The Unsolved Case of Fannie Mae and Freddie Mac

The Unsolved Case of Fannie Mae and Freddie Mac
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Who Are “Fannie Mae” and “Freddie Mac”

Fannie Mae and Freddie Mac are the Government Sponsored Enterprises or GSEs which securitize individual mortgages. They turn individual loans from mortgage originators, including small community banks and large national banks, and package them into securities. These mortgage-backed securities are purchased by institutions around the world to provide necessary income. The GSEs are widely-regarded as efficient in their role.

The highly-regarded Independent Community Bankers Association lauds the performance of the GSEs, stating that “American homeowners have benefited from the critical role Fannie Mae and Freddie Mac have played in helping finance homeownership for decades. The GSEs have provided a steady, reliable source of funding for home mortgage lending through all economic cycles and in all markets. Community banks depend on the GSEs for direct access to the secondary market without having to sell their loans through a larger financial institution that competes with them…And unlike other private investors or aggregators, the GSEs have a mandate to serve all markets at all times.”

While the GSEs received billions of dollars from the government in 2008, there is debate if they themselves needed the government “bailout.” Tim Howard, the former Chief Financial Officer of Fannie Mae has referred to the GSE losses as “…massive temporary or artificial accounting expenses to make them take unneeded and non-repayable senior preferred stock, and then, when the effects of the accounting expenses reversed, taking all of their net income in perpetuity.”

Some also assert that the GSEs were tasked with using the government funds to bail out the “Too Big To Fail” banks by purchasing their bad loans and writing off the losses on the financial statements of the GSEs.

The GSEs were arguably not in the dire cash situation that was presented at the time. Regardless, the GSEs were tasked with purchasing loans from the “Too Big To Fail” banks so those banks could recover. In this regard, the GSEs became a government tool to “bail out” the big banks and restore confidence in the U.S. banking sector.

In the years since the 2008 financial crisis, the GSEs have shown enormous strength in overcoming the worst financial calamity in many decades. They have proven resilient and have repaid billions more than the “bailout” sums received. The GSEs took in $187.5 billion and have paid back $266 billion so far, for a cash profit of $78.5 billion to date.

Yet they are forced to continue paying 100-percent of their earnings to the U.S. Treasury. It’s been many years since the financial crisis and Congress has not acted to unwind government control over the GSEs, and to free the privately-held and publicly-traded mortgage companies which are so vital to the U.S. housing industry.

The GSEs are often scapegoated as a primary cause of the broader housing crisis of 2008. With this as a backdrop, special-interest lobbying groups are eyeing the GSE’s mortgage securitization business for their members. Congress should see through these vested interests and not “take the bait” by dismantling the GSEs on their behalf.

If Congress does not agree on how to move forward, the U.S. Treasury and the Federal agency which oversees the GSEs can act through current authorizations along with the Executive branch to reform them. An Act of Congress is not necessary.

The 100-Percent “Dividend"

Much controversy surrounds the U.S. Treasury and its continued profit-taking from the GSEs. Both Fannie Mae and Freddie Mac securities change hands on the open market daily, with subsequent shareholder rights transferring from one party to another. But with the government taking 100-percent of their profits even to this day, those who buy and sell shares on the market are largely assessing whether or not the government will continue its ongoing profit-taking scheme, which is referred to as the "Net Worth Sweep.” Shareholders hold paper that is not backed by the companies’ earnings.

Since 2012, under the terms of the Net Worth Sweep, pretty much every dollar of profit generated by the GSEs goes directly to the U.S. Treasury in the form of a so-called “dividend” payment. A 100-percent “dividend” — sweeping away all of a company's profit — seems more like an outright ‘robbery’ than a voluntary dividend.

But the U.S. Treasury didn't always take all of Fannie Mae and Freddie Mac's profits. It only did so after a Federal agency took control of the companies and their oversight boards, under less onerous financial terms which called for a fixed dividend payment. It was only after having full control of the GSEs that the terms of the “bailout” drastically changed.

Common shareholders, such as myself, are hoping that either by court decree or administrative actions, that lawful ownership interests in the GSEs will once again have underlying economic value, just like with any other company. It’s hard to believe that this could happen and persist in the United States, as the nationalization of private companies is what happens in corrupt Socialist regimes such as the one in Venezuela.

