Will Fannie and Freddie Go Private?
One of the biggest issues still remaining from the foreclosure meltdown is what to do with Fannie Mae and Freddie Mac, massive companies now operated by the federal government. Billions of dollars are at stake and the big question is who gets the money.
Since their inception Fannie Mae and Freddie Mac have been “GSEs” — government-sponsored enterprises which are private, shareholder-owned companies with a right to borrow directly from the Treasury in case of trouble. They bought “conforming” mortgages from local lenders, bundled them, guaranteed them, and then raised capital by selling off various rights and revenues. The result was a “secondary market” which produced several benefits.
First, investors worldwide could buy and sell mortgage interests. Because the potential pool of capital was so huge mortgage rates were held down as investors competed for loans.
Second, local loan originators had a way to easily sell mortgages. The cash raised from mortgage sales could then be used to create new loans and produce new income.
Third, borrowers could always get mortgages at the best-available market rates even if they lived in areas with few lenders.
The system worked remarkably well until the mortgage meltdown when the two companies were taken over by the federal government. According to a 2015 report from the Federal Reserve Bank of New York, in 2008 the Federal Housing Finance Agency (FHFA) “placed Fannie Mae and Freddie Mac into conservatorship, taking control of the two firms in an effort to curtail any financial contagion and to conserve their value. Concurrently, the Treasury entered into senior preferred stock purchase agreements with each institution. Under these agreements, U.S. taxpayers ultimately injected $187.5 billion into Fannie Mae and Freddie Mac.”
This is where the financial waters get choppy and brings us directly to 2017. Just about everything associated with the 2008 take-over is in dispute. At stake are shareholder interests, huge payments to the federal government, the question of whether Fannie Mae and Freddie Mac should be disbanded and replaced with private companies and the divide between community banks and major banks.
Was The Federal Take-Over Justified?
There’s no doubt that the mortgage meltdown was one of the most significant events in financial history. Total losses have been estimated at $15 trillion. But was there a need to take over Fannie Mae and Freddie Mac?
Fannie Mae and Freddie Mac were absorbed by the Federal government on Sept. 9, 2008. Just eight weeks earlier, on July 10th, James B. Lockhart, director of the Office of Federal Housing Enterprise Oversight, the federal agency overseeing Fannie Mae and Freddie Mac, stated that “they are adequately capitalized, holding capital well in excess of the OFHEO-directed requirement, which exceeds the statutory minimums. They have large liquidity portfolios, access to the debt market and over $1.5 trillion in unpledged assets.”
So which is it? Were Fannie Mae and Freddie Mac financially solid or not? This might seem like a fairly straight-forward question with an equally straight-forward answer, however profits and losses can be artificially created by management through the use of various accounting maneuvers.
As an example, in the second quarter of 2008 Fannie Mae reported a net loss of $2.3 billion. However, according to a 2015 study by Adam Spittler and Mike Ciklin, you “must add back the non-cash Loan Loss Reserve of $5.5 billion. After this adjustment, Fannie Mae shows a cash net income figured of $3.2 billion. You are reading this correctly. Fannie Mae generated roughly $3.2 billion in cash in Q2 of 2008, the quarter just before conservatorship. This is poor evidence of a ‘failing business model’.”
Spittler and Ciklin also say something else: “In 2013 and 2014, these reserves were reversed as unnecessary in the first place showing massive net income to the entity.”
In other words, you can make reserves as large or small as you like. For companies aiming to maximize profits reserves will be held to a minimum but what about federal officials seeking to justify the take-over of Fannie Mae and Freddie Mac?
According to Richard X. Bove, Vice President Equity Research at Rafferty Capital Markets, Treasury money to bail out the GSEs was “not needed for that purpose because the two GSEs were cash flow positive. However, to get the money into and out of the GSEs the Treasury had to prove that the GSEs were insolvent. This was accomplished by accounting manipulation.”
