The Rescue of Fannie Mae and Freddie Mac – Module A: The Conservatorships

The government passed HERA in July 2008 to provide enhanced resolution alternatives to the GSEs’ regulator in light of the severely weakened condition of the firms, their critical role in the stability of the mortgage and housing markets, and the stresses then impacting those markets (among other things) (Frame et al. 2015, 14). Prior to HERA, OFHEO (Office of Federal Housing Enterprise Oversight, former GSE regulator) could have taken the firms into conservatorship, but there existed no viable funding to support such a move, largely rendering the authority ineffective (Frame et al. 2015, 5). Also, the GSEs were exempt from the US bankruptcy code, and there was no authority for OFHEO to place them in receivership (Frame et al. 2015, 18–21). HERA created a new regulator, the FHFA, and provided mechanisms for Treasury to fund the firms during an emergency period, ensuring their solvency during a conservatorship (Frame et al. 2015, 18–21). HERA also provided the FHFA expanded authority to place the firms into receivership if necessary (Frame et al. 2015, 18–21). (See Thompson and Kulam (2021) for more information regarding HERA.)

W. Scott Frame et al. (2015) dismiss the claim that Treasury could have stabilized the GSEs by simply buying their debt or MBS without a formal apparatus (21). Noting the amount of capital required to stabilize the GSEs, Frame et al. argue that the Treasury needed a mechanism to ensure that it could continuously fund the GSEs in the needed amounts (which were unknown at the time, but estimates of which were in the tens of billions) (Frame et al. 2015, 21). As such, Treasury required a government intervention to establish and operate such a mechanism (Frame et al. 2015, 19). Operating with the common understanding that the government needed to save the GSEs, Frame et al. identify three options that government officials could have taken.

Nationalization. The first option was nationalization, which Frame et al. (2015) define as purchasing and controlling at least an 80% equity stake in each company (21). The government considered this option the least favorable because the government would have been compelled to assume all liability for Fannie Mae and Freddie Mac and to consolidate their operations onto its balance sheet (Frame et al. 2015, 21).

However, the definition of the term “nationalization” is fluid, unlike the definitions of “conservatorship” and “receivership” (which are discussed later) (Elliott 2009, 7). For the purposes of this paper, “nationalization” refers to the government gaining a controlling interest in a company (one that might be greater than 50% but less than 80%) such that it is empowered to make or influence critical decisions about how the company operates. Nationalization can be accomplished in a variety of ways but does not denote application of a specific, prescribed administrative process, such as conservatorship or receivership, or the FDIC bank resolution process, although such processes may be employed (Elliott 2009, 13–15). 

In light of this working definition, the government could have nationalized the GSEs by making—via Treasury—a substantial financial contribution and gaining via contractual agreement (such as a stock purchase agreement, memorandum of understanding, or shareholders’ agreement) certain constraints on the GSEs operations (Lockhart 2018, 12). (Also see Appendix B.) However, taking control of the GSEs without the benefit of a known and predictable framework could have created operational and legal messes (Jester et al. 2018, 7). Treasury’s ability to operate the companies would still have been subject to management’s compliance with the operative contract and complicated by the need to comply with various regulations regarding preservation of the GSE charters (Lockhart 2018, 12). Treasury Secretary Paulson was of the opinion that such an arrangement would not adequately protect the taxpayers and, thus, would not agree to contribute capital to the GSEs without their being in a conservatorship or receivership (Jester et al. 2018; Lockhart 2018, 12).

Receivership. After the passage of HERA, receivership was a second viable option available to the government (Frame et al. 2015, 18). The intent of a receivership is to wind down an organization rather than merely stabilize it and have it continue operations (Jester et al. 2018, 7). Under HERA, invoking a receivership would mean the application of timelines and the need for a bridge entity since the GSEs could be dissolved only by an act of Congress (Frame et al. 2015, 18–19). Additionally, the FHFA would be compelled to reform the firms as they were released from receivership, which would have been required in five years (Frame et al. 2015, 20). However, the structure of the GSEs had been debated for years, and Congress had yet to resolve those concerns (Frame et al. 2015, 20).

