During the 1st Quarter of 2012, Fannie Mae (FNMA.ob) reported a profit of $2.7 Billion. Freddie Mac (FMCC.ob) reported a comprehensive income of $1.789 Billion before paying $1.8 Billion in dividends to the U.S. Treasury.
This process of siphoning funds off the top of Fannie and Freddie's balance sheet is not sustainable. The entities will not be able to build adequate equity reserves until a solution is found. Despite proposals, like the one from Jim Millstein, no action has been taken by the Obama Administration.
The U.S. Mortgage Industry Needs the GSEs
Bill Gross, the legendary bond investor and founder of PIMCO wrote about the GSEs in September 2010, discussing the ramifications of destroying them. His stance is that without government supporting the mortgage market by endorsing the 30-year fixed-rate mortgage, consumers would end up paying 300 to 400 basis points more in interest expense on their mortgage debt.
How Did We Get Here?
In the past three years, it has been very popular to pin the financial crisis on the government and the entities sponsored by the government, Fannie Mae and Freddie Mac. I argue that this is too simplistic of a notion to be completely true, though there is some validity.
September 10, 2007
In 2007, the lending standards for Fannie Mae and Freddie Mac were adjusted to allow them to purchase more subprime securities. The following is an excerpt from a New York Times article at the time.
"James B. Lockhart, the chief regulator of Fannie and Freddie, adjusted the companies' lending standards so they could purchase as much as $40 billion in new subprime loans. Some in Congress praised the move."
Congress and regulators encouraged Fannie Mae and Freddie Mac to begin buying subprime securities. These securities didn't meet their own lending standards, but rating agencies had placed AAA ratings on them, the highest grade. Looking back on this crisis, we know that most of these securities were not worthy of a AAA rating.
July 8, 2008
The next July, James Lockhart declared Fannie and Freddie adequately capitalized. Here is a snippet of a Bloomberg story.
"Fannie and Freddie are adequately capitalized at this point," James Lockhart, the director of the Office of Federal Housing Enterprise Oversight, said in an interview with Bloomberg Television today. "They are fulfilling their function."
July 17, 2008
Again in July, Ben Bernanke declared Fannie and Freddie adequately capitalized. This comes from Politico.
"Earlier in the day, Federal Reserve Chairman Ben Bernanke assured lawmakers that Fannie and Freddie, the two government-supported enterprises, are 'adequately capitalized' and 'in no danger of failing.'"
July 21, 2008
Later that month, Hank Paulson, Treasury Secretary, met with hedge fund managers at the Eton Park office complex. Paulson outlined all of the dirty details of the plan to place Fannie Mae and Freddie Mac into Conservatorship. This plan would have a negative impact on the companies' stock prices and blind-side shareholders. Immediately prior to this meeting Paulson met with New York Times reporters and editors. An article published the following day said the Federal Reserve and the Office of the Comptroller of the Currency were inspecting Fannie and Freddie. It also said Paulson expected their examination would "give a signal of confidence to the markets."
In summary, Treasury Secretary Paulson broke his fiduciary duty to Fannie and Freddie shareholders by telling them there was nothing to fear. Then, he gave inside information to his buddies on Wall Street.
September 9, 2008
Then, Paulson and Lockhart announced the nationalization of the two companies in early September 2008, just a few months after the FHFA and Federal Reserve gave them a clean bill of health. Bloomberg ran a story regarding the takeover of Fannie Mae and Freddie Mac. The following paragraph appeared in the story:
"Washington-based Fannie had $47 billion of regulatory capital as of June 30, about $9.5 billion above what FHFA required, according to company filings. McLean, Virginia-based Freddie's capital stood at $37.1 billion, a cushion of about $2.6 billion over FHFA's standard, filings show."
Shareholders had no idea how bad the situation had become and no reason to believe that regulators had withheld the truth. In fact, Treasury Secretary Paulson admits that shareholders were deceived with the following text from his book, "On The Brink." He was briefing President Bush on his plan to nationalize the GSEs.
"Mr. President, we're going to move quickly and take them by surprise. The first sound they'll hear is their heads hitting the floor ."
Paulson took shareholders by surprise, but he told his buddies on Wall Street all about his plans, a month in advance. When will he be charged by the Securities and Exchange Commission?
April 9, 2010
James Lockhart testified in front of the Financial Crisis Inquiry Commission. Here is a portion of Lockhart's testimony.
"It became clear by August 2007 that the turmoil was too big for the Enterprises to solve in a safe and sound manner. …They were critically supporting the conforming mortgage market. We were very concerned that if we released those constraints that it would impair their ability to serve their core market as they were already purchasing or guaranteeing over 60% of the mortgages originated."