In 2008 the Federal government created a $700 billion plan to bail out Wall Street. In exchange for financial help the government obtained shares in many financial institutions and then sold them off as bailout money was repaid, leaving the companies as independent entities.
The situation with Fannie Mae and Freddie Mac is decidedly different. The government says it loaned $187.5 billion to the two GSEs and in return got “a warrant to purchase 79.9 percent of outstanding common stock for a nominal price” according to the Senate Committee on the Budget.
The original agreement, however, was amended several times. According to the Budget Committee, in 2012 the Treasury Department negotiated a “net worth sweep” with another arm of the government which “set the dividend amount at 100 percent of Fannie and Freddie’s net worth — 100 percent of net worth greater than their capital reserves – thus consuming all of the two GSEs’ profits.” Other shareholders get nothing, regardless of how much is paid to the government. It is, says Investors Unite Executive Director Tim Pagliara, “a form of internal embezzlement.”
The new arrangement has worked out pretty well for the Treasury. So far it has (maybe) loaned $187.5 billion to Fannie Mae and Freddie Mac and gotten back $246.7 billion as of mid-2016. That’s a tidy profit of $59.2 billion with lots more to come. It’s hard to know what actually happened because the government refuses to release thousands of documents related to the take-over.
To Privatize Or Not?
The looming question is what to do with Fannie Mae and Freddie Mac. In practice the big questions look like this:
First, should Fannie Mae and Freddie Mac be kept within the conservatorship? For politicians this is a joyous option because it means big bucks for the Treasury without raising taxes. But…
Second, what about shareholders? The “taking clause” of the Fifth Amendment says private property shall not be taken for public use without “just compensation.” So far shareholders have not gotten a dime. A court case is now underway to determine shareholder rights, if any.
Third, should Fannie Mae and Freddie Mac be returned to their prior status or should they be replaced by private firms? The government estimated in 2014 that the two GSEs could generate nearly $180 billion in profits in the coming decade, a huge amount. The real question is who should get that money.
In 2014 Johnson-Crapo plan on Capitol Hill would “wind down and eliminate Fannie Mae and Freddie Mac” and replace them with new, private sector firms. The catch? Just like Fannie Mae and Freddie Mac the new firms would ultimately have Treasury guarantees and the ability to avoid state income taxes. In effect, names would change but public risk would be the same.
The view of Steven Mnuchin, the Administration’s nominee for Treasury secretary, is unclear. He said last year the conservatorship should end and that Fannie Mae and Freddie Mac should be turned back to shareholders. However, according to Bloomberg, at his January confirmation hearing he said “comments he made last year on Fannie Mae and Freddie Mac were not meant to endorse a view that the government should quickly recapitalize the companies and then sell its stakes in them.”
Lastly, what about borrowers? A number commentators argue that if Fannie Mae and Freddie Mac are privatized borrowing costs will rise by 1 percent or so. That’s a big deal in terms of affordability, home sales, and real estate demand. It’s also a big worry for community bankers who fear that their fees and costs will rise if the secondary market is controlled by big banks.
“Whatever the government decides to do with the GSEs needs to be done thoughtfully, and with extreme caution,” said Rick Sharga, executive vice president at Ten-X.com, the online real estate marketplace. ”Fannie Mae and Freddie Mac have an enormously important role in maintaining the health of the mortgage market, and simply unplugging them and hoping that private capital will swoop in and fill the void would very likely be a disaster for consumers, lenders and investors alike.”
Essentially, we have old questions, a new Administration, an ongoing court battle, and no light at the end of the tunnel. Fannie Mae and Freddie Mac are plainly going somewhere, only no one knows where that “somewhere” might be. What we do know with certainty is this: Financial lobbyists and lawyers in Washington, paid to argue any side of any issue, can expect a lot of billable hours in 2017.
Peter Miller is a contributing writer for Ten-X and Auction.com as well as a nationally syndicated newspaper columnist. He is the author of the 2016 edition of The Common-Sense Mortgage.