February 2005
Receivership Powers: What Are They and Should Fannie and Freddie's Regulator Have Them?
On February 3, 2005 AEI hosted a conference to address receivership authority for Fannie Mae and Freddie Mac. Since the enactment of a regulatory regime for Fannie Mae and Freddie Mac, their regulator has had only the powers of a conservator. This ordinarily means that the regulator could take control of them under certain circumstances, but could not--as a receiver can--marshal their assets, pay off their creditors, and close them down. In the regulatory legislation adopted by the Senate Banking Committee last year, the new regulator of Fannie and Freddie was authorized to act as a receiver. But Fannie and Freddie strongly opposed the provision and succeeded in limiting it sufficiently so that the whole bill was ultimately opposed by the administration. Are receivership powers necessary for Fannie and Freddie’s regulator? If so, what elements are essential? And if they are adopted in the new legislation expected this year, will they change the perception in the markets that the two companies will be bailed out by Congress if they encounter financial difficulties?
Richard S. Carnell
Fordham Law School
The conservatorship statute for Fannie and Freddie has serious shortcomings. It does not allow reorganization, nor does it specifically authorize liquidation. By the time the Office of Federal Housing Enterprise Oversight (OFHEO) can place a GSE in conservatorship, the firm’s condition may have so deteriorated that the conservator cannot save the firm. Uncertainty exists about a conservator’s power to effect a de facto liquidation. Greater uncertainty, with great potential for delay and market disruption, would attend an attempt to use common-law receivership to liquidate or reorganize a GSE. No statute specifies the relative priority of creditors’ claims.
If Fannie or Freddie faltered, uncertainty about the priority and process for handling claims could worsen the firms’ problems and the potential harm to financial markets. Such legal uncertainty--combined with creditors’ uncertainty about the firms’ prospects and the market value of the firms’ assets and liabilities--could further reduce the firms’ access to credit, the market value and liquidity of claims against the firms, and under extreme circumstances, the liquidity of financial markets.
Enacting workable liquidation and reorganization mechanisms, including statutory payment priorities, would increase market discipline on the two GSEs and reduce the likelihood of future problems. A GSE insolvency statute should, at a minimum, (1) authorize a GSE’s regulator to appoint a conservator or receiver through a process permitting timely, unilateral action; (2) afford the GSE a prompt post-seizure judicial hearing; and (3) allow the regulator to prescribe implementing regulations. A well-designed statute should also specify the grounds for conservatorship and receivership, specify priorities among claims, and authorize receivers to establish bridge institutions and effect reorganizations.
In prescribing new insolvency mechanisms for Fannie and Freddie, Senate Banking Committee Chairman Richard Shelby’s (R-Ala.) GSE reform proposal met all six of these criteria. But the amendment by Senator Robert Bennett (R-Utah) did much to undercut the Shelby reforms. This amendment would delay any receivership for forty-five days, precipitating a crisis and setting the stage for a congressional bailout.
The lack of an adequate insolvency mechanism for Fannie and Freddie reinforces investors’ perception of implicit government backing by leaving Congress little practical alternative to rescuing creditors if the firms failed. If one of the other three GSEs failed, the government would have the legally credible option of letting the insolvency mechanism work and the GSE’s creditors incur some loss. No similarly credible option exists in the case of Fannie and Freddie. The lack of such an option gives those firms an augmented perception of implicit backing--as though the government had taken itself hostage for the benefit of their creditors. The lack of such an option also leaves Fannie and Freddie more profitable than if the government expressly guaranteed their debts. A receivership mechanism, by providing an orderly means for dealing with a failed GSE’s obligations, would help limit and contain the harm resulting from a GSE’s failure.
Robert Eisenbeis
Federal Reserve Bank of Atlanta
The process for resolving a large bank or housing enterprise is important to both the financial system and to taxpayers. The current system for resolving failed banks has been refined through the handling of a large number of small bank failures. The bank system has most of the basics needed for effective resolution: a clear process by which banks can be forced into resolution, an agency with authority to act as receiver, a variety of resolution options that can be tailored to specific situations, and a well-defined set of priorities on the order in which claims are to be satisfied from the bank’s assets.
The system should be further strengthened to deal with large bank failures by making several adjustments, such as strengthening the process for forcing banks into early resolution, and by paying more careful attention to prioritizing claims in bankruptcy. There also needs to be a credible plan that eliminates market participants’ perception that the government would guarantee the losses of uninsured creditors. Finally, given the unacceptable loss performance of the banking agencies since prompt corrective action was implemented, better incentives should be put in place for banking agencies to avoid forbearance.
