Johnson-Crapo will endanger America’s 5,000 community banks

For the past year, Washington has been engaged in a heated debate over what to do with Fannie Mae and Freddie Mac, the two government sponsored mortgage enterprises (GSEs) that required a taxpayer bail-out in 2008. Since then, both institutions have been conducting operations under a conservatorship directed by the Federal Housing Agency (FHFA).  Under the conservatorship, the U.S. Treasury holds 79.9 percent of the stock and conducts a quarterly “net worth sweep,”  capturing all of the dividends as well as any appreciated stock value.  Consequently, the two entities are unable to recapitalize themselves.

A number of bills are in the hopper that would wind down Fannie and Freddie and replace them with a mortgage insurance fund similar to the Federal Deposit Insurance Corporation (FDIC), including one sponsored by the top Democrat on the Senate Banking Committee, Tim Johnson (S.D.), and the ranking Republican member, Mike Crapo (Idaho).  A committee vote is expected by the end of April.

{mosads}Ironically, as the housing market has recovered, the two companies have more than repaid the $188 billion they received in the bailout–$203 billion as of March 31. And the White House office of Management and Budget recently projected that Fannie and Freddie could generate $367 billion to the Treasury by 2024.  In effect, Fannie and Freddie have become cash cows for the U.S. government.  

While the Johnson-Crapo bill includes provisions to ensure that returns to “senior preferred shareholders”—i.e. the government—are maximized, it doesn’t provide any recourse or recovery for the private holders of Fannie and Freddie’s common and preferred stock who took the investment risks but haven’t benefited from the GSE’s turnaround.

$36 billion in Fannie and Freddie preferred stock was outstanding prior to the conservatorship.  About half is owned by mutual funds, hedge funds, insurance companies, pension funds, and individual investors.  But the other half is held by the banking sector and is counted as Tier 1 capital.  That capital, which helps determine the amount of lending a bank can undertake, is now at risk.  Small, rural and community banks, who were encouraged by bank regulators to buy about $6 billion of Fannie and Freddie preferred stock prior to the conservatorship, are particularly vulnerable.  For example, according to a study by the Federal Reserve, fifteen community bank failures and two distressed mergers can be linked to the government takeover.

Community banks serve a vital economic role in those areas of the country where money center banks don’t operate.  What’s more, relative to their size community banks are prolific small business lenders.  While these banks represent only about 12 percent of bank assets, they account for 40 percent of the dollars loaned to small, minority and women-owned enterprises.  Nearly half of all small business loans under $100,000 are made by community banks while money center banks account for only 22 percent.

America’s small businesses are the key to supporting the country’s economic growth. They represent 99 percent of the nation’s enterprises and employ half of the private sector workforce.  Because 26 million small businesses are responsible for most of America’s job creation, their viability is more important than ever.  To the extent community banks have to write down their capital as a result of possible Congressional action regarding Fannie and Freddie, the pool of lendable funds to small businesses could decline.

Community banks also provide much of the mortgage financing for homes and farms in small towns and rural communities.  More so than money center banks, they rely on Fannie and Freddie to buy their mortgages, thereby providing additional funds to support new loans.  Not only do these institutions face the prospect of constraints on lending should Fannie and Freddie be dissolved, they may also have to pull back if their Tier 1 capital includes GSE stock and that capital is impaired.

Whatever the outcome of the current debate over the future of Fannie Mae and Freddie Mac, it’s imperative that fair consideration and compensation be afforded the GSE’s equity shareholders.  If dissolution is the path chosen, Fannie and Freddie should go through a structured bankruptcy that would allow private investors to seek just financial recovery.  Preferred Fannie and Freddie shareholders, including community banks, should also be compensated for the Treasury’s decision to eliminate all dividend payments.

The Johnson-Crapo bill is the wrong approach to a Fannie and Freddie wind-down.  It is tantamount to an uncompensated government taking that violates the “rule of law” and ignores private property rights.

Low interest rates and the costs of complying with new federal regulations are already squeezing many small banks.  If Johnson-Crapo becomes law, these institutions will see a further impairment of their capital levels that, in turn, will reduce the availability of credit to households and businesses in small towns and rural communities.  

Weinstein is an adjunct professor of business economics in the Cox School of Business at Southern Methodist University in Dallas and a fellow with the George W. Bush Institute.  He was formerly on the board of a large mortgage company.