Fannie and Freddie, Back in the Black
Fannie Mae and Freddie Mac were among the biggest disasters of the financial crisis. In September 2008, nine days before Lehman Brothers failed, the federal government took over the mortgage companies; it eventually spent more than $187 billion bailing them out. For decades, the companies had provided an implicit government backstop to the U.S. mortgage market, buying loans from private lenders and guaranteeing payments to investors. That helped spur a steady rise in homeownership—until the subprime crisis hit and Fannie and Freddie were on the hook for billions in losses.
Lawmakers vowed to overhaul the companies and some planned to wind them down completely. But more than eight years later, Fannie and Freddie still operate under government control—and they’re now a bigger part of the system, guaranteeing payment on just under half of all U.S. mortgages, up from 38 percent before the crisis.
There is one key difference: Any profits the companies generate go to the government instead of investors. The latest payment, a combined $9.9 billion to the U.S. Treasury at the end of March, pushed the total amount of cash Fannie and Freddie have paid to taxpayers to $266 billion, making their bailout one of the most profitable in history.
There’s now a pitched battle over who should get those profits. The companies’ precrisis common and preferred stocks still trade over-the-counter, and investors who snapped up the shares, such as hedge fund managers Bill Ackman and John Paulson, say Treasury is breaking the law by taking the money. The fight goes back to a change the Barack Obama administration made to the bailout terms in 2012.
When the government took them over, Fannie and Freddie issued Treasury a new class of preferred stock that paid a 10 percent dividend, along with warrants to acquire almost 80 percent of the companies’ common stock. In 2012 the government changed the terms to say that every quarter Fannie and Freddie would send Treasury all their profits except for a certain amount of money kept in reserve. That reserve started at $3 billion in 2013 and was scheduled to fall by $600 million every subsequent year, until hitting zero in 2018.
The department said this would hasten the wind down of the companies. In 2013, Fannie and Freddie became profitable again. All those earnings went to taxpayers, infuriating investors who hoped to share in the rebound. Ackman, along with mutual fund manager Bruce Berkowitz, and Richard Perry, a prominent hedge fund manager, said the changes were illegal and sued. In more than 20 lawsuits, investors have made claims including that the dividend payment is an illegal confiscation of private property, that the government lied about its reasoning, and that the structure of the regulator in charge of Fannie and Freddie, the Federal Housing Finance Agency (FHFA), is unconstitutional.
Judges who’ve ruled so far have come down on the government’s side. Matthew McGill, an attorney with Gibson, Dunn & Crutcher who represents Perry in one of the cases, says Perry plans to keep pressing his case. “This is a case where the government’s conduct and the damage it’s done to investors is simply immense,” McGill says. An FHFA spokeswoman declined to comment. Treasury didn’t respond to a request for comment.
Investors want the government to begin the process of selling its stake in Fannie and Freddie by stopping the dividend, but they don’t want the companies to go away. Ackman favors a plan that would strengthen the companies and keep their activities largely intact. “There is simply no credible alternative to Fannie and Freddie,” he wrote in a letter to investors in March.
The Obama administration left it to Congress to pass legislation dealing with the problem, but nothing has emerged. Texas Republican Jeb Hensarling, chairman of the House Financial Services Committee, wants to wind down Fannie and Freddie completely, while some Democrats think they should be strengthened rather than killed.
Some small lenders and advocates for affordable housing would also like to see the dividend suspended to let the mortgage companies build their reserves. They’re nervous that any alternative Congress might put in place would make it harder for lower-income borrowers to get mortgages. Investors had hoped Donald Trump’s administration would move to sell the government’s stake, but so far the view from the White House is unclear. Treasury Secretary Steven Mnuchin has said that ending government control is a priority, but that he’s focused on regulatory relief and tax reform.
In the middle of the debate is Mel Watt, the Obama appointee who heads the FHFA and essentially controls Fannie and Freddie. Watt has the authority to order the companies’ boards of directors to suspend the dividend payments. He came close to doing so at the end of March, just before Fannie and Freddie’s last payment was due, according to people familiar with the matter. A group of senators wrote Watt a letter that week, warning him against stopping payment, and Watt decided to make it.
Stopping the payment would have let Fannie and Freddie build their reserves, making it less likely they would need more money from taxpayers in the event of a loss. Under terms of the bailout, the companies could still borrow up to $259 billion in an emergency, so insolvency is a long way off. Watt, a former North Carolina congressman, has told people around him that he’d consider it a dereliction of duty if the companies needed more money on his watch.
Investors would’ve been thrilled if Watt had withheld the dividend in March. Building capital is a necessary precursor to selling Fannie and Freddie back to the private market, where their shares could be worth billions. Mnuchin put one of his counselors, Craig Phillips, in charge of the situation. In meetings, Phillips has floated ideas as wide-ranging as putting the companies into receivership, which could wipe out investors, as well as legislation to replace or supplement them with a new system, according to people familiar with the matter. Clarity on what the administration wants to do could be a long way off.
The bottom line: Fannie Mae and Freddie Mac have paid $266 billion to the U.S. Treasury. Investors say it’s time for them to get paid.