Dan Jester served in Paulson’s Treasury during the rescue and, with other Treasury officials, questioned the feasibility of setting up the receiverships in time to be effective (Jester et al. 2018, 7). They doubted the GSEs would acquiesce to such a forceful intervention and worried the firms would respond by filing lawsuits and drumming up congressional opposition to it (Jester et al. 2018, 7). Secretary Paulson also worried that receiverships might also “spook the markets” and might put some debtholders at risk, increasing instability of some banks and other financial institutions (Lockhart 2018, 12). Moreover, even if the receiverships were put in place, Jester et al. expressed doubt that the FHFA—a new agency with “no institutional experience managing a receivership”—was up to the task of overseeing the successful implementation of one (Jester et al. 2018, 7).

Conservatorship. The final option was conservatorship. Although a conservatorship could last indefinitely, it was seen as a temporary measure that would allow the government to take control of the companies and stabilize them for continued operation, while Congress considered how to address the more contentious structural aspects of the GSEs’ special status (Frame et al. 2015, 20; Jester et al. 2018, 7). Conservatorship also was seen as an option that could be implemented swiftly, which was important given the rising number of concerns at other major financial institutions that were debtholders (Frame et al. 2015, 20; Jester et al. 2018, 7–8).

Most importantly, however, conservatorship allowed the GSEs to continue their operations and supply the secondary mortgage market, something critically needed as the private market severely contracted (Frame et al. 2015, 26–27; Jester et al. 2018, 7). The efficacy of this option hinged on the Treasury’s ability to finance the conservatorship, which was made possible by HERA (Frame et al. 2015, 19). Frame et al. (2015) note that if the Treasury could not have financed the conservatorship, then receivership would have been the best option (20). HERA also included a clause that allowed the FHFA to later place the GSEs into receivership from conservatorship (Frame et al. 2015, 21). However, James Lockhart, then director of the FHFA, stated that this was something that his agency never seriously considered (Lockhart 2018, 8–10). See Appendix B for a comparison of the attributes of the three possible solutions and see Wiggins et al. (2021) for further discussion of the conservatorship decision.

Secretary Paulson identifies secrecy, speed, and timing as the three aspects in the execution of Fannie Mae and Freddie Mac’s conservatorship that avoided a protracted battle with the GSEs, news leaks to the public, and a major market swing (Paulson 2010, chap. 1). After keeping the conservatorship discussion (and later the conservatorship decision) a secret for several weeks, Paulson, FHFA Director Lockhart, and Fed Chairman Ben Bernanke presented the option to Fannie Mae and Freddie Mac’s CEOs with no warning (Paulson 2010, chap. 1). These officials knew that the CEOs might fight to keep their positions and thus gave them no time to publicize the conservatorship or solicit assistance from their political contacts on Capitol Hill (Paulson 2010, 75–76). Paulson feared that if either CEO decided to resist the conservatorship, they could delay its implementation and instigate panic in the markets (Paulson 2010, 75–76).

Federal officials also met with Fannie Mae’s CEO and executive board first, since they anticipated that Fannie Mae’s team would be more resistant to the idea (Paulson 2010, 83–84). Federal officials took caution to avoid any press coverage of the event and selected the FHFA’s office as the location for their private meetings with Fannie Mae and Freddie Mac (Paulson 2010, 83–84). They arranged for the first meeting with Fannie Mae to start at 4:00pm on Friday, September 5 so that the markets would have closed before the meeting had finished (Paulson 2010, 83–84). After each meeting, they informed members of the House Financial Services Committee and Senate Banking Committee, so that they would not be surprised when the news broke to the public (Paulson 2010, 87–93). Lockhart and Paulson announced the conservatorships as part of a four-part rescue plan for the GSEs on Sunday, giving the public an opportunity to react before markets reopened on Monday (Paulson 2010, 95–98).

The FHFA has used plans, reports, and scorecards to disseminate information and increase public transparency regarding the conservatorships. On December 15, 2008, the FHFA released its first annual performance plan, for fiscal year 2009. The plan outlined the FHFA’s objectives for the GSEs and detailed how it would use its resources to achieve those objectives (FHFA 2008e). Beginning in 2010, the FHFA also released a quarterly Conservator’s Report on the Enterprises’ Financial Performance, which summarized the fiscal health of both enterprises under conservatorship; the report lasted through the first quarter of 2013 (FHFA 2013). In 2012, the FHFA began to release an annual scorecard, which was designed to make the FHFA’s duties and objectives more transparent for the public (FHFA 2012b; FHFA 2021). The FHFA also continued the practice of publishing the GSEs’ annual examination results within the annual reports to Congress.

