As e21 first pointed out last October, Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are extremely profitable. The cash flow relationship between the government-sponsored enterprises (GSEs) and the Federal Government has now reversed: instead of receiving bailout funds from the Treasury in the form of senior preferred stock purchases, the GSEs now send billions of dollars in dividend payments to Treasury to fund unrelated government spending.
Fannie Mae announced yesterday that it earned $17 billion in 2012 – the greatest profit it has ever earned in a single year – and is now generating profits at an astounding $30 billion annual rate. At current rates, Fannie and Freddie will combine to contribute enough dividends to the Treasury in 2013 – $40 billion – to cover the costs of the National Institutes of Health (~$30 billion) and half of the Department of Agriculture (~$20 billion). And due to a looming change to the accounting treatment of deferred tax assets, the actual cash payments to Treasury in 2013 could be a multiple of this figure.
The GSEs have become a de facto slush fund for the general fund of the Treasury as a result of the Obama Administration's August 2012 amendment to the terms of the original bailout. Under the original terms, the Treasury committed to buy senior preferred stock in whatever amount necessary to ensure Fannie and Freddie maintained a positive net worth. This senior preferred stock carried a 10% dividend rate; so if the GSEs required a $100 billion bailout, they would owe the Treasury $10 billion per year in dividends.
The problem was that when Fannie and Freddie were hemorrhaging cash, they had to borrow from the Treasury to meet their dividend payments to Treasury. For example, Fannie and Freddie requested $130 billion from the Treasury between 2008 and 2010, which meant they owed the Treasury $13 billion in dividends in 2011. Yet, since both GSEs continued to post large losses, they had to request an additional $13 billion from the Treasury in 2011 to pay dividends on the bailout received in prior years. Through the end of 2012, the GSEs have requested $187.5 billion from the Treasury but $50 billion of this total had been borrowing to pay dividends. On net, the bailout has cost taxpayers $127 billion.
The Obama Administration's stated rationale for amending the bailout terms was to end the circularity of the prior arrangement. Instead of demanding a 10% dividend rate, the Administration said that the Treasury would be content to take whatever profits the GSEs made that quarter. But the Administration made this change right as it was becoming clear that the GSEs were on the cusp of a huge surge in profitability. The Obama Administration's amendment requires the GSEs to distribute all profits to the Treasury as dividends each quarter. This means that instead of paying the Treasury $2.9 billion in dividends, as required under the old arrangement, Fannie Mae will pay $4.2 billion; similarly, Freddie Mac's dividend obligation will increase from the originally scheduled $1.8 billion to $5.8 billion. What was billed as a reduction in the GSEs' financial obligations to the Treasury was actually a pure money grab.
With no plans for a new mortgage finance system, the Obama Administration appears happy to have the GSEs serve as the federal government's profit center for indefinite future. Consider the host of factors driving the GSEs' record profits: (1) Fannie and Freddie enjoy nearly 100% market share; (2) the fees they collect for guaranteeing mortgage payments to investors have more than doubled; (3) their post-2008 book of business consists exclusively of borrowers with sterling credit histories; (4) the more strict underwriting has reduced refinancing rates since fewer borrowers can qualify for new loans, which means the older, higher interest loans owned by Fannie and Freddie carry higher market values; and (5) house prices have risen and unemployment has declined, which places downward pressure on default rates and loss severities. Between 2011 and 2012, Fannie and Freddie's credit expense – i.e. losses on delinquent mortgage loans – fell by 97%, from a combined $37.4 billion to just over $1 billion. Fannie Mae actually reversed its prior losses by $852 million, as it found that it had overestimated losses on delinquent loans. With ultra-low borrowing costs as a result of government ownership, the GSEs collect $40 billion more in interest payments than they pay out to their creditors.
There is a mistaken impression that Fannie and Freddie's collapse had been building up for some time, or that their basic business model didn't work. In fact, prior to the collapse Fannie and Freddie were viewed by critics as excessively profitable. Many believed the guarantee fees they charged to borrowers were too high to be justified by expected credit losses and instead reflected the monopoly pricing power afforded by government charter. In 2005, GSE critic Peter Wallison highlighted a Mortgage Bankers Association analysis that purported to show that "if Fannie and Freddie targeted a return on equity that is roughly equivalent to that of commercial banks they could charge considerably lower [guaranty] fees." The pre-2007 critique of Fannie and Freddie was that they were too powerful and the financial and housing system was too dependent on them. Fannie and Freddie were viewed as bullies, armed with a government charter that conferred unfair benefits; not as hopeless entities that were somehow destined to fail.
It was widely understood that Fannie and Freddie generated "systemic risk," which is to say that these government-sponsored firms were too big, interconnected, and integral to housing finance markets to fail. But the risk that their failure would impose incalculable costs on the rest of the financial system is different from the suggestion that huge losses are an inexorable feature of their business model. As made clear in the Federal Housing Finance Agency (FHFA) conservators' report, the GSEs' losses come almost entirely from losses on Alt-A and interest-only loans made in California, Arizona, Florida, and Nevada in 2006 and 2007. Their failure was the result of a sudden surge in nontraditional lending and a 50% collapse in house prices in those states.
The profits at Fannie and Freddie are about to explode upward in 2013, as Fannie and Freddie write up the value of deferred tax assets they have accumulated over the years. At year end, Fannie and Freddie reported valuation allowances that reduced the value of their deferred tax assets by $58.9 billion and $31.6 billion, respectively. Now that the outlook has improved, it is reasonable to expect Fannie and Freddie to generate future taxable income necessary to realize a large portion of their deferred tax assets. Whenever they reach this judgment, their net income for the quarter will increase by tens of billions of dollars, which will require Fannie and Freddie to either sell assets or issue new debt to pay the required dividend to Treasury. When adding the $40 billion in profits to the $90 billion in deferred tax assets, the total 2013 dividend to the Treasury could exceed $130 billion.
Senator Bob Corker introduced the "Jumpstart GSE Reform Act," which would prevent guaranty fee revenue from the GSEs to be spent on other government programs. As Corker explains, "reforming these mortgage behemoths would become nearly impossible" if they are allowed to become profit centers for the federal government. The problem is that the Act doesn't go far enough. It prevents Congress from affirmatively requiring the GSEs to increase fees and then using the additional revenue to offset new federal spending, but it does not address the problem of the Obama Administration's unlimited dividend sweep. Congress does not need to mandate an increase in guarantee fees for the GSEs to be huge contributors to the Treasury in 2013 and beyond.
The Obama Administration has played on the mistaken impression of many in Congress that the GSEs are a hopeless basket case to change the terms of the bailout in a way that will dramatically boost government receipts. Within five years, the bailout of the GSEs has completely reversed. Today, the GSEs are bailing out the federal government.