Fannie and Freddie face the moment of truth on their taxpayer bailouts

Published in The Hill.

Almost nine years ago, in September 2008, Fannie Mae and Freddie Mac were broke and put into government conservatorship by the Federal Housing Finance Agency. Less than two months before, the regulator had pronounced them “adequately capitalized.” As everybody knows, the U.S. Treasury arranged to bail them out with a ton of taxpayer money, ultimately totaling $187.5 billion, in order to get their net worth up to zero.

The original form of the bailout was senior preferred stock with a 10 percent dividend. By agreement between two parts of the government, the FHFA as conservator and the Treasury, the dividend was changed starting in 2013 from the original 10 percent to essentially 100 percent of the net profit of the two companies, whatever that turned out to be, in this notorious “profit sweep.”

By now, under the revised formula, Fannie and Freddie have paid in dividends to the Treasury $276 billion in total. That sounds like a lot more than $187.5 billion, a point endlessly repeated by the speculators in Fannie and Freddie’s still-existing common and junior preferred stock. Does this mean that Fannie and Freddie have economically, if not legally, paid off the Treasury’s investment? Nope. Not yet. But almost.

Let us suppose—which I believe to be the case—that the original 10 percent is a reasonable rate of return on the preferred stock for the taxpayers, who in addition got warrants for 79.9 percent of Fannie and Freddie’s common stock with an exercise price that rounds to zero. The 10 percent compares to the interest rate of 2 percent or so on 10-year Treasury notes and is greater than the average return on equity of 8 percent to 9 percent for banks in recent years.

The question is: When would all the payments by Fannie and Freddie to the Treasury constitute first a 10 percent annual yield on the preferred stock and then have been sufficient to retire all its par value with the cash that was left over?

This is easy to calculate. We lay out all the cash flows, all the investment that went into Fannie and Freddie from the Treasury, and all the dividends they paid to the Treasury, and calculate the cash-on-cash internal rate of return. When the internal rate of return gets to 10 percent, the economic payoff will have been achieved. I call this the “10 percent moment.”

As of the second quarter of 2017, the internal rate of return is 9.68 percent, so the 10 percent moment is close. If Fannie and Freddie pay the third quarter dividends they have projected, on a combined basis, the 10 percent moment will arrive in the third quarter of this year. The internal rate of return will have reached 10.02 percent.

However, viewing Fannie and Freddie separately, it is slightly more complex. Fannie is at 9.36 percent and should get to 10 percent by the fourth quarter of this year. Freddie has already made it, with an internal rate of return of 10.11 percent as of the second quarter of 2017.

At the 10 percent moment, let’s say the end of 2017, the Treasury could very reasonably and fairly consider its senior preferred stock as fully retired and agree to amend the agreements accordingly. Treasury should then also exercise all its warrants, to assure its 79.9 percent ownership of any future retained earnings and of whatever value the common stock may develop, guaranteeing the taxpayers the equity upside which was part of the original deal, and also assuring its voting control.

At that point, should it develop, the capital of Fannie and Freddie would still be zero. In this woefully undercapitalized state, they would still be regulated accordingly, and still be utterly dependent on the Treasury. They should begin immediately to pay a fee to the Treasury for its effective guaranty of their obligations. This fee should be charged on their total liabilities and be equivalent to what the Federal Deposit Insurance Corp. would charge a large bank with their level of capital for deposit insurance — for starters, a bank with zero capital.

There are a few other requirements for this new deal for Fannie and Freddie. They should immediately be designated as the large and “systemically important financial institutions” they so obviously are by the Financial Stability Oversight Board. The massive systemic risk they represent should be supervised by the Federal Reserve, and their minimum capital requirement should be set at a 5 percent leverage capital ratio.

They must immediately start complying with the law that sets their guarantee fees at the level which a private financial institution would have to charge to cover its cost of capital. This requirement for guarantee fees is clearly established in the Temporary Payroll Tax Cut Continuation Act of 2011. Finally, they should pay the relevant state and local corporate income taxes, like everybody else.

Under these conditions, with the profit sweep and the senior preferred stock gone, but also with most of their economic rents and special government favors removed, Fannie and Freddie would have a reasonable chance to see if they could become successful competitors. They would still be too big to fail, of course, but they would be paying a fair price for the privilege.