There is no established process for completely resolving an economically insolvent housing enterprise, and there is no guarantee that OFHEO’s conservatorship powers will be sufficient to prevent such insolvency. If a housing enterprise became insolvent, that could lead to significant market disruption, and Congress would likely be forced to bail out the failed housing enterprise’s creditors. Fortunately, the process by which banks are resolved--especially with our suggested improvements in large bank resolution--provides a road map for the creation of an effective process for resolving a failed housing enterprise. Banks and the housing enterprises are sufficiently similar so that the process that has been designed to address problems with the banks would address similar concerns with the housing enterprises. The one major difference between the two entities is that some may regard the perception of implied government backing as an intended indirect subsidy to residential mortgage borrowers. If this subsidy were provided directly to those borrowers who need it most (i.e. low to moderate income, first-time home buyers), however, the gains from subsidizing residential mortgages could be obtained without providing a subsidy to the housing enterprise owners, which would create an incentive for the housing enterprises to take excessive risk, thereby putting financial markets in jeopardy of disruption or imposing large contingent liabilities on the taxpayers.
Michael DeStefano
Standard & Poor’s
I liked the Eisenbeis and Carnell papers very much. I can comment as one who follows the GSEs from a credit perspective. Standard & Poor’s rates several hundred of institutions like the GSEs around the world. This is not unique to the United States. We categorize GSEs and other entities into different classes.
Class 1 includes what we call solvent equivalents, that is to say we rate them because the links to the government are so strong that one could not imagine the government not bailing out the bondholders. And that was our guiding judgment until about a year ago, and I think that that judgment was well grounded in an understanding of the charter, the laws, the precedents, and everything that you would look at to try to reach a level of confidence that the government would be there for the bondholders.
About a year ago, however, a whole series of things led us to believe that we could no longer consider the U.S. GSEs as Category 1. Now in Class 3 there are institutions in which we think there is a strong governmental interest and where bondholders could count upon being bailed out if the institution becomes insolvent. Our approach there is to do a financial assessment of the institution and then enhance the rating up from that assessment based upon a reasonable degree of confidence that because of the strong governmental interest the bondholders can count upon special consideration.
Is there anything in receivership that would inherently preclude one reaching a judgment that there is a strong governmental interest and that the bondholders can be bailed out? And I would have to say, actually, no. As Richard Carnell concluded, “Enacting workable insolvency mechanisms for Fannie and Freddie would make a congressional rescue less inevitable but would neither preclude such a rescue nor by itself eliminate the perception of implicit backing.”
And it is possible for market participants to walk away from this discussion, see receivership, and breathe a sigh of relief and say that is the last piece that we wanted to be in place so that we could have confidence that the government will, in fact, intervene in a timely way, in an orderly way, and in such a way that bondholders will not lose any money. Others may see it as unfinished business. From a rating perspective, receivership is relatively neutral.
And another consideration we would probably make is that while we certainly encourage the Fed to make statements about moral hazard, the notion that a GSE would be liquidated by anybody, under any circumstance, would be so remote that I think it would be hard for us or for capital markets participants to take that seriously as a real option. That is not to say that there could never be circumstances under which--because there is in our view a default differential between the U.S. government and the GSE debt--there is a default differential. We think that differential would manifest itself only in the extreme. It would be a situation where the government could barely meet its obligations, so here is this other class of obligations on which it chooses to stop. If it was just insolvency of a GSE, you could have permanent corrective action. You could have conservatorship.
Patrick Lawler
Office of Federal Housing Enterprise Oversight
OFHEO supports Congress providing us with receivership authority or a successor regulator. And anything else I say are my views and may or may not be the views of OFHEO. I like the Carnell and Eisenbeis papers very much. I thought Carnell’s paper was especially strong in the nature and implications of government sponsorship, and I thought the Atlanta Fed paper was especially strong in the areas of practical issues and resolving large financial institutions.
I think both papers do an excellent job of pointing out the advantages of receivership authorities. We currently have conservatorship authority. We are in the process of working on a regulation that would clarify what we intended.
Another important factor is speed, and the Atlanta Fed paper emphasized the importance of being able to reorganize a failing institution, to be able to do it quickly in a way that might help establish or maintain the functioning of the institution so that it could support housing finance markets and so that any resolution and the losses associated with such a resolution would have lower magnitudes regardless of who bears those losses.
I think the flexibility that is provided by receivership could prove to be especially valuable. In every possible resolution, there are different circumstances that might attend to resolution, and so there are some things that would be important to specify and other issues on which we presumably want some flexibility. How to determine receivership authority is the main question, and we do not yet know the answer. Congress has a great deal of authority, and can demonstrate it not only in legislative language, but also in report language, in floor speeches, and public statements. It can indicate itself what it thinks the purpose should be for receivership authority.
AEI research assistant Jessica Browning prepared this summary.