Through its regular reports, the FHFA identified at least two reasons for governing the GSEs transparently: (1) to increase public confidence in the GSEs and foster secondary mortgage market activity, and (2) to inform taxpayers FHFA’s efforts to prevent foreclosure (FHFA 2008d, 137–46; FHFA 2009b, 61–62). In addition, DeMarco, who replaced Lockhart in 2009 as FHFA acting director, acknowledged that taxpayer funds kept Fannie Mae and Freddie Mac in operation (DeMarco 2010, 3). For this reason, DeMarco pledged to outline how the FHFA had limited, and would continue to limit, GSE losses (DeMarco 2010). Additionally, as the GSEs by their size were systemic in nature, many investors around the world were paying attention to developments with respect to the conservatorships (Paulson 2010, 77–78).

When the FHFA placed Fannie Mae and Freddie Mac into conservatorship, it also replaced the firms’ CEOs and appointed new nonexecutive chairmen of the boards (FHFA 2008b). Secretary Paulson expressed the gravity of the intervention to justify firing the GSEs’ CEOs (Paulson 2010, 93–94). When asked for his rationale to fire Fannie Mae’s CEO, he replied, “I don’t think that you could do something this drastic and not change the CEO” (Paulson 2010, 93–94). FHFA director Lockhart justified removing the GSE boards with similar logic and noted, “Although it is not necessary in a conservatorship, new boards are being formed as a matter of good governance” (Lockhart 2008).

As conservator, the FHFA ascended to all authority of the boards and management but eventually delegated some of that authority back to the new board and management while retaining a right of review (DeMarco 2010, 3–4). Even under conservatorship, in exercising their authority, the GSE officers remained “subject to the legal responsibility to use sound and prudent business judgment in their stewardship of their companies” (DeMarco 2010, 3).

The FHFA adopted this approach to save money, to increase public confidence in the two GSEs, and most importantly, to keep the GSEs operating. After enacting the conservatorship, the FHFA froze the GSEs’ dividend payments and shareholder voting rights (except for Treasury’s senior preferred stock) (Fannie Mae 2008b, 21). The FHFA estimated that freezing dividends would save the GSEs about $2 billion in reserve capital annually (FHFA 2008b). The GSE stock remains outstanding, but there is no guarantee that it will be restored to its full rights when the firms exit the conservatorships (Fannie Mae 2008b, 50; FHFA 2008c, 3).

Given Treasury’s funding commitment to guarantee GSE solvency (up to the stated limits), the GSE bondholders were protected (Jester et al. 2018, 8–9). Federal officials recognized that protecting bondholders was critical to minimize immediate risks to the financial system, to protect future investors in debt and MBS, and to quiet any concerns about the government’s credibility (Lockhart 2009; Paulson 2010; UST 2008). On the day after Fannie and Freddie entered conservatorship, FHFA announced that conservatorship did not change the legitimacy of current and future financial contracts (FHFA 2008a; Lockhart 2008). Important factors supporting the government’s decision to protect all holders of debt and MBS included: (1) the sheer size of the GSEs’ liabilities, (2) the nature of the bondholders, and (3) the GSEs’ close alignment with the government (Jester et al. 2018, 8–9; UST 2008). 

GSE debt and obligations benefited from an “implied government guarantee,” which helped them enjoy a robust market with their debt being widely held (Frame et al. 2015, 1). Much of this debt was held by foreign central banks and foreign and domestic financial institutions that believed that GSEs’ securities were effectively risk-free (UST 2008). Secretary Paulson felt that allowing the international debtholders to suffer losses could undermine foreign investors’ confidence in the United States’ creditworthiness, which could cause a run on the dollar or a Treasury sell-off (CBO 2010, 22; Paulson 2010, 77–78). Also, many domestic banks, which were already under stress, held GSE debt due to favorable capital rules (Rice and Rose 2016, 7–9).

