The following post comes to us from Brent J. Horton, Associate Professor at Fordham University’s Gabelli School of Business. It is based on his recent paper entitled “For the Protection of Investors and the Public: Why Fannie Mae’s Mortgage-Backed Securities Should be Subject to the Disclosure Requirements of the Securities Act of 1933,” which is forthcoming in the Tulane Law Review and is available here.
Increased risk-taking at Fannie Mae in the years preceding the financial crisis led to massive losses for the company, and unfortunately, a $116 billion taxpayer bailout in 2008. The back story: from 2002-2007, Fannie Mae had issued—and personally guaranteed—securities backed by risky mortgages (“mortgage-backed securities” or “MBS”). The guarantee required Fannie Mae to “supplement amounts received by the MBS trusts as required to permit timely payments of interest and principal.”[1] When borrowers began to default in large numbers, investors called Fannie Mae on its guarantee. Unfortunately, Fannie Mae did not have enough cash set aside, so taxpayers footed the bill (pursuant to an implicit federal guarantee that became explicit).[2]
However, what to do about excessive risk-taking at Fannie Mae has eluded lawmakers in Washington. Dodd-Frank ignored Fannie Mae. More recently, the Housing Finance Reform and Taxpayer Protection Act of 2014 (Johnson-Crapo) was voted out of the Senate Committee on Banking, Housing and Urban Affairs.[3] Johnson-Crapo would wind down Fannie Mae and allow private entities to assume its secondary market function. Rather than Fannie Mae guaranteeing returns on MBS, a new entity will provide that guarantee, the Federal Mortgage Insurance Corporation (FMIC). The FMIC guarantee would be funded by private companies that choose to participate in the new housing finance system (i.e., a tax on issuers).[4] However, Senator Schumer, Senator Warren, and other key democrats recently pulled their support for Johnson-Crapo and it appears dead.[5]
The apparent demise of Johnson-Crapo opens the door for a better way to reduce risk-taking at Fannie Mae: use the Securities Act of 1933 to regulate Fannie Mae’s MBS issuances. Securities Act disclosure would reduce risk taking at Fannie Mae by spotlighting risk. Information will allow investors in Fannie Mae’s MBS to better use market mechanisms to “discipline” Fannie Mae by requiring a discount up front, or a higher return on the back end; and information will allow the taxpaying public to better influence the “amount and mix of public sector expenditures” through pressure on their representatives in Washington.[6]
Currently Fannie Mae’s MBS are not registered, and any disclosure is voluntary—and as I discuss in my Article, Fannie Mae’s voluntary disclosure is deficient. Thus, Fannie Mae’s MBS are distinguishable from private-label MBS, which issuers must register with the SEC. Private-label MBS are offered via prospectus meeting the disclosure requirements of the Securities Act of 1933, and more importantly, the particularized disclosure requirements of Regulation AB.[7] Regulation AB requires that private-label MBS issuers disclose loan-to-value ratios, Fico scores, and whether those risks are layered into the same mortgages (which were purchased and securitized into MBS). Regulation AB also requires information about the originators of the purchased mortgages.
Unfortunately, memories are short. The urgency behind reform has lessened as Fannie Mae has returned to profitability, paid back much of the Treasury bailout, and even regained “some of its old swagger.”[8] However, the reality is that those profits are the result of Fannie Mae being the last entity standing (because of the taxpayer funded bailout); most of Fannie Mae’s private-label competitors were wiped out by the 2008 financial crisis. It is not hard to return to profitability when you have a virtual monopoly over an entire industry. According to SIFMA, Fannie Mae issued $734 billion in MBS in 2013,[9] while private-label issuers during the same time period issued only $8.1 billion in MBS.[10]
The reality of the situation is best reflected in recent comments by former White House economist Austin Goolsbee. As recounted in the Wall Street Journal: “In a 2011 meeting with the president, . . . Goolsbee compared Fannie and Freddie with comic-book villains that had been captured and imprisoned in a cell on the ocean floor. It would be folly, he said, to turn the companies loose because they promised to behave.” Goolsbee concluded, “[i]f Fannie and Freddie are allowed to return to their old business model, then shame on us as a nation.”[11]
[1] Fed. Nat’l Mortg. Ass’n, Single Family MBS Prospectus 6-10 (Mar. 1, 2013) , available here. It is important to note that the Fannie Mae’s prospectus is created voluntarily, and does not satisfy the substantive requirements of section 10 of the Securities Act of 1933. “Section 10(a) establishes requirements for so-called statutory prospectuses (also referred to as the final prospectus) that must be delivered prior to or at the time of the sale of a publicly offered security pursuant to Section 5(b)(2).” Joseph A. Franco, A Consumer Protection Approach To Mutual Fund Disclosure And The Limits Of Simplification, 15 Stan. J.L. Bus. & Fin. 1, 11 n.15 (2009) (citing Gustafson v. Alloyd Co., 513 U.S. 561, 569 (1995)).
[2] See David Reiss, The Federal Government’s Implied Guarantee Of Fannie Mae And Freddie Mac’s Obligations: Uncle Sam Will Pick Up The Tab, 42 Ga. L. Rev. 1019 (2008) (predicting that the federal government would bail out Fannie Mae and Freddie Mac).
[3] Senate Banking Committee Passes Bipartisan Housing Finance Reform Legislation, May 15, 2014, available here.
[4] Summary of Senate Banking Committee Leaders’ Bipartisan Housing Finance Reform Draft, available here.
[5] Ben Lane, Schumer, Warren, other key Democrats will not support Johnson-Crapo, Housingwire, May 8, 2014, available here.
[6] Ann Judith Gellis Mandatory Disclosure for Municipal Securities: A Reevaluation, 36 Buff. L. Rev. 15, 20 (1987). Professor Gellis—in the context of municipal securities—suggested that disclosure has a secondary audience, the taxpaying public, who are ultimately responsible for the obligation. The same is certainly true for Fannie Mae’s MBS. Id. The argument was recently renewed by Professor Christina Sgarleta Chung in Municipal Securities: The Crisis of State and Local Government Indebtedness, Systemic Costs of Low Default Rates, and Opportunities for Reform, 34 Cardozo L. Rev. 1455, 1468-69, 1475-77 (2013). Professor Chung points out that that while the risk of investing in municipal securities is low, that is because the risk is shifted to municipal taxpayers who are forced to take on the risk of default—or more precisely, default avoidance—by paying higher taxes. Id.
[7] Regulation AB, 17 C.F.R.§§ 229.1100-229.1123 (2010) (listing additional disclosures for MBS).
[8] Nick Timirous, Five Years Later, Fannie Mae, Freddie Mac Remain Unfinished Business, Wall St. J., Sept 6, 2013, available here.
[9] Fannie Mae now controls 46% of the MBS market while private-label issuers control less than 1% (Freddie Mac and Ginnie Mae each control 27% respectively). Statistics, Sec. Indus. & Fin. Mkts. Ass’n, http://www.sifma.org/research/statistics.aspx (under “structured finance” header, follow “US Agency Mortgage-Backed Securities Issuance and Outstanding”).
[10] See Statistics, Sec. Indus. & Fin. Mkts. Ass’n, http://www.sifma.org/research/statistics.aspx (under “structured finance” header, follow “US Mortgage-Related Securities Issuance”).
[11] Timirous, supra note 8.