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Corporate Tax Cut Could Expose Net Worth Sweep Folly

As a $1.5-trillion tax measure moves incrementally toward becoming law, Washington policymakers could have to confront the consequences of the raid on Fannie Mae and Freddie Mac’s capital that has been going on the last five years.

The House of Representatives approved a sweeping bill to reduce taxes and reform the tax code November 16 on a vote of 227-205. The same day the Senate Finance Committee completed a four-day markup of its own tax cut measure. While the measures are different in many ways, they overlap in cutting the corporate tax rate to 20 percent from the current 35 percent.  The Senate bill, however, would delay that provision from taking effect until 2019.  Should the House prevail in cutting the rate sooner, taxpayers could be shocked to learn they might have to kick in to support Fannie and Freddie once again.  The reason is a little understood matter of “deferred tax assets.”

An analysis by Ike Brannon in the Weekly Standard from last spring noted that the $150 billion in losses Fannie and Freddie posted leading up to the 2008 financial crisis have been carried forward to reduce tax obligations in future years. At the 35 percent corporate tax rate, he estimated the value of the deferred tax assets would reduce future tax bills by $53 billion. But if the rate drops to 20 percent, the value of the deferred tax assets would drop to roughly $30 billion.

Why does this matter? Because if the GSEs’ quarterly profits are not greater than the value of the estimated $23 billion in remaining deferred tax assets at the time the rate cut goes into effect, the GSEs will face a shortfall.  For reference, while Fannie and Freddie have been posting quarterly profits fairly consistently for more than five years, quarterly profits of more than $23 billion are unlikely. Their combined third quarter profits added up to $7.7 billion.

Under the Net Worth Sweep, Fannie and Freddie’s capital buffers have been systematically whittled down since 2012. In just over a month, they will have zero in reserve capital. That means Treasury will need to make up for losses with taxpayer funds.

While reducing and simplifying taxes has broad support, bailing out Fannie and Freddie would likely anger many taxpayers, justifiably so. Nine years of using the GSEs as a piggy bank will have consequences.