The government’s actions, in essence, made the implied guarantee firm, which seems to have increased confidence in the GSEs, which Lockhart (2008) and Frame et al. (2015, 22) argue is evidenced in falling yields—at least before Lehman Brothers collapsed. (See also Wiggins et al. [2021] for further discussion of these points.)

To manage the conservatorships, the FHFA established a new infrastructure^FThe FHFA described efforts to enhance its governance practices through various white papers and annual reports (FHFA-OIG 2015, 13). consisting of the Office of Conservatorship Operations and the Conservatorship Governance Committee (FHFA-OIG 2012a, 20–21). The OCO acted as the liaison and administrator between the GSEs and the FHFA, relying on FHFA resources to resolve issues (FHFA-OIG 2012a, 20–21). The CGC was composed of senior FHFA executives whose goal was to “ensure coordination on regulatory or supervisory matters that might need to be brought to the attention of the conservator” (FHFA-OIG 2012a, 21).

Because the OCO employed only six people, the OCO also relied on the regulatory resources throughout the FHFA to evaluate the GSEs’ success in achieving these goals and address conservator issues (FHFA-OIG 2012a, 21; FHFA-OIG 2012b, 22–23). One audit report highlights the possible tensions that may arise from FHFA’s status as both conservator and supervisor: “For example, FHFA could potentially be faced with criticizing its own actions or those of its senior officials” (FHFA-OIG 2012a, 30). The Office of Inspector General also noted that the conflict was partly addressed by the delegation of most management decisions to the enterprises’ boards and managers (FHFA-OIG 2012a, 30).

The FHFA defended its original structure and claimed that the unknown duration of conservatorship prevented the agency from making long-term investments in its own infrastructure (FHFA-OIG 2012a, 31–32).

Nevertheless, the FHFA agreed with most of the OIG recommendations and took steps to implement them (FHFA-OIG 2012b, 31–37). As it became more apparent that the GSEs would not soon exit the conservatorship, the FHFA refined its strategic plans and evaluation mechanisms by developing a reporting scorecard; establishing an approval tracking and resolution process; and in 2013, consolidating all conservator functions into a Division of Conservatorship, which employed 25 people as compared to the previous six-person OCO (FHFA-OIG 2012b, 9–11; FHFA-OIG 2015, 11, 14).

The FHFA’s inspector general (IG) noted that a conservator generally can take one of three approaches: “Actively managing every aspect of an entity’s operations; Monitoring the conserved entities’ decision-making and stepping in when it feels it is appropriate; or deferring to the conserved entity on most decisions and stepping in only in cases of greater significance” (FHFA-OIG 2012a, 22). The IG noted that FHFA had taken the third approach.

FHFA has determined to (1) delegate authority for general corporate governance and day-to-day matters to the Enterprises’ boards of directors and executive management, and (2) retain authority for certain significant decisions. (FHFA-OIG 2015, 11–12)

Within three months of establishing the conservatorships, the FHFA had delegated significant authority to the new boards of directors and CEOs (FHFA-OIG 2012a, 22, 30). It did this as an efficient way to run the massive businesses consistent with the tenets of the conservatorship—to manage the firms as going concerns, stabilize them financially, and return them to independent operation (FHFA-OIG 2012a, 23). However, it’s important to note that the FHFA retained authority over a group of key business decisions, for which it required the GSEs to seek prior approval (FHFA-OIG 2012a, 19–20). These powers were referred to as nondelegated authorities (FHFA-OIG 2012b, 6). Among other things, these included capital actions, compensation policies, and other large transactions, including legal settlements, merger activities, and deals with subsidiaries (FHFA-OIG 2012a, 19–20). (See Figure 2 for a summary of the nondelegated authorities.) In addition to specified nondelegated authorities, the FHFA retained the right to review (and to overturn) any other business decision it deemed important along the way (DeMarco 2010, 3–4).

The FHFA cited three reasons in defense of its style of conservatorship: efficiency, concordant goals, and operational savings (FHFA-OIG 2012a, 23–24). The GSE employees knew the business and were well equipped to continue to carry out normal business operations (FHFA-OIG 2012a, 23). The goals of the enterprises were consistent with those of the conservatorships, i.e., return the firms to stability: “FHFA views part of its ‘preserve and conserve’ mandate to include preserving the entities as private companies with the capacity and responsibility to make business decisions following normal corporate governance procedures” (FHFA-OIG 2012b, 31). Acting Director Edward J. DeMarco suggested that delegating authority to GSEs created operational savings because FHFA avoided duplicating work that the GSEs were already doing (FHFA-OIG 2012a, 23–24).

