Voices

The GSEs are on their way to pay­ing back the money they owed the gov­ern­ment un­der the orig­i­nal bailout deal, mak­ing 2018 an op­por­tune time for an over­haul of the hous­ing fi­nance mar­ket.

National Mortgage News - - Contents - BY ALEX J. POLLOCK

the trea­sury depart­ment and the Fed­eral Hous­ing Fi­nance Agency re­cently struck a deal amend­ing how Fan­nie Mae and Fred­die Mac’s profits are sent to Trea­sury as div­i­dends on their se­nior pre­ferred stock.

But no one pre­tends this is any­thing other than a patch on the sur­face of the Fan­nie and Fred­die prob­lem.

The gov­ern­ment-spon­sored en­ter­prises will now be al­lowed to keep $3 bil­lion of re­tained earn­ings each, in­stead of hav­ing their cap­i­tal go to zero, as it would have done in 2018 un­der the for­mer deal. That will mean $6 bil­lion in eq­uity for the two com­bined, against $5 tril­lion of as­sets — for a cap­i­tal ra­tio of 0.1%. Their cap­i­tal will con­tinue to round to zero, in­stead of be­ing pre­cisely zero.

Fan­nie and Fred­die’s top reg­u­la­tor, Mel Watt, had wor­ried about their run­ning with ex­actly zero cap­i­tal go­ing for­ward, so any quar­terly losses, per­haps from the va­garies of de­riv­a­tives ac­count­ing, would force re­newed bailout in­vest­ments from the Trea­sury. That would have looked bad.

Ad­di­tional bailout in­vest­ments may well be nec­es­sary any­way, as Trea­sury and the FHFA ad­mit, be­cause by drop­ping the cor­po­rate tax rate, the new tax re­form law im­plies ma­jor write-downs in Fan­nie and Fred­die’s de­ferred tax as­sets. That will look bad, too.

Here we are in the 10th year since Fan­nie and Fred­die’s cred­i­tors were bailed out by Trea­sury. Re­call the orig­i­nal deal: Trea­sury would get div­i­dends at a 10% an­nual rate, plus — not to be for­got­ten — war­rants to ac­quire 79.9% of both com­pa­nies’ com­mon stock for an ex­er­cise price of one-thou­sandth of one cent per share. In ex­change, Trea­sury would ef­fec­tively guar­an­tee all of Fan­nie and Fred­die’s obli­ga­tions, ex­ist­ing and newly is­sued.

Of course, in 2012 the gov­ern­ment changed the deal, turn­ing the 10% pre­ferred div­i­dend to a pay­ment to the Trea­sury of es­sen­tially all Fan­nie and Fred­die’s net profit in­stead. To com­pare that to the orig­i­nal deal, one must ask when the re­vised pay­ments would be­come equiv­a­lent to Trea­sury’s re­ceiv­ing a full 10% yield, plus enough cash to re­tire all the se­nior pre­ferred stock at par. The an­swer is eas­ily de­ter­mined. Take all the cash flows be­tween Fan­nie and Fred­die and the Trea­sury, and cal­cu­late the Trea­sury’s in­ter­nal rate of re­turn on its in­vest­ment. When the IRR reaches 10%, Fan­nie and Fred­die have sent in cash eco­nom­i­cally equiv­a­lent to pay­ing the 10% div­i­dend plus re­tir­ing 100% of the prin­ci­pal. This I call the “10% Mo­ment.”

Fred­die reached its 10% Mo­ment in the sec­ond quar­ter of 2017. With the $3 bil­lion div­i­dend Fan­nie was pre­vi­ously plan­ning to pay on Dec. 31, the Trea­sury’s IRR on Fan­nie would have reached 10.06%. The new Trea­sury-FHFA deal will post­pone Fan­nie’s 10% Mo­ment a bit, but it will come. As it ap­proaches, Trea­sury should ex­er­cise its war­rants and be­come the ac­tual owner of the shares to which it and the tax­pay­ers are en­ti­tled. When added to that, Fan­nie reaches its 10% Mo­ment, then pay­ment in full of the orig­i­nal bailout deal will have been achieved, eco­nom­i­cally speak­ing.

That will make 2018 an op­por­tune time for fun­da­men­tal re­form.

Any real re­form must ad­dress two es­sen­tial fac­tors. First, Fan­nie and Fred­die are and will con­tinue to be ab­so­lutely de­pen­dent on the de facto guar­an­tee of their obli­ga­tions by the U.S. Trea­sury, thus the tax­pay­ers. They could not func­tion even for a minute with­out that.

Sec­ond, Fan­nie and Fred­die have demon­strated their abil­ity to put the en­tire fi­nan­cial sys­tem at risk. They are with no doubt what­so­ever sys­tem­i­cally im­por­tant fi­nan­cial in­sti­tu­tions. In­deed, if any­one at all is a SIFI, then it is the GSEs. If Fan­nie and Fred­die are not SIFIs, then no one is a SIFI.

Alex J. Pollock is a se­nior fel­low at the R Street In­sti­tute and was pres­i­dent and CEO of the FHLBank of Chicago from 1991 to 2004.

Here we are in the 10th year since Fan­nie Mae and Fred­die Mac’s cred­i­tors were bailed out by Trea­sury.

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