help that Fannie and Freddie received when the Fed and Treasury purchased trillions of dollars of Fannie’s and Freddie’s bonds and mortgage backed securities, thus staving off further losses that could have required even more bailouts.

Despite all of these bailouts, the federal government chose to place Fannie and Freddie into conservatorship (to preserve their assets) rather than receivership (to liquidate their assets and shut them down). Conservatorship was a bad choice in 2008 because Fannie and Freddie had blown through their capital buffer and had no prospects for building capital without additional support from taxpayers.

Now that the FHFA is taking its job seriously and trying to get Fannie and Freddie out of conservatorship, lack of capital is a major hurdle to a smooth exit. Before they can exit, Fannie and Freddie will have to meet their capital requirements (which were suspended throughout the conservatorship), and the FHFA director will have to classify them as either: (1) adequately capitalized, (2) undercapitalized, (3) significantly undercapitalized, or (4) critically undercapitalized. 

As this new paper explains, the authority of the FHFA director to intervene in Fannie’s and Freddie’s operations widens as the capital classification deteriorates. Ultimately, the director has the discretionary power to place the GSEs into receivership and liquidate their assets if they are classified as critically undercapitalized.

As the paper also shows, Fannie and Freddie are critically undercapitalized by (combined) approximately $200 billion. This shortfall is a major hurdle to exiting conservatorship, so there was a great buzz when the FHFA and Treasury recently agreed to allow Fannie and Freddie to retain some of their profits and maintain capital reserves of $25 billion and $20 billion, respectively. 

If, however, retained earnings are the firms’ only source of capital, it could take close to decade to build the required amount. And that’s if everything goes well.

So it would seem that the companies will have to raise capital from outside sources, with a public offering. That option, however, also has a few major hurdles. First, given that $200 billion dwarfs the largest public equity offerings in history, it is not clear that the companies can pull this off even if they build capital through retained earnings for the next several years.

A bigger problem is that the liquidation preference, the mechanism that is supposed to protect taxpayers’ investment, now sits at approximately $200 billion. As the agreement with Treasury stands, to protect taxpayers, Fannie and Freddie cannot exit conservatorship until the liquidation preference is paid off.

So the companies actually need to raise about $400 billion in equity.

It may be argued that the most politically expedient option is to provide yet another bailout so that the companies no longer have to pay off the liquidation preference. There is, however, a much better solution to this problem.

• Reinstate capital standards for Fannie and Freddie.
• Place Fannie and Freddie into receivership and liquidate their assets because they are critically undercapitalized.

These moves will cause a firestorm, but it doesn’t really matter: The FHFA director has legal authority to take these steps, and it’s what should have been done in 2008. Besides, anything the administration does to shrink Fannie and Freddie’s footprint will cause a firestorm. (The shareholders can still have their day in court no matter what.)

Liquidating the two companies would have been the right thing to do in 2008, and it is still the right thing to do. This government-protected duopoly prevents the housing finance market from being competitive and better serving customers’ needs. As the FHFA has said, a competitive market helps people because it “effectively delivers market-affordable prices with customer satisfaction and continual innovation to improve product quality.”