The Supreme Court's ruling on the Federal Housing Finance Agency (FHFA) is likely to bring major changes to the U.S. housing industry, which is fueled by trillions of dollars in loans. The FHFA, an agency whose name is unfamiliar to many consumers, was set up during the financial crisis to oversee faltering mortgage giants Fannie Mae (FNMA) and Freddie Mac (FMCC), which back half of the $11 trillion mortgage market. The Supreme Court opened the door to major changes at the agency when it ruled on June 23 that FHFA's structure was unconstitutional because of its lack of accountability to the president of the United States.
That decision is likely to dramatically change the agency's future direction. The ruling was a major defeat for investors who lost their claim to $124 billion. The court also dismissed claims made by Fannie and Freddie's private shareholders who wanted the two firms to be privatized after the government took control of the two companies during the 2007-2008 financial crisis. By contrast, the decision was a major victory for President Joe Biden, though he and his administration weren't original parties in the case. Biden quickly removed the FHFA's current director and appointed his own interim director. Instead of privatization, Biden is expected to focus the agency on helping solve the nation's massive housing needs.
The ruling also dealt a major blow to Fannie and Freddie shares in the stock market. Fannie's stock closed 32.1% lower on Wednesday. And Freddie's stock was down 36.8%.
Background on the FHFA
The FHFA is an independent federal agency that was created in 2008 under the Housing and Economic Recovery Act (HERA) to help strengthen the U.S. housing finance system during the mounting subprime mortgage crisis. That crisis helped push the U.S. economy into the worst recession since the Great Depression in the 1930s, and also fueled the most severe bear market in decades. The agency was given oversight of Fannie Mae and Freddie Mac, two government-sponsored enterprises (GSEs) tasked with supporting homeownership by providing liquidity to the mortgage market. Fannie and Freddie don't originate mortgage loans. Instead, they buy mortgages from lenders, package those mortgages into mortgage-backed securities (MBS), and then sell them to investors. Securitization increases the amount of financing available to potential homebuyers.
Prior to the financial crisis, Fannie and Freddie bought close to a third of U.S. mortgages, which they packaged into securities and sold off to investors. But during the depths of the crisis in 2008, both entities suffered enormous losses on toxic mortgages, pushing them to the brink of insolvency. They were subsequently placed under the FHFA's conservatorship, which granted the agency broad powers over the regulatory and financial affairs of the flailing mortgage giants. The move essentially nationalized the two firms.
The Private Shareholder Lawsuit
The Supreme Court's ruling concerned legal issues that arose from a 2012 decision by the FHFA to direct all of Fannie and Freddie's profits to the Treasury Department. The Treasury initially injected about $190 billion into the two companies in order to keep them afloat during the financial crisis. In exchange, the Treasury received shares of senior preferred stock and warrants to acquire close to 80% of the firms' common stock. Fannie and Freddie were required to make annual 10% dividend payments on the issued shares as well as other fees, which was how the Treasury planned to recoup the initial investment of taxpayer dollars.
The failure of Fannie and Freddie to make the required dividend payments subsequently prompted the Treasury to lift the requirement to make payments during quarters when the two firms were not profitable. However, this meant that nearly all subsequent profits earned had to be handed over to the Treasury as dividend payments. As of December 2020, Fannie and Freddie had paid more than $300 billion back to the government. Some argue that the Treasury has not even come close to being fully repaid for what was originally owed to the U.S. government.
In addition to bailouts, critics say that Fannie and Freddie get other advantages from the U.S. government. As GSEs, they are quasi-governmental entities that enjoy an implicit backing from the government despite having private shareholders. This type of organizational structure is often criticized for privatizing profits while socializing risks. Private shareholders rake in huge profits during good times, but it is ultimately taxpayers that end up bailing these companies out when they are at risk of becoming insolvent, as happened during the financial crisis.
The private shareholders who initially filed the lawsuit argued that the profit sweep initiated by the government was an illegal end-run to prevent Fannie and Freddie from rebuilding capital that might eventually be paid out to investors. They also argued that the director of the FHFA held too much unchecked power, rendering the agency's structure unconstitutional. The shareholders claimed that Fannie and Freddie had overpaid the Treasury by $124 billion, an amount for which they demanded to be reimbursed. They also asked that the Treasury stop collecting future profits, and that both Fannie and Freddie be entitled to $29.5 billion worth of future tax credits.
In response, the government argued that the FHFA was granted broad legal authority in order to ensure the solvency of Fannie and Freddie, and to protect the country's investment in the two companies. Any problems related to the agency's structure did nothing to undermine that power, the agency said.
Supreme Court Ruling
The Supreme Court concluded that the FHFA was structured unconstitutionally because, as stipulated by Congress, the president could not easily remove the agency's director if policy priorities were contrary to the president's. The court's latest ruling means that the director can be quickly replaced. Under the previous arrangement, the director could only be fired for cause. The court's ruling followed a similar major decision in 2020 that the structure of the Consumer Financial Protection Bureau (CFPB) was unconstitutional because its director's authority was too insulated from the White House. The CFPB was created in the wake of the financial crisis to protect consumers from financial abuses in areas such as mortgages and credit cards.
In the case of the FHFA, the high court sent the case back to the lower courts to determine the issue of whether any remedial action should be taken to compensate shareholders for the alleged financial harm done to them by the agency's structure. Justice Samuel Alito wrote that the FHFA's "structure violates the separation of powers, and we remand for further proceedings to determine what remedy, if any, the shareholders are entitled to receive on their constitutional claim." However, the Supreme court also unanimously ruled that the profit sweep did not exceed the statutory authority of the FHFA.
What The Supreme Court Ruling Means
The Supreme Court's ruling means that Fannie and Freddie, which back approximately half of the mortgage market, will remain under government control for the time being. It was a harsh blow to shareholders looking for the mortgage giants to return to private hands after a dozen years under government control. As mentioned, stock investors in Fannie and Freddie suffered major losses in the stock market on news of the court's ruling. The publicly traded shares of Fannie and Freddie both plunged on Wednesday.
Immediately following the court decision, President Biden exercised his new authority to dismiss current FHFA director Mark Calabria . Calabria, whose term was set to expire in 2024, was appointed by the Trump administration. During his term, he aggressively pushed to privatize both Fannie and Freddie. In Calabria's place, Biden appointed Deputy Director Sandra L. Thompson as acting director. Since 2013, Thompson has overseen regulatory, capital, policy, and other issues for Freddie and Fannie.
President Biden has signaled that he is in no hurry to return Fannie and Freddie to the private sector. Biden's successor to Calabria is likely to focus on addressing the president's policy goals. That could mean aiding those in lower-income communities to buy homes and reducing the racial homeownership gap.