Keeping the Net Worth Sweep, is nothing short of an embarrassment to our values as a nation, the rule of law and private property rights.

The GSEs Are Fully Controlled by FHFA

Fannie Mae and Freddie Mac are regulated by The Federal Housing Finance Agency (“FHFA”). When FHFA took on the role as “conservator” of the GSEs in 2008, it also assumed fiduciary responsibilities to make the companies safer and sounder. The head of the FHFA and conservator, Melvin Watt, has been clear that these are not the same entities they were years ago, and he underscored their reforms in testimony to Congress.

While under FHFA control, many improvements were made to the GSEs. Operations were streamlined and risk profiles were reduced. But that has not stopped Watt’s agency, FHFA, from taking the entirety of profits from the GSEs and leaving them financially weaker today, with even less capital, than they had when they were first taken over in 2008. This does not seem like the traditional role of a conservator.

Currently, plans are in place for the GSEs to have essentially no capital buffer by January 1, 2018. Action by Congress, or the Executive branch in concert with the U.S. Treasury and FHFA, needs to occur within the next six-months to prevent the possible “rattling” of the markets. Operating the GSEs without a sufficient capital buffer will lead to concerns over government indifference toward factors which effect market stability and investor confidence. It is perilous to risk market confidence, a clear necessity to maintaining stable investment conditions, particularly in the areas of housing finance and construction.

Global investment allocators are highly aware that U.S. financial markets are backed by a strong and stable government, and this must be at the forefront of policy makers mindsets. A possible quarterly GSE loss or accounting adjustment that exceeds diminishing capital buffers would force another taxpayer “bailout” of the GSEs — despite the GSEs apparent operational and financial strength. Operating the GSEs without a sufficient capital buffer, and needing to “claw back” GSE profits in the event of a quarterly loss or accounting adjustment, is simply unnecessary. Concern over another "housing crisis" is a significant issue to be avoided, and could destabilize investor mindsets and stock markets. Mel Watt, conservator of the GSEs, has said that he may use his existing authority as conservator to withhold payments to the U.S. Treasury if actions are not taken to address housing reform and the GSEs. In his words, Mel Watt may “dance alone.”

The Original “Bailout” Agreement

As part of the original 2008 agreement, the GSEs agreed to receive taxpayer funds, and to repay those funds, along with a fixed dividend. In total, the government received senior preferred shares which carried a generous ten-percent dividend, and warrants which could be converted into nearly 80-percent equity ownership of the GSEs. It’s unclear why taking of such a large ownership stake was necessary in addition to the lofty dividend rate.

Upon the enactment of the Net Worth Sweep in 2012, while the GSEs were under FHFA control, terms of the bailout were radically changed — from payment of a ten-percent dividend to a 100-percent dividend. There has been great concern that the timing of the government’s Net Worth Sweep was made just as the GSEs were about to become profitable, and with the FHFA likely knowledgeable of this fact, given their role as conservator.

The GSEs were on the cusp of being able to repay the government its principal, the corresponding 10-percent dividend, and to have extra funds to rebuild their financial strength — and “recapitalize” themselves to a healthier state by keeping some of their own profits. Instead, the GSEs were forced to turn over all profit to the U.S. Treasury.

The GSEs need to retain their own profits to act as a margin of safety in the event of periodic fluctuations in earnings, accounting adjustments, or a financial crisis. This would help ensure that taxpayer funds are not needed in the future.

Treasury Secretary Steven Mnuchin has said that he wants to free the GSEs from government control, but he has not yet said exactly how. He also seemed to confirm reporting that the historical profits from Fannie Mae and Freddie Mac were used to fill a funding gap related to the Affordable Care Act. The diversion of funds from the GSEs to the U.S. Treasury seems to have entirely bypassed the typical Congressional appropriations process, which if true, would seem to be an unconstitutional act. This happened by using FHFA’s conservatorship over the GSEs, which itself was granted by Congress. This seems to be a significant loophole which should not have been allowed, much less to persist.

Return on Investment: Up to 100%

In the years since the 2008 financial crisis, the GSEs have shown enormous strength in overcoming the country’s worst financial situation in many decades. The GSEs have paid back the $187.5 billion given to it during the crisis, plus $78.5 billion more, giving the government a nearly 42% return on its investment. With a total payment to the U.S. Treasury of $266 billion so far, the GSEs have proven resilient.

