Business has never been better for government-sponsored entities (GSEs) Fannie Mae and Freddie Mac, which required a government bailout five years ago to stay solvent and now turn over record profits. Politicians would like to see the GSEs returned into private hands, but the bills on offer do not answer many questions, particularly when it comes to investors who held onto their shares and expect a payday once the GSEs come out of conservatorship and are placed back in the private sector. Additionally, no one is quite sure what it will do to the mortgage market, so for now Fannie and Freddie will continue to enjoy government securitization. For more on this continue reading the following article from TheStreet.
Five years ago this week, the government bailed out housing finance giants Fannie Mae (FNMA) and Freddie Mac (FMCC) and placed them in conservatorship.
It was the first of many bailouts to follow, but it was the largest, with taxpayer support adding up to $188 billion over time.
Today, these government-sponsored enterprises, or GSEs, are back to making record profits, thanks in part to a recovery in housing. By September, Fannie and Freddie will have collectively paid Treasury $146 billion in dividends. Analysts predict the dividends from GSE could make taxpayers whole by the end of 2014.
Shares of Fannie Mae and Freddie Mac are rising from the dead, up 384% and 329% respectively year-to-date.
The GSEs also remain the biggest providers of liquidity in the mortgage market. Together with the Federal Housing Administration, they back nine out of every 10 new mortgages originated today, with private capital largely missing from the market.
Still, there is no talk of the companies returning to private hands, much to the chagrin of shareholders who have held onto the shares. In fact, practically everyone in Washington wants them dead.
‘Guaranteed to Fail’
That’s because the fall of Fannie Mae and Freddie Mac was not merely a story of reckless risk-taking and corporate excess. It was also deemed a failure of a system of mortgage finance that the government promoted for decades.
Fannie Mae and Freddie Mac were private companies that were chartered by the government. That meant that while they pursued maximum shareholder profits like any other private company, they also served a public mission — to provide liquidity to the mortgage market and keep mortgage loans affordable.
The GSEs did not directly lend to borrowers. Rather they bought mortgage loans from banks, thereby leaving lenders with the liquidity to make more loans. They made it possible for a product like the 30-year fixed rate mortgage to become widely available at low interest rates because they absorbed the risks of borrower default, as well as the risk that market rates could rise over the repayment period.
The GSEs held the mortgage loans on their balance sheets but also routinely packaged loans into securities and sold them to investors. They continued to guarantee payment of principal and interest on the loans backing those securities, while investors shouldered the interest rate risk.
Wall Street Meltdown: Five Years Later:
As GSEs, the companies had some explicit benefits, such as a line of credit from the U.S. Treasury.
But their real advantage was implicit. Because of their special ties to the government, the agencies were able to access funds from the market at rates that were lower than their competitors, and they came to dominate the market in the ’90s.
Fannie and Freddie became extremely powerful politically and dodged regulation and criticism by lobbying heavily and using their affordable housing mission as a trump card.
The GSEs were, however, increasingly required to meet affordable housing goals set by the Department of Housing and Urban Development. By 2001-03, the agencies were required to ensure that half of the mortgages they purchased were made to low-income and underserved borrowers.
But by 2005, the agencies found that they were steadily losing market share to commercial banks, investment banks and non-bank companies who also began buying and securitizing home loans. The private sector had looser underwriting standards than the GSEs and they increasingly made loans to sub-prime borrowers and borrowers with little or no documentation and securitized them.
Meanwhile, the agencies were also struggling to meet their affordable housing goals. So in 2005, they too began to loosen their underwriting standards and started buying mortgages made to borrowers with little documentation and poorer credit, in a quest to regain market share as well as meet the affordable housing goals set by Congress and regulators.
When the housing bubble burst, the agencies racked up billions of dollars in losses. Like all the big banks that nearly failed on Wall Street, they were undercapitalized. In the summer of 2008, the markets began to question the solvency of the agencies as the financial crisis deepened.
On Sept.6, 2008, the government announced the agencies were to be placed in "conservatorship." It did not put the agencies in receivership which would have wiped out shareholders and triggered the liquidation of the GSEs.
The government wanted to avoid taking the GSEs’ debt on to its balance sheet. It also feared that placing them in receivership would add further turmoil to a jittery market. Less than 10 days later, Lehman Brothers filed for bankruptcy.
So the conservatorship agreement left shareholders with a 20% stake in the company. Those shares plummeted to pennies on the dollar as the enormity of the bailout loomed large.
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But the idea was to temporarily place the companies in conservatorship until the government could figure out how to get rid of them for good.
It was already clear back then that policymakers no longer saw a future for the old public-private model. The expensive bailout was seen as too big a price to pay for the goal of homeownership.
Aftermath
Under the leadership of the Federal Housing Finance Agency and its acting director Edward DeMarco, Fannie and Freddie have over the past five years set out on a path to return to profitability.
They have tightened underwriting standards tremendously. The average credit score of a borrower qualifying for a Fannie Mae loan is currently over 750.
The agencies have also more than doubled the fees they charge to guarantee loans.
These measures, along with improving credit quality thanks to the housing recovery, has led to record profits at the companies. Fannie Mae reported a profit of $10.1 billion in the second quarter of 2013, its sixth straight quarterly profit. Freddie Mac posted a profit of $5 billion in the second quarter.
Still, the path forward for the agencies is unknown. The conservatorship does not have a timeline. Until Congress decides how to wind them down, they remain in limbo.
Shareholders of Fannie Mae and Freddie Mac meanwhile are eager to see taxpayers repaid so that they can get a piece of the pie.
But there is no provision in the bailout agreement that allows the agencies to buy back the government’s senior preferred stake in the company.
