“It was amazing how little actual authority we had over Fannie and Freddie considering they were entirely dependent on Treasury’s cash to stay alive.”
—Timothy Geithner, Secretary of the Treasury, 2009–2013
Just after Fannie and Freddie were put into conservatorship, Jim Lockhart stepped down as the director of the new agency created to regulate them. He left as acting director Ed DeMarco, the free-market economist who had worked with him on privatizing Social Security—and who had previously recommended the privatization of Fannie and Freddie. While the Obama Administration did try to replace DeMarco, the politics around any appointment that required congressional approval quickly became a manifestation of the increasingly poisonous atmosphere in Washington. And so DeMarco would end up staying in his job for almost six years.
The situation was strange, even by the standards of the GSEs. As a Fannie employee says drily, “It is unusual for a regulator to have a strong point of view that is antithetical to the existence of your regulatee.” That wasn’t the only oddity. DeMarco was a longtime civil servant, and on the surface he appeared to be exactly what you’d expect: mild-mannered and academic. But now he was effectively the CEO of a $5 trillion enterprise on a government salary. Most unusual of all is that DeMarco had a crystal-clear view of what his job as conservator was, and that was to protect taxpayers. There’s an argument that that was not precisely what the law governing conservatorship said (the mandate was to “conserve and preserve” the companies’ assets), but DeMarco would hold true to his view in the face of extraordinary pressure.
In the beginning, it was triage. The market was crashing, home prices were plummeting, and almost everyone thought Fannie and Freddie would be an endless black hole. Quarter after quarter, they posted stunning multibillion-dollar losses, which required huge draws from Treasury. In early 2009, the Treasury amended its agreement to increase the total amount of funding available for Fannie and Freddie from $200 billion to $400 billion—half the 10-year estimated cost of Obamacare. On Christmas Eve, 2009, the Treasury amended the agreement again to remove any cap on the funding for the next three years. In addition, the Federal Reserve began to buy Fannie and Freddie securities to help the perception that they were safe. According to Paul Willen, a senior economist at the Boston Federal Reserve, between 2008 and 2014 the Fed would purchase $2.8 trillion of agency mortgage-backed securities.
Employees of Fannie and Freddie, now dubbed the “Toxic Twins,” were demoralized by the flood of criticism, and under the terms of the conservatorship they weren’t allowed to say anything to defend themselves. They weren’t allowed to lobby, or even go to conferences, talk to academics or thought leaders, write op-eds, or attend outside meetings without permission (which, says an employee, was often withheld). “We had no voice,” says a former executive. “So the philosophy was, ‘Head down, focus on what you can do. We do not want the company to be remembered this way. We’ve got to fix this’.”
Private capital totally disappeared from the mortgage market. By the end of the year, Fannie and Freddie, along with Ginnie Mae, accounted for about 97 percent of mortgage-backed securities issuance, according to the Government Accountability Office.
Over the next few years, Treasury and Fannie and Freddie would roll out a variety of programs to try various ways to help people stay in their homes. In the beginning especially, the programs didn’t work very well. This led to fury because, in people’s minds, the government, which had done so much to help the banks, wasn’t doing enough to help homeowners.
There were bitter battles over these programs. The biggest one was over principal reduction, or whether the administration should enable the write-down of mortgages that were larger than the value of the homes. By the fourth quarter of 2009, according to research firm CoreLogic, 24 percent of borrowers, or 11.3 million mortgages, owed more than their homes were worth, for a total of around $700 billion in negative equity. The numbers would get worse before they got better. Many borrowers will walk away from their mortgage in such circumstances; the default hurts the borrower, the lender, and everyone else in the neighborhood when the now-empty house gets trashed. So why not have a program that forgave the amount of the loan that was greater than the value of the house?
The fight over principal forgiveness became one of the ugliest parts of the post-crisis landscape. Republicans were opposed to it. The prospect that the government would bail out borrowers became a spark for the Tea Party movement. There were a lot of real issues, despite the headline appeal of principal forgiveness. Take two neighbors, one of whom borrowed responsibly, and one of whom did a cash-out refinancing in order to buy a boat and go on vacation. How does the first feel if he gets nothing, while the second has his debt forgiven? Next, who was going to pay for it? Investors? Taxpayers? There was $50 billion in the Troubled Asset Relief Program that was supposed to be dedicated to keeping people in their homes. Most of it hadn’t been spent, which was a source of great anger among progressives. But even $50 billion wouldn’t buy much.
Initially, it seemed that the administration and DeMarco were of the same skeptical view. Obama’s political team was afraid that principal reduction would feed into the narrative that the president wasn’t out to protect the responsible middle class but just the rich and the poor, according to a former official. Yet by 2011, a lot had changed. The entire progressive base fixated on principal reduction as the issue. The lack of it began to feed a narrative of unfairness to the little guy, in contrast to the largesse given to the big banks. That there was money at all left in TARP was a constant source of criticism of the administration. Why hadn’t it been used to help struggling homeowners? The political team began to believe it was important to fire up the base before the election, says a former official. Most of all, President Obama very much wanted action. Treasury Secretary Timothy Geithner had originally been opposed to principal reduction, but his team began to argue that it could make sense for a targeted set of underwater borrowers with Fannie- and Freddie-backed loans, and Geithner came around to that view.
