Don't Like Fannie and Freddie's Bonuses? Then Dissolve Them

The government has no standing to complain about these companies' high compensation levels as long as it allows these firms to exist

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Congress is angry about bonuses again. But instead of focusing on banks that no longer owe the government any money, politicians' latest outrage is directed at the biggest bailout recipients of them all: Fannie Mae and Freddie Mac. Reports indicate that 10 executives will be paid $12.79 million in bonus pay this year after hitting performance targets. This week, we learned that taxpayers will have to plow another $14 billion into the troubled firms after a bad third quarter. Their net bailout exceeds $150 billion. While frustration over these bonuses is rational, the only legitimate way to ensure that the big bonuses stop would be to dissolve these firms.

Upon hearing about these bonuses, several members of Congress have demanded that these bonuses be rescinded. They may try to pass legislation that curbs Fannie and Freddie pay. Instead of solving the problem, this would just make matters worse.

These Bonuses Are Necessary for Fannie and Freddie to Exist

Let's say that you're a seasoned housing finance expert with a decade or two of experience in the industry. You have a job on Wall Street or at some other financial firm that pays well into six figures, possibly even seven. A recruiter calls you and tells you that a firm is interested in hiring you. It has a terrible reputation and probably won't exist in a couple of years. What would it take to get you on board? If you're rational, then it would take an awful lot of money.

That's the problem that Fannie and Freddie face. Indeed, Edward J. DeMarco, acting director of the Federal Housing Finance Agency (Fannie and Freddie's conservator), wrote a letter to Congress explaining why these bonuses are necessary. He made an argument similar to the one above: to attract people capable of protecting taxpayers from more severe losses, you've got to provide a very competitive salary. Here's a paragraph from his letter that sums up the problem:

Today, as Conservator I need to ensure that the companies have people with the skills needed to manage the credit and interest rate risks of $5 trillion worth of mortgage assets and $1 trillion of annual new business that the American taxpayer is supporting. I have concluded that it would be irresponsible of me to risk this enormous contingent taxpayer liability with a rapid turnover of management and staff, replaced with people lacking the institutional, technical, operational, and risk management knowledge requisite to the running of corporations with thousands of employees and more than $2 trillion in financial obligations each. That conclusion is further buttressed by the realization that, from an Enterprise executive or staff's point of view, continued employment at an Enterprise risks substantial job and career uncertainty. The public scrutiny and criticism is often harsh, and almost everyone expects the Enterprises to cease to exist, at least in their current form, in the future. At the same time, the taxpayer is backing Enterprise financial commitments that have thirty year lives, and we will need expert management of those guarantees for years to come. Given the amount of money at risk here, small mistakes can easily be amplified to losses far greater than the compensation paid to Enterprise executives.

In other words, those million-dollar bonuses are the price taxpayers must pay to avoid billions of dollars in additional losses if unqualified people are running Fannie and Freddie. Indeed, that sounds like a small price to pay. We don't have to like this assertion, but it's true. Actual expertise is required for these companies to continue to function properly.

In the letter, DeMarco also explains that those responsible for the problems that caused Fannie's and Freddie's losses in the first place have all been fired or left the firms, without golden parachutes. So those getting bonuses are employees working diligently to protect taxpayers.

Otherwise, Get Rid of Fannie and Freddie

But let's say that you don't care about that logic. You think that since these firms are owned by taxpayers, they should not be providing giant Wall Street-like bonuses to their employees. Then there's only one solution: you must dissolve Fannie and Freddie as quickly as possible. This could be done by ending the government guarantee on most new mortgage originations and liquidating the firm's assets as quickly as possible.

Many people would love to see this happen. And if we're really lucky, one day it may. But doing so right now would be catastrophic to the U.S. economy. Although there are ways to get the private market comfortable taking on mortgage risk again, the process will take time and must be gradual. You can't suddenly remove the government support for over 90% of new mortgages originated and expect the market to function smoothly.

So the only realistic solution is for us to frown and accept big bonuses being paid out for the next couple of years. As the economy and housing market begin to recover more robustly, measures can be taken to wean investors off of the government mortgage guarantee. Then, Fannie and Freddie can be safely dissolved, and the U.S. can get out of the business of providing million-dollar bonuses to housing finance executives. But as long as Fannie and Freddie maintain their role in the market, they must attract adequate talent to minimize taxpayer losses.

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