Under the original terms of the bailout, the companies paid a 10% cumulative dividend on the preferred shares, which often meant that they had to draw from the Treasury to pay the Treasury.
In 2012, the agreement was amended. Rather than pay a 10% dividend, the companies were required to transfer almost all their profits to the Treasury. Essentially the companies would not be able to build capital, a move seen as a step toward accelerating the wind-down of the GSEs.
This, of course , has foiled the hopes of shareholders who held on to their stock through these years with the expectation that the agencies will be allowed to return to private hands much like other bailed out companies such as AIG (AIG). Former presidential candidate Ralph Nader is one among them.
The amendment came as a further blow to some hedge funds including Paulson & Co., Perry Capital and Akanthos Capital, who piled into the junior preferred shares of the agencies in 2010 when they were trading for pennies on the dollar on a bet that the shares would recover in value once the companies became profitable again and repaid the government.
Shareholders, including Perry Capital and Fairholme Capital’s Bruce Berkowitz have challenged the legality of both the takeover and the amendment and remain optimistic.
"Fannie Mae and Freddie Mac have accomplished their mission. They did it. Mission Impossible accomplished," Berkowitz told CNBC on Wednesday. "It is time for them to be resuscitated, rehabilitated and to let equity build in these companies and prepare for the next rainy day.
Preferred shares of both the agencies have zoomed over the past year. But these investors have few sympathetic ears in Congress.
Right now there are two proposals on mortgage finance reform that have vastly different solutions, but they agree on one thing. Fannie and Freddie must die.
Fannie and Freddie by Any Other Name
A bipartisan bill introduced by Senators Bob Corker (R., Tenn.) and Mark Warner (D., Va.) calls for a wind-down of the GSEs, replacing them with private players who would purchase loans and issue mortgage-backed securities. Those securities could be backed by the government for a fee, but only in the event of a catastrophic loss.
So the government’s guarantee will be both explicit and limited and will be paid for by mortgage borrowers rather than taxpayers.
The Protecting American Homeowners and Taxpayers (PATH) bill advanced by the House Financial Services Committee chairman Jeb Hensarling (R., Texas) is more extreme, calling for a fully private system to replace the GSEs with no government guarantees.
But under either proposal, mortgage rates are set to go up. Mark Zandi of Moody’s analytics expects mortgage loan rates to climb 50 to 75 basis points for a borrower with an 80% loan-to-value ratio and a 750 credit score.
Goldman Sachs analysts believe that interest rates could climb as much as 100 basis points.
According to Vitaliy Liberman, a portfolio manager at Doubleline who invests in mortgage-backed securities, the prospect of rising interest rates will likely ensure there isn’t any progress in GSE reform in the near term.
"Clearly there is movement in Congress to do something about the GSEs. The problem is on one hand there is a desire to reform and on the other, desire to not affect the prevailing mortgage rate," he says. A 50-to-100-basis-point increase "is not palatable" to most policymakers.
Liberman believes that Fannie Mae and Freddie Mac as they exist now are actually delivering well on the promise of improving access to homeownership. He is not sure that they should be wound down, especially if the government still wants to promote homeownership.
"We have two very profitable entities that serve their purpose," he said. "We had a problem four years ago. Not today. Looking backwards is a wrong way to solve this."
According to Liberman, Congress is seized with the idea of winding down the giants but they have done a poor job of explaining what the overhaul of the mortgage finance system would mean to borrowers.
"Consumers and citizenry do not understand how the debate is being framed now. They are duped into supporting something they don’t fully understand."
Liberman is not the only one arguing that Fannie Mae and Freddie Mac should be kept alive.
Michael Kao, co-founder of hedge fund Akanthos capital, is one of the early investors in the junior preferreds of Fannie Mae and Freddie Mac.
He advocates returning the GSEs to private hands in a General Motors (GM) style recapitalization, where senior preferred shares and old preferred stock are converted into common shares and sold to the public.
The newly private Fannie and Freddie simply need to increase guarantee fees further to entice private capital. "The road to privatization [of the mortgage market] is greater profitability," he argues.
They could also be more tightly regulated and prevented from dabbling in anything but pure vanilla loans. "Think of them as utilities," he says.
Kao, of course, has a vested interest in this argument. Akanthos has long and short positions in preferred and common shares of the GSEs.
But he argues that the current proposals in Congress come with great transition risk in unraveling a multi-decade mortgage system. His way, he argues, is a winning approach for all stakeholders.
Political analysts believe investors such as Kao disregard political reality. The fact is Fannie Mae and Freddie Mac are political poison in Washington.
"The possibility of truly privatizing them isn’t there," says Lawrence White, professor of economics at NYU’s Stern School of Business and author of Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance.
Fannie and Freddie were once credible institutions with great human capital but all of that has gone now, he says. That ship has sailed. The blow to their reputations has been too great for either agencies to exist as their former selves.
And policymakers are very mindful of ensuring that the old model does not resurface. "We cannot allow a plan to become law that simply puts Fannie and Freddie in the federal witness protection program, gives them cosmetic surgery and new identities, then releases them upon an unsuspecting public," Hensarling said in a recent speech.
Still, GSE reform could be years in the making. White expects inertia will keep the government from moving ahead on reform.
The companies are making profit, mortgages are being originated, the government is seeing a lower deficit thanks to the agencies. No one is in any hurry to do anything.
Kao remains hopeful. "At some point politicians will see they are destroying huge value just to make a point. Politicians can talk tough but do they have the fortitude to cause an implosion in the market by stripping away the GSEs?"
So that’s where we are five years after bailing out Fannie and Freddie.
Everybody still hates them. But no one is sure if we can live without them.
This article was republished with permission from TheStreet.
