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Treasury and its Allies Imprison Fannie and Freddie with Math That Doesn’t Add Up

It was quite a week on the question of recapping and releasing Freddie and Fannie. The main takeaway is that Treasury and its allies are more dug in than ever in opposing the end of the conservatorship.

First, it seemed too good to be true and it was. Mortgage Bankers Association President and CEO David H. Stevens had a lot of good things to say about the vital role Fannie Mae and Freddie Mac play in the housing system in a commentary published by Housing Wire last week, in which he praised Federal Housing Finance Agency Director Mel Watt for calling for an end to the conservatorship.

There is only one problem: “Unfortunately allowing them to just recapitalize is simply not a mathematical possibility.”

This conclusion is possible only because Treasury officials have tried so deviously hard to make it so. First, Stevens argued, those profits Fannie and Freddie reported two weeks ago – the new revenues for Treasury’s piggy bank – really weren’t that hefty. This claim rests on his assertion that the GSEs’ earnings are, in fact, declining due to the reduction of their investment portfolios, the end of windfalls from large legal settlements, the recouping of deferred tax assets, and the release of credit loss reserves as this credit cycle flattens out.

Let’s add that having their capital forcibly depleted for over three years under the Net Worth Sweep hasn’t helped either. The amount of money involved in these accounting practicalities pales in comparison to the $55 billion that should have been used to build up Fannie and Freddie’s  capital buffers once the GSEs paid back the $187.5 billion Treasury extended as  part of the bailout under the Housing and Economic Recovery Act.

Then Stevens’ analysis became even more intriguing and revealing. Things would be even worse if the Net Worth Sweep was not in place, he explained.  Without the Sweep, the GSEs would have had to pay the 10% dividend that was in place under the original terms of the conservatorship. Accordingly, while Freddie paid $5.5 billion in dividends in 2015 under the sweep, it would have had to pay $7.2 billion under the 10% dividend.  Similarly, while Fannie Mae paid $10.3 billion under the sweep in 2015, this was also less than the $11.6 billion they would have paid under a 10% dividend.  Heads, Treasury wins – tails, Fannie and Freddie lose.

However, as Josh Rosner pointed out today in a commentary on Housing Wire that responds to Stevens, “The 10% dividend is not legally required at all – and especially not in perpetuity. The contract is nothing more than an agreement between two government agencies and could be amended at any time without congressional approval.” 

This narrative about the untenable situation for Fannie and Freddie, frequently parroted by Stevens and the Wall Street Journal’s  John Carney, that the GSEs are somehow better off under the sweep, completely ignores the fact that the companies paid off their loans almost $55 billion ago  – at least in the world where math makes sense and officials don’t engage in politically-inspired sleights of hand. Once Fannie and Freddie returned to profitability, FHFA should have exercised its mandate to return them to “sound and solvent” condition, allowed them to retain earnings and ultimately exit conservatorship.

The math supporting the hopeless-GSE narrative gets even better – at least for Treasury. Under the terms of their conservatorship, Treasury should be charging the GSEs for the government backstop, Stevens explained. But Treasury is not charging this fee option, called the “commitment fee.” The GSEs are backed today by a line of credit of more than $250 billion from the U.S. Treasury to act as the guarantee against defaults. “Therefore, $250 billion is a commitment expense from taxpayers that would come with a charge for any truly private company,” Stevens wrote. 

This is because of the first two amendments to the PSPAs, made before infamous third amendment mandated that Treasury would receive all the GSEs’ earnings in perpetuity.  The first amendment to the Preferred Stock Purchase Agreement in 2009 essentially increased the credit line for each GSE from $100 billion to $200 billion, and the second amendment to the PSPA changed Treasury’s commitment from a fixed rate, $200 billion commitment for each company to a “new formulaic maximum amount.” 

Thus, Treasury has simultaneously engineered a depletion of the GSEs’ capital buffers while also implementing credit terms that would make it all but impossible for Fannie and Freddie to break free of the conservatorship even if they retained their huge profits. Never mind the simple fact that the GSEs’ have not required a single draw against this line of credit since they returned to profitability, nor the fact that the only reason they would have to do so in the future is because the Treasury systematically robs them of what would otherwise be generous capital buffers. And now, according to Stevens, Fannie and Freddie should be grateful for not being charged a fee on a line of credit they do not want and should not need.

When the latest profits were announced, Treasury poured cold water on them, pointing out that the GSEs are still dependent on $258 billion credit line that remains in place. That figure, no doubt, derives from the credit lines and formulaic scheme it imposed.

Nonetheless, last week, Bank of America offered a different interpretation, suggesting that Watt’s speech could be seen as the impetus to find a way of recapitalizing and exiting the conservatorship.

“In an unusual speech, the FHFA director flagged lack of capital as the most serious risk for Fannie and Freddie,” Ralph Axel, rates strategist for Bank of America Merrill Lynch, wrote in a research note last Wednesday, as reported by Reuters. “We think this opens the door to FHFA pursuing a recapitalization plan, eventually leading to the end of the conservatorships.”

Treasury took its cue and responded the next day, insisting that the $258 billion straight jacket was for the good of the markets and recapping was not happening. DS News asked Treasury about Watt’s speech and, apparently, about Axel’s comments, and got this reply.

Taxpayers injected $188 billion into the GSEs to stabilize the housing market and lay the groundwork for our economic recovery. Director Watt’s remarks underscore the Administration’s consistent position regarding the GSEs’ conservatorship:  the best long-term solution is comprehensive housing finance reform. Until then, Fannie Mae and Freddie Mac will continue to rely on the $258 billion of taxpayer provided support to sustain market confidence.

Treasury’s assertion that Fannie and Freddie continue to “rely on the $258 billion of taxpayer provided support to sustain market confidence” and Stevens’ mathematical contortions must raise suspicions that the foes of recapitalizing Fannie and Freddie are moving the goal posts just as FHFA Director Mel Watt and  civil rights groups have made more urgent calls for recapitalization. It is clear that Treasury has helped construct a prison from which it hopes there will be no escape, only death for the GSEs.  But the bars are not made of iron in this case – just “fuzzy” math.

Therefore, we continue to believe the warden might not get the last word.