Instead, the FHFA communicated with the GSE employees about the conservatorship and tried to maximize retention (FHFA-OIG 2012a, 13). The OCO and the CGC worked to ensure that the firms were operating in a manner consistent with their delegations of authority, the stated conservator goals, and the overall objectives of the conservatorship (FHFA-OIG 2012a, 20–21).

However, the OIG found that the agency’s practices were flawed:

FHFA-OIG’s reports consistently have revealed two trends: (1) the Agency, in its role as a conservator, does not independently test and validate Enterprise decision-making; and (2) the Agency, in its role as a regulator, is not proactive in its oversight and enforcement. In addition, FHFA may not have enough examiners to meet its oversight responsibilities. (FHFA-OIG 2012a, 2)

As a result of these procedures, the OIG criticized FHFA for not overseeing several major decisions that the GSEs made (FHFA-OIG 2012b, 12–13). These included changes to Fannie’s single-family underwriting standards and the High Touch Servicing Program, whereby Fannie Mae transferred $1.5 billion in mortgage servicing rights to third-party specialty servicers (FHFA-OIG 2012b, 12–13). The inspector general also found that the agency often failed to question decisions that were submitted to it for approval and relied too often on management’s decision without an independent proof or business case (FHFA-OIG 2012b, 20–22).

Additionally, the OIG concluded that the agency could better accomplish its oversight mission by proactively exerting greater control over its conservator approval process:

Specifically, FHFA-OIG recommends that the Agency: (1) revisit FHFA’s non-delegated authorities to ensure that significant Enterprise business decisions are sent to the conservator for approval; (2) guide the Enterprises to establish processes to ensure that actions requiring conservator approval are properly submitted for consideration; (3) properly analyze, document, and support conservator decisions; and (4) confirm compliance by the Enterprises with conservator decisions. FHFA agreed with most of FHFA-OIG’s recommendations.” (FHFA-OIG 2012b, sec. “At a Glance”)

The GSE intervention was designed to keep the firms in operation so that they could “continue to fulfill their mission of providing stability, liquidity, and affordability to the [mortgage] market” (FHFA 2009a, ii). As a result, under the conservatorship, the FHFA directed the GSEs to continue their key business operations and MBS securitizations and placed no restrictions on the amount of MBS they could issue or guarantee (FHFA 2008d, 92). Under the SPSPAs, they also were allowed to expand their portfolios for a short time—up to a limit of $850 billion—before having to start reducing them in 2010 (UST/Fannie Mae 2008, 9). The GSEs’ ability to continue operations was especially critical early in the conservatorship; when private-label securitization shrank during the global credit crisis, the GSEs assumed a still larger role in the housing market and purchased a greater proportion of new mortgages (OFHEO 2008, 9–17).

The GSEs’ housing mission was also targeted to assist with the government’s wider foreclosure prevention efforts. At the end of 2008, FHFA reported the GSEs were “playing an important role in assisting the federal government in foreclosure mitigation activities” (FHFA 2009a, 4). Less than one year after the conservatorship began, the GSEs started to participate in the Home Affordable Refinance Program (HARP) and Home Affordable Modification Program (HAMP) (FHFA 2010b, 7–8). HARP and HAMP were intended to serve the dual goals of limiting GSE credit losses and alleviating wider mortgage market stress, both of which were important for the GSEs’ long-term stability (DeMarco 2010, 5; FHFA 2009a, 85–87; FHFA 2010b, 7–8).

During the mortgage crisis, the government continued to prioritize affordable housing goals and relied on Fannie Mae, Freddie Mac, and the Federal Home Loan Banks to meet them (CBO 2010, vii; Lockhart 2009). Through HERA, FHFA received the authority to enforce these goals (which had previously rested with the US Department of Housing and Urban Development) but mandated a change in the way they were structured beginning in 2010 (FHFA 2010b, 3–4). Within the first year of the conservatorship, the FHFA adjusted its affordable housing goals to account for prevailing market conditions (Lockhart 2009). By the end of 2010, a new structure was in place, and the GSEs were required to meet four core single-family goals, one multifamily “special affordable” goal, and two related subgoals, on an annual basis (FHFA 2011, 97).

