August 17, 2012, The Net Worth Sweep, And Fairholme's 16 Questions

Aug. 18, 2015 1:19 PM ETFMCC, FNMA4 Comments
Wayne Olson, CFA profile picture
Wayne Olson, CFA


  • August 17, 2012 was a terrible day for FMCC and FNMA common and preferred investors.
  • Fairholme asked 16 important questions for GSE investors in its semi-annual report.
  • The ongoing GSE saga presents important questions about oligarchy and grand corruption in the U.S. financial system.

August 17, 2012, was both a memorable and a terrible day for Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA) (together known as the government-sponsored enterprises or GSEs) common stockholders and preferred stock holders. On this day, the 3rd Amendment to the Senior Preferred Stock Purchase Agreements (SPSPAs) was announced, which included the establishment of the net worth sweep, which "eliminates the possibility of the Enterprises having to borrow from U.S. Treasury (Treasury) to pay dividends, which could have eroded market confidence. This change also ensures all the Enterprises' earnings are used to benefit taxpayers."

In addition to the FMCC and FNMA common stocks, the net worth sweep also affects the Freddie Mac and Fannie common stocks. Table 1 provides summary information - circa mid-2012 - on two GSE preferred stocks, FMCKJ and FNMAS. These preferred stocks are notable because they were issued shortly before the financial crisis. May 2, 2012 and August 17, 2012 were high-volume days for these preferred stocks. The trading prices of these preferred stocks had gradually risen during the May 2, 2012 to August 16, 2012 period - and then dropped like a rock on August 17, 2012.

Table 1: FMCKJ and FNMAS Volume and Closing Prices, May 2, August 16, and August 17, 2012


Volume (No. of Shares)

Closing Price ($)


May 2, 2012



August 16, 2012



August 17, 2012




May 2, 2012



August 16, 2012



August 17, 2012



For better or worse, the future prospects of the FMCC and FNMA common stocks and the GSE preferred stocks are largely based on overturning the 3rd Amendment.

Fairholme, in its semi-annual report, asks 16 questions about their search for the truth despite "clear indications of more disturbing elements at work-including greed, spite, and ulterior political motives." In this article, I will comment on several of Fairholme's 16 questions, starting with the 16th and working my way toward the first.

Q16. Were certain federal government employees who crafted the Net Worth Sweep acting at the behest of crony capitalists seeking to displace Fannie and Freddie?

A16. While it is impossible to answer this question definitively, there are some indications and evidence of an interplay of oligarchy and democracy in America. Jeffrey Winters and Benjamin Page explain that "oligarchy refers broadly to extreme political inequalities that necessarily accompany extreme material inequalities." Oligarchy theory suggests that oligarchs may exert influence over macroeconomic economic and monetary policies, tax policy, and the politics of re-distribution, among others. The 2008-2009 bailout of financial institutions - rather than "underwater" homeowners - can be viewed to be consistent with oligarchy.

Princeton professors Marty Gilens and Benjamin Page have tested the influence on public policy of economic elites (with high income and wealth) and interest groups that cater to corporations, business associations, and professional groups relative to "average citizens." They find that there is empirical evidence that supports the theory that economic elites and the interest groups that serve big business have a great deal of influence on U.S. public policy. Simply put, the "collective action problem" may mean that it is hard for large groups of individuals to organize and fund participation on public policy issues.

Arguments about the influence of economic elites and the interest groups that serve them lead to questions about corruption. Grand corruption involves acts that are committed at a high level of government that distort policies or the central functioning of the state, enabling leaders to benefit at the expense of the public good. Political corruption is the manipulation of policies, institutions and rules of procedure in the allocation of resources and financing by political decision makers, who abuse their position to sustain their power, status and wealth. Crony capitalism is where political networks dominate important private assets. State capture is where private firms are able to influence public policy to their own benefit. Grand corruption, crony capitalism, and state capture may be highly relevant to the situation facing GSE investors - there may have been a "quiet coup" such that the big banks and their agents may have "effectively captured our government."

A recent Seeking Alpha article suggests that Judge Wheeler's decision in Starr v. U.S. may be relevant to the plight facing GSE investors. Judge Wheeler found that there was an illegal exaction when the government unilaterally demanded taking equity in AIG as a condition for an extension of a loan by the Federal Reserve to AIG, despite the lack of statutory authority to do so. Essentially, it is possible that AIG was "seized" in order to provide a vehicle for the "stealth" bailout of more politically favored financial entities (e.g., Goldman Sachs). It is at least possible that this was also the case with respect to conservatorship for the GSEs. The GSEs may, however, have a better argument with respect to damages, given that the quantification of damages caused by the 3rd Amendment is more readily calculable.

Q15. Why do some Treasury officials question the sustainability of Fannie and Freddie's earnings power in the years ahead, when Treasury's own 2014 Annual Report indicates that the companies will be consistently profitable for each of the next 25 years?

