In a surprise move in September 2008, government-sponsored entities (GSEs) Fannie Mae and Freddie Mac were placed under government control under supervision of the Federal Housing Finance Administrator (FHFA) and through authority granted by the Housing and Economic Recovery Act (HERA). This move was a shock to investors who had been repeatedly reassured by the Treasury Secretary himself that Fannie Mae and Freddie Mac were adequately capitalized.
Over the next few months, the FHFA abruptly wrote off over $187B in obligations. Most of the write-offs were non-cash assets known as Deferred Tax Assets (DTAs) and their disallowance rendered the institutions insolvent. In order to restore solvency and confidence, Treasury loaned the GSEs $189B at 10% interest and received warrants equivalent to the ownership of 79.6% of the outstanding shares of the combined companies.
In the years that followed, the GSEs became the whipping post for the financial crisis. Senators Bob Corker and Mark Warner proposed legislation that would radically change our housing finance system through the elimination of the GSEs — despite the fact that they were created to provide a counter-cyclical force to keep liquidity in the housing markets.
Some history here: In the Great Depression, housing prices dropped 50%, employment hit 25%, and banks were forced by regulators to clean up their balance sheets. Fannie Mae was created in 1938 to buy loans from the banks and create longer terms for repayment, and thus, the 30-year mortgage was born. Banks had fresh capital, and the new system of housing finance created a whole new generation of homeowners. In 1968, faced with mounting concern about the level of debt from the Vietnam war, Fannie Mae was chartered as a privately held, government-sponsored entity and listed on the NYSE (FNMA). Its unusual structure created a private capital buffer that allowed the mortgage debt to be taken off the federal government’s balance sheet.
Freddie Mac was created for similar reasons and increased competition in the mortgage finance industry. Today, the GSEs provide mortgage liquidity in much the same way they did in 1938. Both Fannie and Freddie buy mortgages from banks and re-package them for sale to insurance companies and pension funds that rely on predictable income to offset the liabilities for pension and annuity payments.
By the summer of 2012, the chief financial officer of the GSEs briefed the Treasury and the FHFA that the GSEs were so profitable that they would have to reverse the DTAs that were the basis of the insolvency in the first place. The justification for conservatorship could no longer hold water. But instead of telling the truth and allowing the GSEs to pay back the government and exit conservatorship (as had been done with the Troubled Asset Relief Programs, or TARP), Treasury officials instead concocted a scheme to sweep 100% of their earnings and profits in an amendment to the original senior preferred purchase agreement known as the Third Amendment Sweep. Treasury Secretary Tim Geithner and FHFA director Ed DeMarco justified the move by telling the world that the GSEs continued to languish in a death spiral and would never return to profitability.
The profound and deliberate obfuscation about the actual financial condition of these two pillars of housing finance spawned the most complex pieces of litigation ever filed against the federal government. On Sept. 5, 2019 in Collins v. Mnuchin, the Fifth Circuit in an en banc hearing held that the government violated the Administrative Procedures Act and remanded the case back to the trial court for a remedy. The court called out email communication from Obama administration advisor Jim Parrott as evidence that the government acted in bad faith and contrary to their mission to conserve and protect the assets of entities as conservator.
The court also held that the FHFA was an unconstitutionally structured agency but disagreed on a remedy. Nine judges believed that the objectionable part of the statute could be corrected with a blue pen. Seven believed FHFA’s unconstitutional actions negated the Sweep itself. In an unusual move following the decision, plaintiffs’ lawyers filed an appeal to the U.S. Supreme Court arguing that a blue-pen correction to the statute does nothing to remedy the harm shareholders faced from the 100% sweep of the earnings and profits of the companies.
The court also acknowledged current FHFA Director Mark Calabria’s written statements, i.e., that the government acted improperly and violated the statutory authority of HERA. Perhaps that is why he said, “The status quo was not an option,” as he repeatedly defaulted to his responsibility under the statute that he and the former FDIC General Counsel Michael Krimminger wrote in 2006. During the time Calabria worked with Senator Richard Shelby on the Senate Banking Committee, they were guided by the belief that “well run, adequately capitalized, properly regulated financial institutions, do not fail.”
Despite President Trump’s executive order directing the Treasury to reprivatize the companies and end 11 years of U.S. government control and the emphatic smack down from the Fifth Circuit, there continues to be rogue arguments for the shut-down of the GSEs – more Jim Parrott.
On Sept. 30, Director Calabria momentously announced the end of the Third Amendment Sweep by allowing both Fannie Mae and Freddie Mac to retain $25B and $20B in capital, respectively. For the time being, the retained capital would be added to the government’s liquidation preference. (Liquidation Preference is defined as the money the GSEs still owe the government prior to being released from conservatorship.) At the current level of profitability and a win in the courts, the GSEs could accumulate $40B to $50B in capital in the next 12 months.
All of this sets up drama for investors. What should we look for next?
If the court changes the remedy in finding the Sweep unconstitutional, or that FHFA’s actions violated the Administrative Procedures Act, then multiple damage models show the money the government advanced has been paid back and the Treasury owes the companies $26B.
In summary, three things are critical for the next step in reform and re-privatizing the GSEs.
First, Director Calabria needs to establish the capital buffer and regulations that these entities must comply with in order to protect the taxpayer as publicly traded companies.
Second, the companies will have to sell themselves to the investment community as worthy of their hard-earned investment dollars. The GSEs are among the most profitable companies in the world. This type of investment attracts serious money that is interested in and understands the benefit of a long-term, predictable stream of earnings, profits and dividend income. In a world with $17T of negative interest rates, there is a nice market for companies like Fannie Mae and Freddie Mac.
Finally, the liquidation preference from the senior preferred purchase agreement needs to be written down. Both the courts (through force) and the Treasury and the FHFA (through regulatory conscience) seem to be moving in the same direction. Allowing the GSEs to retain capital is a milestone in ending the conservatorship and honoring the government’s commitment to GSE shareholders, taxpayers and the next generation of homeowners.
Investors need patience in the extreme. This is a long game, and we play it to the end. To paraphrase Winston Churchill: America is about to do the right thing in housing finance reform. We have tried everything else.
Tim Pagliara is the founder, chairman and chief investment officer of CapWealth. Tim is also a Forbes contributor. This article was originally written for and published on Forbes.com. Find the original article here.
Disclosure: Tim Pagliara and his clients own shares of Fannie Mae and Freddie Mac Junior Preferred Shares.