Through HERA, the FHFA had the power to review any decision affecting executive compensation and could amend GSE compensation practices as it saw fit^FThese broad authorities over executive compensation were granted as part of the arrangement enabling Treasury to purchase GSE obligations. Like Treasury’s purchasing authority, these powers were temporary and set to expire December 31, 2009. However, on a permanent basis, HERA gave the FHFA other powers over executive compensation, including the authority to withhold executive compensation and prohibit severance payments. For more information, see Sections 1113, 1114, and 1117 of HERA (Public Law 110-289). (FHFA 2009a, 84).

During the conservatorship, acting FHFA Acting Director DeMarco (who replaced Lockhart in September 2009) identified enabling the GSEs to retain and recruit talented executives as key to fulfilling his agency’s mission as conservator (DeMarco 2011). Without competent executives, the two firms were at high risk of running into trouble yet again—an operational risk that could result in more losses and potentially add billions of dollars to the steep price taxpayers already had paid (DeMarco 2011).

Early in the conservatorship, the GSEs endured “key person risk” to their human resources (FHFA 2010b, 17–18, 41). FHFA officials argued that potential downsizing, possible dechartering, and general public scrutiny could have motivated executives to leave (FHFA 2010b, 17–18, 41). To offset its key person risk, the FHFA set out to adjust executive compensation policies to give talented executives more of an incentive to stay (FHFA 2010b, 17–18, 41).

After consulting with Treasury (including the Special Master for TARP Executive Compensation) and the boards of both firms, and retaining a private consulting firm (Hays Group) to serve as advisor, the FHFA instituted a three-pronged executive compensation policy at both firms (DeMarco 2011). FHFA designed the new system to both motivate high-performing executives to stay and curb the GSEs’ pre-conservatorship excesses (DeMarco 2011). For example: FHFA prohibited the golden parachutes that were formerly promised to outgoing CEOs and other senior executives (DeMarco 2011). Although prior executive compensation policies included company stock, FHFA pivoted to a cash-only compensation scheme because regulators sought to prevent executives from taking excess risks to raise the low prices of their company shares (DeMarco 2011).

The new system provided for three components of executive compensation—(1) base salary, (2) deferred salary, and (3) performance-based incentives—and was modeled after policies put in place at “institutions receiving exceptional TARP assistance” (DeMarco 2011). Important aspects of these components are highlighted below:

• Except for a few top executives, maximum base salaries was set at $500,00—less than half of what they were prior to conservatorship.
• Performance-based compensation was determined using only two years of results given the lack of a clear long-term plan for the firms.
• Deferred salary was paid out a year after the base portion and was to be forfeited by officials choosing to leave before the year’s deferred payments were due.
• Deferred payments made up the largest portion of top executives’ total compensation packages. (DeMarco 2011)

In March 2011, the FHFA-OIG published a report analyzing the executive compensation policies put in place at both entities and criticized the FHFA for its lack of formal enforcement of the new policies (FHFA-OIG 2011, sec. “At a Glance”). The report advised the FHFA to: (1) make information on GSE executive compensation more accessible to the public (and “more user-friendly”) and (2) develop formal control mechanisms to better enforce the entities’ compliance with the new policies (FHFA-OIG 2011, 20–22).

FHFA balanced the need to attract and retain qualified leadership with mandatory restrictions on executive compensation, which was a challenge for both the firms and their conservator. In 2019, audits by the FHFA-OIG found that FHFA’s approval of senior executive succession planning at both firms had “acted to circumvent the congressionally mandated cap on CEO compensation” (FHFA-OIG 2019a, 1–4; FHFA-OIG 2019b, 1–5).^FSee FHFA-OIG 2019a for the latest report on Fannie Mae and FHFA-OIG 2019b for the latest report on Freddie Mac. The firms disagreed with the auditor’s conclusions (FHFA-OIG 2019a, 1–4; FHFA-OIG 2019b, 1–5).