Fannie And Freddie: Current Plans Could Affect Iowa Pensions

| About: Fannie Mae (FNMA)
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IPERS holds $1 billion in GSE Mortgage Securities.

Some GSE reform plans would "bifurcate" the securities market.

Treasury and FHFA actions call their motives into question.

Iowa residents are hearing a lot about the Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) investor lawsuits these days. There's good reason. The outcome of these lawsuits could rock the country's economy and impact the future of housing finance. It also sets a precedent for how the U.S. government can approach any private-public partnership in the future.

The government-sponsored entities (GSEs) are integral parts of the nation's economy, providing the bulk of financing for home purchases and building, which happens to be about 25% of the overall economy. Investors believe they were given a raw deal by the U.S. Treasury and the Federal Housing Finance Administration (FHFA), which is the GSE's conservator.

Treasury and FHFA decided to amend their financing agreement in 2012. They switched from having Fannie and Freddie pay a 10% dividend to paying 100% of their net worth each quarter. Thus, all of the companies' profits have been sent to Treasury - a whopping $225 billion. This has left taxpayers with a substantial profit, as the companies had received about $187 billion in support (including the 10% dividend). On a cash basis, the numbers are even better for taxpayers and even worse for the future of the companies.

So, what's the problem? Investors relied on the original agreement that was made in 2008. Four years after the financial crisis, it was amended without any consideration given to shareholders. In fact, the result of this change is that the companies have had more than $130 billion in equity capital swept off their books that would have stayed with the original contract terms. The equity capital that was swept away would have gone a long way toward recapitalizing the companies and allowing them to regain their financial footing in the market. This would have ensured a strong future for housing finance.

How does this affect pensions and retirements?

Currently, Fannie and Freddie guarantee trillions of dollars in mortgage-backed securities (MBS). These MBS are sold to banks, foreign nations, mutual funds and pension funds. With the tremendous run-up in bond prices, people are underestimating the fragility of the bond market. If interest rates ever rise, bond prices will fall. This is one portion of the perilous situation facing investors.

Another concern is the warnings that came from the Securities Industry and Financial Markets Association (SIFMA) in 2010. SIFMA encouraged policymakers to avoid "bifurcation" of the MBS market when enacting GSE reform. In this sense, bifurcation of the market refers to the marketability and trading of certain MBS issues. Currently, Fannie and Freddie are two of the largest issuers. Certain GSE reform proposals included a phase-out of Fannie and Freddie securities, and the creation of a new common security issued through a separate platform.

This creates a new problem. As the old market for Fannie and Freddie begins to go away, the marketability of those assets will be impaired. Pensions and mutual funds holding the old securities could find themselves in a liquidity problem if the bond market were to begin dropping. Securities with low liquidity can lose value very quickly.

The GSEs also operate without a capital cushion. So, another future shock to the financial system could devastate bond prices. There is no capital in a first-loss position.

A final concern for retirements and pensions has to do with the complete lack of regard for contractual agreements made with GSE shareholders. Who does Treasury think they will find to provide first-loss capital for the new mortgage finance system? The current treatment of GSE shareholders has set an awful precedent that should make any investor think twice about partnering with the government.

For investors in the Iowa Public Employees' Retirement System (IPERS), this should be a primary concern. In the most recent Annual Report, the system reports to holding more than $1 billion in GSE MBS.

Why did Treasury change their agreement with FHFA?

Let's step back and examine this contract change one more time. One of the main reasons was specified in August 2012, when they announced the action to the market:

This change also ensures all the Enterprises' earnings are used to benefit taxpayers.

In business school, most students take a course that includes some basic contract law. One of the important tenets of a business contract is that if a party to a contract is giving something up, that party must receive something in return. Otherwise, the lack of "consideration" given to one of the parties could be a good reason to nullify a contract amendment. Additionally, the amount of consideration must be equal to the amount of benefit given away. Here, shareholders who were not part of the negotiations gave up at least $130 billion in potential capital and received nothing of comparable value in return.

At least one of the judges may see things the same way.

In 2015, policymakers may come to their senses and preserve the best parts of the mortgage finance system. There is tremendous value in the current GSEs, Fannie and Freddie. This includes the companies' earnings power, which could push share prices much higher with some positive GSE reform.

Disclosure: The author is long FNMA, FMCC.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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