A recently-announced plan by investment bank Moelis & Company outlines how the U.S. Treasury could further profit by an additional $75 billion to $100 billion by selling its nearly 80-percent equity stake in the GSEs. Factoring this in would lead to an 82% to 101% return on the government’s original investment.

Critics of the plan argue that holders of the remaining 20-percent equity will profit from its implementation, but have not offered much in the way of specific criticism of the Moelis plan itself.

Critics of efforts to recapitalize the GSEs, and indeed the powerful banking lobby, often refer to greedy “hedge fund” investors seeking to make profit. However, many investors in the GSEs, whether made directly or through investment managers such as hedge funds, include a broad range of investors such as pension plans, endowments, foreign governments, and individual investors.

If the GSEs are unwound as some critics desire, those funding the banking lobby will likely be more than happy to assume the securitization role currently being performed by the GSEs. Their motivations to dismantle the GSEs are transparent.

If opponents of GSE reform prevail in their desire to “wind down” the companies, it would be most difficult to envision raising the necessary capital buffer to backstop the new entities — given that that GSE investors will have been essentially wiped out by government action. The precedent of wiping out private capital, and in the process also destroying the government’s nearly 80-percent interest in the GSEs, seems to make little sense. In fact, it makes no sense other than to serve special interest groups to the clear disadvantage of the U.S. taxpayer. Additionally, the U.S. taxpayer owns the rights to tax both the corporate profits of the GSEs and any secondary-market investor capital gains. Relaunching these massive ships is overwhelmingly in the interest of the U.S. taxpayer.

It Remains To Be Seen If “Help Is On The Way”

The GSEs play a vital role in the U.S. mortgage market, as they securitize mortgages, effectively returning capital to loan originators so that they can make more new loans. In this way, loan originators such as community banks and large national banks continue to serve the needs of borrowers, including first-time home buyers which need conforming 30-year mortgage loans. The process of securitization is vital to the health of the U.S. housing and construction industries.

The rights of GSE common and junior preferred shareholders should be upheld and not trampled on to the point that investors will lose a large degree of confidence in the U.S. financial system and whether or not the rule of law will ultimately prevail in safeguarding private property rights. Investors, including international investors which are essential in the purchase of U.S. Treasury securities, will surely become sceptical of the surety of their principal investments in Treasury securities. The cost of funding the U.S. national debt will also likely rise. Investors will similarly become more reluctant to risk their capital in any mortgage-backed security. Increased interest rates for home borrowers will likely be necessary to compensate for the additional risk.

It is important to keep the loan origination and servicing businesses separate from the securitization business. Allowing commercial banks to securitize the loans that they themselves originate and service, would be giving them significant control over large segments of the U.S. mortgage industry. They could easily “box out” smaller independent community banks from participating on an equal playing field in the market.

As the Independent Community Bankers Association noted, “The GSEs must be allowed to rebuild their capital buffers…GSE shareholder rights must be upheld. Any reform of the housing finance system must address the claims of GSE shareholders and respect the rule of law that governs the rights of corporate shareholders.”

In the meantime, many external law firms have been hired by the U.S. Treasury and FHFA to respond to the various lawsuits that have been filed. Millions of dollars in legal fees to fight “tooth and nail” to justify and defend the effective nationalization of these two companies which operate under lawful Federal charters.

While the GSEs were part of the U.S. housing finance system during the 2008 housing crisis, they surely did not cause the melt-down of the entire system. The GSEs are however being used as a scapegoat, and their profits are effectively being unjustly ”confiscated.”

It remains to be seen if the clear finanicial interests of the U.S. taxpayer, the rights of both common and preferred shareholders, and confidence in the U.S. financial system, will be shattered by efforts to wind-down the GSEs and give the mortgage securitization business to special-interest lobbying groups.

In this political environment, it is difficult to envision Congress agreeing on housing reform. A solution will likely be driven by the Executive branch, U.S. Treasury, and FHFA.

For shareholders such as myself, it remains to be seen if “Help Is On The Way.”

Follow Me on Twitter: @ TomLauria

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