DeMarco did not agree. In 2012, he got a call from Treasury, which told him that it was going to use the leftover TARP money to triple the incentives offered to investors to do principal reductions. So he should get with the program too. DeMarco said he’d study it, and study it he did. Fannie and Freddie’s analysis showed that under a best-case scenario, principal reduction could save money, because borrowers would pay their reduced mortgages instead of defaulting. But as soon as you factored in even a small number of people who were paying their mortgages but would choose not to as soon as they had the option—this is called strategic default—the program quickly imposed a significant loss on taxpayers. Almost 90 percent of homeowners with a GSE-guaranteed mortgage were paying. (Indeed, according to a Congressional Budget Office analysis, while Fannie and Freddie owned or guaranteed some 60 percent of outstanding mortgages, they had only 30 percent of the underwater mortgages.) Why risk a hit to taxpayers?
So on July 31, 2012, DeMarco said he wouldn’t do principal reduction. He’d shared all of FHFA’s analysis with Treasury. Less than ten minutes later, Geithner fired back a letter saying that the GSEs’ own analysis showed that principal reduction could help up to half a million borrowers and save several billion dollars. The core difference was in their views of the risk of strategic defaults, which Treasury argued was minimal. “You have the power to help more struggling homeowners and heal the remaining damage from the housing crisis,” Geithner wrote to DeMarco. But DeMarco would not budge.
Treasury officials, and at least some of the National Economic Council economists, thought DeMarco’s view was ridiculously narrow. Taxpayers, after all, would benefit from what benefited the broader economy. “The White House couldn’t believe it,” says a former official. “You’ve got the NEC, HUD, and Treasury saying, ‘These are the numbers,’ and this guy who is not even confirmed is completely blocking us. There was nothing we could do.” Geithner was furious. By the fall of 2012, people were picketing outside DeMarco’s modest house in Silver Spring, Maryland, chanting “Ed DeMarco, we’re coming for you.” Time ran a story headlined, “Is This Man Single-Handedly Stifling the U.S. Housing Recovery?” In 2013, a group of state attorneys general publicly called on President Obama to fire DeMarco.
The widespread view of Ed DeMarco was that he was just a right-wing lapdog who was morally opposed to principal reduction. But that’s as much a misreading of him as it would be to argue that he was trying to help save Fannie and Freddie by limiting their losses. What he was trying to do was to save taxpayers money. He might well have been right. Economist Paul Willen argues that for struggling borrowers, it is much more important to reduce monthly payments than it is to reduce principal, and Fannie and Freddie have done that.
(You can see proof of DeMarco’s determination to minimize the losses to taxpayers in something else he did. In 2011, DeMarco’s FHFA sued 18 big banks, seeking to recover losses on a total of roughly $200 billion in private-label securities that the banks had sold to Fannie and Freddie. The lawsuits alleged that the banks had violated securities laws and, in some instances, committed fraud, because the quality of the underlying mortgages in their securities was so much worse than they had represented. Although most banks settled—to date, Fannie and Freddie have collected roughly $18 billion in settlements—they complained bitterly that the FHFA was being far too aggressive and insisted that they did nothing wrong, a stance that mirrors their overall defense of their behavior during the boom. Two banks, Nomura Securities and the Royal Bank of Scotland, even took the case to trial, providing a rare public airing of their behavior. In a scathing 361-page decision, Judge Denise Cote of the Federal District Court in Manhattan ruled against them. “The magnitude of falsity, conservatively measured, is enormous,” she wrote.)
Still, as time went on, you could see that DeMarco, true as he was to his responsibilities as he defined them, certainly hadn’t changed his underlying views on Fannie and Freddie. “Ed started as a good little civil servant and at first it was, ‘I’ll just try to keep the lights on and you tell me what to do,’” says someone who knows him well. “But bit by bit, he got more aggressive, because he got frustrated by the lack of a broader policy.” A former Fannie executive explains DeMarco this way: “At some point, Ed said, ‘You’re not going to be able to get rid of me. I’m the conservator. If no one is making policy, I’ll make policy!’“
Everything DeMarco did seemed to be designed to prepare the mortgage markets for the day when Fannie and Freddie no longer existed. (Which was in keeping with what the administration was saying it wanted.) For example, Fannie and Freddie began to build a new system for turning mortgages into securities, one that would be available to anyone, so that when private investors came back to the mortgage market, they could simply plug into it. Under DeMarco’s prodding, the GSEs steadily increased their guarantee fees for new mortgages. Fannie Mae’s average effective guarantee fee on new loans tripled from 21 basis points in the first quarter of 2009 to 63 basis points in the first quarter of 2014. In December 2013, DeMarco proposed another hike in guarantee fees. He also began charging extra fees for riskier mortgages in order to decrease the amount of cross-subsidization in the system. The whole idea was that as the cost of Fannie and Freddie’s insurance policy rose, the private sector would see an opportunity to make money, and come back into the market.
“DeMarco is very smart,” says Franklin Raines. “He pushed the ball further and did more to reduce Fannie’s and Freddie’s role in the future than anyone else.” He adds: “It was brilliant. I thought he’d get away with it.”