Fannie and Freddie’s Big Loan Mod

August 17, 2012

The Administration today gave Fannie Mae and Freddie Mac a major loan modification and moved a step closer to their de facto nationalization by eliminating the quarterly compounding dividend payment they have been paying and replacing it with a sweep of any operating profits generated by the companies after paying for operations and reserves.   While these moves fall far short of the comprehensive plan for the mortgage system’s future promised in the Administration’s 2011 White Paper, they reinforce an emergent bipartisan Congressional and stakeholder consensus on the need for a continuing future federal role in assuring a stable and consumer-friendly mortgage finance system. 

In 2008, Treasury rescued Fannie and Freddie from insolvency and provided fresh capital to the companies by purchasing senior preferred stock, initially $100 billion each.  Existing common stockholders and other preferred stockholders were essentially wiped out, and the infusions enabled the companies to continue to intermediate capital investments in housing.  Good thing, too – as private investors fled the mortgage market, Fannie and Freddie’s share of mortgage financings grew to record-high levels, along with FHA and its securities gurantor Ginnie Mae.  Together these entities now provide nearly all capital used for refinances and home purchases.

As time went on and the companies’ distress from failed loans in securities they had guaranteed deepened, Treasury increased its infusions, ultimately committing to unlimited support through 2012, when the commitment would be capped at outstanding commitments made in 2010-2012, plus a maximum additional amount of $200 billion each.

The government’s help didn’t come cheap – both companies were required to pay quarterly compounding dividends of 10 percent on the capital advances, or twice as much as bank recipients of TARP funding paid.  Since Treasury’s investments began, the companies have paid out $45.7 billion in dividends on a total of $188 billion in Treasury capital infusions.  And because these payments were required every quarter, both companies repeatedly have had to seek additional Treasury assistance, primarily to pay the dividends, turning the Treasury agreements into perhaps the biggest, baddest payday loan ever.

Working with the companies and their conservator, the Federal Housing Finance Agency, Treasury has now amended these agreements.  The required quarterly dividends have been converted to a claim on all profits generated by the companies after paying for operations and maintaining a capital reserve fund.  Rather than continuing to accrue a compounding repayment obligation, the agreement caps the repayments to this amount.  Whether the commitment would end should the companies manage to pay back in full the amounts already advanced by Treasury is unclear; the amended agreements run through 2017.  But Treasury’s announcement states that the GSEs “…will be wound down and will not be allowed to retain profits, rebuild capital, and return to the market in their prior form,” and given the large amounts already advanced such a full repayment seems unlikely for the foreseeable future.”

Reassuring the Market

This shift from dividend to profit sweep converts Fannie and Freddie’s repayments from an above the line expense to a below the line expense.  This means that while the companies still have to repay the Treasury and taxpayers for their support, they will do so out only if their operating income exceeds their costs.  Under the agreements released today, no dividend obligation will be collected or, more importantly, accrue in any quarter where the companies do not meet this test.  Given that both Fannie and Freddie reported sufficient net income in the last quarter to fully repay the dividend and fund all their operations without needing additional Treasury support, the conversion greatly reduces the likelihood that any further infusions will be necessary.  

The change also should ease investors’ concerns over the capping of Treasury commitments that takes effect at the end of this year.  While the dividend payments were an above the line expense, they posed a constant drag on earnings and a threat that more Treasury capital would be needed to pay for them.  With contributions capped, investors feared that the day might come when the government’s backing for the companies effectively ended, throwing the value of their securities guarantee into doubt.  This anxiety is part of why investors have bid up the price of Ginnie Mae securities and bid down GSE bonds recently.  Today’s announcement likely will eliminate that concern.  Higher bids for GSE bonds would be direct evidence of that.  This should also mean lower mortgage costs for borrowers using conventional, rather than FHA, loans, since the bonds’ yields should rise.

Treasury also announced some other changes in GSE oversight today.

• Fannie and Freddie will be required to submit an annual report to Treasury “…on its actions to reduce taxpayer exposure to mortgage credit risk for both its guarantee book of business and retained investment portfolio.”
• The companies will accelerate the wind down of their mortgage portfolios from the current 10 percent per year to 15 percent per year, and reach a stabilized level of $250 billion each four years earlier than under the previous plan.

Who’s Your Daddy?

These changes mark a subtle but important shift in the government’s relationship with the GSEs.  The original investment model made Treasury and the taxpayers “super investors” in the companies.  They provided capital for entities still operating in theory as independent but heavily supervised private companies.  This left open the possibility, however remote, that the companies might someday be able to claw their way out of their hole, buy back the senior preferred stock and emerge intact from conservatorship. 

Now Treasury has made it clear that they basically own the companies and will collect every dollar of retained or excess earnings they produce.  When combined with FHFA’s own Strategic Plan for the companies’ future, the change moves the government closer to a path through which Fannie and Freddie are reengineered into a government owned operation of some kind to carry out the important utility functions needed to support a liquid mortgage securities market.