Fannie, Freddie Don’t Deserve Capital Punishment
The rebound in the real estate market has breathed some life back into Fannie Mae and Freddie Mac, the giant mortgage financiers that have been wards of the state since their near-collapse in 2008. The government should seize the opportunity to put them on a path to recovery, rather than killing institutions that, properly managed, could help stabilize U.S. housing finance for generations to come.
This week, Fannie Mae reported net income of $17.2 billion for 2012, the largest annual profit in company history. Freddie Mac earned $11 billion over the same period. Oddly, not a dime of that money will go toward paying back the $188 billion the federal government has lent the two companies over the past several years. Instead, at the government’s behest, about $11 billion will go toward sky-high interest payments on the debt, which the Treasury holds in the form of preferred shares. The onerous payments will leave the mortgage giants thinly capitalized and undermine the investment of U.S. taxpayers, who hold 80 percent of the companies’ stock.
How did we reach this absurd state of affairs? For perspective, turn the clock back to 1937, when Fannie Mae was founded. Mortgages were harder to get and more vulnerable to busts. One bad year and families could get booted from their homes and wake up in the poor house. Fannie Mae and later Freddie Mac made the mortgage market more resilient, engineering 30-year loans with predictable payments, pooling risk and attracting a wide range of investors. For almost five decades, they helped establish a culture of middle-class home ownership that was regarded as a bedrock of American values.
The system worked so well that politicians couldn’t leave it alone. Steady demands for greater home ownership, lower mortgage fees and, that Beltway delight, special treatment gradually gutted what risk acumen Fannie Mae and Freddie Mac could muster. By 2006, both companies were barely profitable. Rather than maintain credit standards in the face of a housing bubble, they blindly repackaged billions of dollars in risky mortgages that by September 2008 forced them into government conservatorship.
The government bailout placed an unusually heavy burden on Fannie Mae and Freddie Mac. Under terms negotiated by the Federal Housing Finance Agency, the Treasury received a 10 percent interest rate on the preferred shares it received in return for injecting enough money to cover the companies’ losses. That’s double the 5 percent rate initially paid by Bank of America Corp., Citigroup Inc., Goldman Sachs Group Inc., JPMorgan Chase & Co., Morgan Stanley, AIG and other financial institutions that received Treasury funding.
For Fannie Mae and Freddie Mac, the deal worked like the worst of the negative-amortization loans made in the run-up to the crisis. When they couldn’t afford to pay the interest, the Treasury lent them more money to make up the difference. The result is a debt of $188 billion. As conservator, the FHFA did nothing to offer a debt restructuring, a workout or any other relief along the same lines that Fannie Mae and Freddie Mac themselves were doing for tens of thousands of homeowners who owed more than they could pay.
Now the times have changed. As evidenced by the record profits at Fannie Mae and Freddie Mac, the mortgage market is once again lucrative, and big U.S. banks have taken notice. The combined 2012 net interest income at Fannie Mae and Freddie Mac represents over 70 percent of that of JPMorgan, the largest U.S. bank by assets. With such mouthwatering returns on display, what self-respecting banker wouldn’t want to kick Fannie Mae and Freddie Mac out of the securitization market and eat their lunch? The question is whether the government is helping them do so.
So far, the government’s approach has been highly inequitable. It has encouraged the banks to pay back their bailout money, and most have done so. At the same time, the FHFA is forcing Fannie Mae and Freddie Mac to pay usurious rates, and plans to ratchet up the payments sharply from 2013. Instead of using their profits to rebuild their capital and prepare for the next housing downturn, Fannie Mae and Freddie Mac will send all the money back to the Treasury, without paying down their debt. With a conservator like the FHFA, Fannie Mae and Freddie Mac will eventually need an undertaker.
The demise of Fannie Mae and Freddie Mac would mean a drastically different marketplace for mortgage securities. It would be dominated by large banks that already have far more sway over the Washington bureaucracy than Fannie Mae and Freddie Mac ever did. Many are the same financial institutions that misbehaved so egregiously during the housing boom that Fannie Mae and Freddie Mac successfully sued them for tens of billions of dollars in damages. If they ran into trouble, the potential repercussions would be so threatening to the economy that taxpayers would have little choice but to bail them out again.
A better option would be to give Fannie Mae and Freddie Mac a chance to get out from under their debt burden. If the government reduced the rate of interest, it’s possible that the two companies could redeem the $188 billion in preferred shares in four to five years. The Treasury would receive the same amount of money whether it comes in payment of dividends or principle. If the companies’ market values then recovered to just half the historic peak, the U.S. government’s stake would be worth more than $70 billion.
How the government acts will be a crucial test of its loyalties. Whose interests is it serving, those of the country’s biggest banks, or those of American taxpayers and homeowners?
(James Fenkner is a certified financial analyst living in Santa Barbara, California. He was a Moscow-based managing partner at Red Star Asset Management LP from 2005 to 2009. The opinions expressed are his own.)
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