Fannie, Freddie And The Treasury: Examining The Dynamics Of The New Arrangement

 |  Includes: FMCC, FNMA
by: Colin Lokey

On Friday, the U.S. Treasury announced plans to "accelerate the wind down" of Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). The "modifications" to the Preferred Stock Purchase Agreements require that 1) the two GSE's [government sponsored enterprise] portfolios be wound down by 15% annually [up from 10%], 2) an annual report be filed by both entities outlining their plan to reduce taxpayer exposure to mortgage credit risk, and 3) all income will be swept from the companies each quarter. According to the Treasury's press release, the new plan will expedite the wind down of Fannie Mae and Freddie Mac, make sure that every dollar of earnings each firm generates is used to benefit taxpayers, and support the continued flow of mortgage credit during a responsible transition to a reformed housing finance market.

The quarterly profit sweep replaces the 10% dividend payment Fannie and Freddie were required to pay to the Treasury. Surprisingly, the Treasury was quite candid about why it eliminated the dividend payment and replaced it with the income sweep.

[The new arrangement will end] the circular practice of the Treasury advancing funds to the GSEs simply to pay dividends back to Treasury. (emphasis mine)

This point is worth taking note of if you aren't aware of how this "arrangement" has functioned since Fannie and Freddie were put into conservatorship in 2008. While the entities owe the Treasury annual dividends in the amount of $11.7 billion (Fannie) and $7.2 billion (Freddie), they have been understandably unable to pay because they don't make enough money.

From Fannie Mae 2011 10K (pdf):

The amount of this dividend payment exceeds our reported annual net income for every year since our inception.

From Freddie Mac 2011 10K (pdf):

Treasury is entitled to annual cash dividends of $7.23 billion, which exceeds our annual historical earnings in all but one period.

Ultimately, the dividends are paid to the Treasury though, and this is made possible by cash injections from...the Treasury. As Fannie Mae explains in its annual report,

...Treasury has made a commitment under a senior preferred stock purchase agreement to provide us with funds under specified conditions and...we will continue to need funds from Treasury as a result of a number of factors, including the dividends we are required to pay Treasury. (emphasis mine)

So taxpayers have been paying themselves back for quite sometime now. Mercifully, the Treasury has decided to end this "circular practice" by replacing the dividend it was paying to itself with a "profit sweep."

The first thing to note about this is that the Treasury was running a ponzi scheme. Putting it in these terms is not an attempt to disparage the Treasury or make something different of it than it was, it is merely calling it like it is. The second thing to note here is that it is highly questionable if these two entities will be able to generate any profits that can be swept. While both Fannie and Freddie reported a profit for the second quarter those profits were largely credit-related:

From Fannie's press release (pdf):

The company's continued improvement in financial results in the second quarter of 2012 was almost entirely due to credit-related income

From Freddie's press release (pdf):

The increase in net income for the second quarter of 2012, compared to the first quarter of 2012, primarily reflects a decline in the provision for credit losses due to positive trends in the housing market.

If the housing market does not continue to recover, it seems logical to say that Fannie and Freddie may not be profitable. This leaves no profits for the Treasury (taxpayers). Is this better than taxpayers paying themselves a dividend? Who really knows.

Lastly, it is worth mentioning that the new arrangement will speed the process by which Fannie and Freddie wind down their investment portfolios. It isn't clear who the buyer for these additional securities is, but as ZeroHedge rightly notes, it might well be the Fed. This of course begs the question as to whether the Fed and the Treasury are just replacing one circular funding scheme with another: if the Fed creates money to buy (more) mortgage backed securities from two entities whose profits are pledged to the Treasury, it would be just one more example of the government's left pocket to right pocket accounting.

All in all, investors shouldn't necessarily view the Treasury's move as a positive development for taxpayers. The worry seems to be that these new measures have done very little to facilitate the wind down of Fannie and Freddie. Indeed several congressmen have suggested that this is merely a kick-the-can approach that leaves taxpayers on the hook for mortgage credit risk. Without a viable private-market alternative for loan securitization, it appears the public will be forced to backstop risky MBS for the foreseeable future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.