This establishes that Lockhart believed the companies were undercapitalized in August 2007, nine months before Fannie Mae made a preferred stock offering and four months before Freddie Mac issued preferred stock. This was also just one short month before Lockhart and Congress encouraged the companies to load up on subprime securities. It was one year before Paulson's Eton Park meeting and eleven months before Ben Bernanke and Jim Lockhart publicly stated that the firms were adequately capitalized.
The Big Bad Bank
Hopefully, readers of the timeline above are able to follow the events and significance of each action, but let's add one more layer of complexity to the situation. In January 2009, the Obama Administration proposed a new type of "bad bank" called an "aggregator bank." We'll call this bad bank the "Big Bad Bank." Supporters of the plan included Sheila Bair and Ben Bernanke.
Generally, with bad bank scenarios, the government would bail out each bank separately, moving toxic assets off of each bank's balance sheet, one bank at a time. Each bank would get it's own bad bank for toxic assets.
With the Big Bad Bank, you would create one large toxic asset pool and move assets off of each bank's balance sheet to the central pool. The pool of bad assets would need to be administered, efficiently, with the intention of reducing losses. What better way to create a Big Bad Bank than to use the existing backstops, Fannie and Freddie.
Fannie and Freddie rewrote over 2.3 million mortgages, absorbed billions in dollars of losses from subprime mortgage securities, and settled repurchase claims for pennies on the dollar. Regarding the repurchase settlement with Bank of America (BAC), Congresswoman Maxine Waters said,
"This settlement may have been both premature and a giveaway." The deal may "amount to a backdoor bailout that props up the bank at the expense of taxpayers."
The Conservatorship Agreement
Part of the Conservatorship Agreement, forced upon shareholders, was a promise by the FHFA to "preserve and conserve" these companies' assets. It has been stated multiple times that
"The purpose of conservatorship is to preserve and conserve each company's assets and property and to put the companies in a sound and solvent condition. The goals of the conservatorships are to help restore confidence in the companies, enhance their capacity to fulfill their mission, and mitigate the systemic risk that contributed directly to instability in financial markets."
However, almost immediately, the companies were turned into massive foreclosure prevention instruments, administering mortgage modification programs and working as a financial backstop to the entire sector. During the height of the crisis, the GSE's market share spiked as private lenders fled the market. As of today, the GSEs have modified over 2.3 million mortgages to help homeowners avoid foreclosure.
This has led some to say that the terms of conservatorship have been violated as the companies are used for public policy purposes rather than to support the private owners. It has also led many to call them public utilities.
Public Utility Model
There are many reasons why investors believe the companies have already become public utilities.
First, the government imposed strict rules on what type of mortgages the company was allowed to buy.
Second, they set limits on the amount of fees the GSEs could charge, lowering them to razor thin levels. The companies lobbied to increase the fees unsuccessfully. However, in December 2011, a payroll tax relief bill was extended, paid for by the increased fees at Fannie and Freddie. It is unclear how the payroll tax is related to housing finance.
Third, they broadly expanded the size of the loans they were allowed to purchase and guarantee, which pushed them into lending for the higher market value homes.
Fourth, they created programs like HAMP and HARP which encouraged borrowers to apply for mortgage restructuring, which in many cases gave incentive for the borrowers to default on their loans. The Philly Fed issued a report in the Fall of 2010 that proved many borrowers were choosing to default on their first mortgages, while continuing to pay other debts, including credit cards and second mortgages.
Fifth, they imposed restrictions on the size of the mortgage portfolios, even for loans that were generating stable income. This is the most important factor in the profitability of these companies. Historically speaking, Fannie Mae was created during the Depression as an entity that would purchase mortgage loans in the private market and hold them as investments, increasing mortgage availability by absorbing excess supply. This action lowered borrowing costs and helped propel America out of the Depression. Today, the Federal Reserve has taken on this function by buying over a trillion in mortgage securities guaranteed by Fannie and Freddie. If the borrowers connected to these securities default, Fannie and Freddie take the losses, but all of the profits go to the Federal Reserve. The Fed has made almost as much money from this program as the bailouts have cost to taxpayers.
Sixth, they imposed a 10% penalty on the borrowings of the company. This is twice the rate charged to TARP banks. As Ed Royce once stated in a Congressional hearing, the purpose of the 10% dividend is solely to punish these companies and prevent them from surviving.
10% Dividend Violates Conservatorship Agreement
Ever since the Conservatorship of these companies was established, the management and shareholders of these companies have objected to the 10% dividend on the Treasury's cash infusions. While other companies receiving cash injections from the government paid 5%, the dividend at the GSEs was twice as much. Currently, the annual dividend surpasses annual earnings posted by these companies ever in their entire history. This is the reason these companies have been borrowing funds from the Treasury to pay the dividend back to the Treasury. This vicious cycle is contrary to the expressed goals of Conservatorship and is clearly a violation.