A15. How can a forecast of $191.2 billion in GSE dividends to the Treasury based on the net worth sweep be reconciled with a forecast of a draw on the Treasury of as much as $157.3 billion? The answer is: the $191.2 billion is derived from a base case analysis with assumptions that are presumed to be consistent with what is expected to occur, while the $157.3 billion is a "worst case" analysis that uses assumptions that reflect economic conditions that are not expected to occur.

An Office of Management and Budget (OMB) analysis anticipates that Freddie Mac and Fannie Mae could return $153.3 billion in profits to taxpayers and/or GSE investors over the next 10 years, which would total $191.2 billion since the SPSPAs were established. The OMB's budget is based on governmental accounting, which focuses on inflows of cash to the Treasury and outflows of cash from the Treasury. Interestingly, the difference between $153.3 billion and $191.2 billion appears to be the payments in excess of "net investment" (senior preferred dividends in excess of draws on the Treasury) that the GSEs have paid into Treasury even though the government's senior preferred stock is still on the books. In addition, deficit reductions of $39.5 billion from FY2012 through FH2015 are expected pursuant to a 10 basis point fee on security guarantees issues that flow directly to Treasury (after being "passed through" the GSEs) pursuant to the Temporary Payroll Tax Cut Continuation Act of 2011.

A Federal Housing Finance Agency (FHFA) analysis, on the other hand, states that the GSE could draw anywhere from $68.6 billion to $157.3 billion on the Treasury, down from the range of $84.4 billion to $190 billion the previous year, with the actual outcome depending on the treatment of deferred tax assets if the draws were to occur. The FHFA's April 30, 2015 Dodd-Frank Act Stress Test (DFAST) "worst-case analysis" is intended to reflect a substantial global weakening in economic activity combined with a severe recession in the U.S. In a previous article, I explained that the assumptions used in the FHFA analysis are extremely stringent. Thus, I opined that "while I cannot, as a financial economist, say that any one of these assumptions will not occur sometime over the 20 or 50 years, I would say that the likelihood of all eight of these assumptions occurring is remote. More than anything, if results anywhere near those of the DFAST ever occur, it would mean an utter failure of U.S. financial and housing regulation."

Q14. Why has the Securities and Exchange Commission (SEC) permitted a single controlling shareholder (i.e., Treasury) and its affiliates to simultaneously act as director, regulator, conservator, supervisor, contingent capital provider, and preferred stock investor of two publicly traded companies?

A14. Let's parse this out a bit. The FHFA can, I suppose, be said to act as director, regulator, conservator, and supervisor, but its two statutory duties are to act as an independent regulator of the GSEs and, if the GSEs are in conservatorship (or receivership), to act as conservator (or receiver). Treasury is the single controlling shareholder, contingent capital provider, and senior preferred stock investor for the two GSEs.

FHFA is supposed to act as an independent regulator, but it's a bit difficult to see them as fully independent of Treasury as major changes in the SPSPAs must be agreed to by Treasury. Nevertheless, FHFA does appear to act as an independent regulator with respect to policies that are clearly within its regulatory ambit and outside the ambit of the SPSPAs.

Like the FDIC, the FHFA, when acting as conservator, is traditionally given a great deal of discretion by other regulatory and executive branch departments, as well as by the courts. The proper extent of the FHFA's discretion as conservatorship is currently being challenged in the courts. An issue before the federal Court of Claims is whether or not the FHFA has been acting as "the government" in its actions as conservator, i.e., pursuing outcomes that are favorable for Treasury (and taxpayers) rather than comply with its fiduciary duties to act on behalf of the GSEs and GSE investors.

It is possible that the reason why the SEC has allowed this to occur may reflect the fact that no one has asked the SEC to investigate the issues raised by Q14. It may also reflect state capture as discussed in the answer to Q16.

Q13. Why did Fannie Mae CEO Tim Mayapoulos describe the Net Worth Sweep as a "positive change" with "a lot of good in it" in his August 2012 announcement to employees? Was he coerced by federal regulators?

A13. While I can't speculate on why FNMA's CEO thought that the net worth sweep was a "positive change" in 2012 (or whether he was "coerced" by federal regulators to say what he said), my own view is that the net worth sweep was beneficial in the short run because it led to the acceleration of repayment of Treasury in terms of net investment, but bad in the long run because of the creeping expropriation of GSE common and preferred investors and the de facto nationalization of investor-owned companies.

I will continue with my responses to Fairholme's 12 remaining questions in a subsequent article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

This article was written by

Wayne Olson, CFA profile picture
CFA, CPA, MA in Economics.

Disclosure: I am/we are long FMCKJ, FNMAS, AND OTHER GSE PREFERRED STOCKS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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