Why have so many community banks failed during the past few years?
For starters, these banks loaded up on the bad paper created by the Wall Street subprime securitization factories. The toxic assets soured and they took huge write-downs.
For another reason, the federal government made a concerted effort to fix the big banks, while at the same time ignoring issues that lead to multiple small bank failures. This Too Big To Fail concept led decision making throughout the crisis. I can tell you about at least one small bank that failed because the government didn't stand behind their implicit guarantee of Fannie and Freddie Preferred Stocks.
"Small banks were the most frequent users of the Federal Reserve's discount window during a 14-month period in 2008 and 2009, among them seven units of an Illinois bank-holding company that turned to the emergency-lending facility a total of 330 times before they failed."
"FBOP Corp., based in Oak Park, Ill., got short-term funding from the Fed more often than any other financial firm, according to data released by the central bank last week."
"FBOP was battered by the U.S. takeover of Fannie Mae and Freddie Mac, which wiped out preferred shares in the two mortgage giants held by FBOP."
Why Did These Banks Hold Fannie and Freddie Preferreds?
The preferred stocks were issued with documentation that was clearly crafted to give the impression of the Treasury's seal of approval, but with no legal ramifications for not standing behind the investments.
"As a federally chartered corporation, we are subject to the limitations imposed by the Charter Act, extensive regulation, supervision and examination by OFHEO and the U.S. Department of Housing and Urban Development ("HUD"), and regulation by other federal agencies, including the Department of the Treasury and the SEC."
Many investors purchased these securities believing that the U.S. Government would never let them default on their dividend payments. They were sold to investors as investment grade agency securities. However, in September 2008, dividend payments were suspended. It doesn't stop there.
Buy These Stocks "Without Limit"
In April 2002, the Comptroller of Currency, a division of the Treasury, issued letters to banks that stated the following:
"A national bank may invest in perpetual preferred stock issued by the Federal National Mortgage Association ("Fannie Mae") and by the Federal Home Loan Mortgage Corporation ("Freddie Mac") without limit,"
That's right. The Treasury told banks to buy Fannie and Freddie preferred stocks "without limit" and then they suspended the dividends to the same stock shares.
Volcker, Issac, and Meyer Call It Boneheaded
In the book, "Senseless Panic: How Washington Failed America," Paul Volcker and other authors write "Wiping out Fannie and Freddie preferred stock was a boneheaded idea. It sent shock waves throughout the world." $37 billion in securities that were believed to carry a U.S. Government guarantee were wiped out. And even more interestingly, subordinated bondholders were saved. A large portion of these securities were held by the Chinese.
Congress Wants to Know Why the Chinese Were Spared
In a Congressional hearing, a Congressman asked Tim Geithner why these events unfolded the way they did. Geithner says that he cannot answer for the actions of his predecessor. Shareholders watched intently during these hearings, but we never got to hear Tim Geithner's response to this Congressman.
Nader Inquires with the Treasury
On April 11, 2011, Ralph Nader sent a letter to Inspector General Eric Thorson at the Department of the Treasury. Nader called for an investigation of "misleading statements by high government officials about the financial health of Fannie Mae & Freddie Mac" prior to their nationalization. This 11 page document outlines a variety of issues, little noticed by the general public.
First, Nader points out some of the basics of the situation. The companies were suddenly and swiftly seized by the U.S. Government in September 2008. Shareholders were not bought out. They weren't eliminated. They continue to exist as 20.1% owners of a company without a defined future. Since 2008, they've become the de facto mortgage market, along with FHA, making mortgages at a government mandated loss.
Next, Nader illustrates the fact that multiple government officials said the companies were "well capitalized," "adequately capitalized," or in "good shape" two months before shareholders were essentially wiped out. The list of shareholder pacifiers includes James Lockhart (OFHEO Director), Barney Frank (Congressman), Chuck Greener (Fannie VP), Christopher Dodd (Senator), Hank Paulson (Treasury Secretary), Ben Bernanke (Federal Reserve Chairman), and Daniel Mudd (Fannie CEO).
The letter then continues to outline some questions that need to be answered. In my opinion, the following questions are the ones most important to be answered by the Treasury:
"If the two companies should recover, does the FHFA intend to release Fannie Mae and Freddie Mac from conservatorship and relist their securities on the NYSE?"
"Does the Treasury Department have a moral obligation to provide GSE common stockholders with the legal rights they had before the conservatorship was established?"
Shareholders haven't received an answer to these questions.
Additional disclosure: Holdings include FMCKI, FMCKP, FMCCO, FMCKJ, FMCKK, FNMAL, FNMAO, FMCCL, FMCCS, FMCCP, FMCCT and FMCCK.