Two years ago, in August 2012, the U.S. Treasury Department issued its so-called “sweep” rule forcing mortgage giants Fannie Mae and Freddie Mac to surrender all future profits. Shareholders were angered. Some sued the government. Their displeasure now has a measure of vindication. Near the end of July, an unnamed source leaked a confidential Treasury document (see pdf) to the public, dated June 13, 2011, showing that the department was willing to go to bat on behalf of outside investors, particularly The Blackstone Group, to facilitate purchases of equity stakes in the companies. At the time, Fannie and Freddie were rebounding from a deep slump, yet their management, under tight federal conservatorship since September 2008, had their hands tied. The latest revelations may strengthen the claims of existing shareholders, and more broadly, the cause of property rights.
National Legal and Policy Center for more than a year (such as here) has retold the saga of Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”). A combined $5 trillion in assets is at stake. These two publicly-traded corporations, chartered by Congress, respectively, in 1968 and 1970, have been a major engine in the growth of the mortgage industry. Their main function is to buy mortgages from primary lenders (i.e., banks, savings & loan associations) and then either hold them for investment or package them for sale as company-guaranteed bonds known as “mortgage-backed securities.” Through this process, Fannie Mae and Freddie Mac expand mortgage market liquidity. The arrangement, in theory, is a winner all the away around. Banks receive cash in return for unloading long-term (typically 30-year) assets, thus gaining more flexibility in lending. Individual and institutional investors, such as equity funds, hedge funds and banks, gain access to a steady, high-yield income stream. And homebuyers realize a reduction in their mortgage interest rate of roughly 20 to 50 basis points.
The problem is that things don’t necessarily go according to plan. And when that happens, somebody has to pay. This has been the story of the past decade. Fannie Mae and Freddie Mac, as official Government-Sponsored Enterprises (GSEs), long had enjoyed advantages that were unavailable to competitors, such as a $2.25 billion line of U.S. Treasury credit and exemption from state/local taxes. But this duopoly also was beholden to government rules. And beginning in the early Nineties, and accelerating thereafter, Congress and its new regulator, the U.S. Department of Housing and Urban Development, tightened the rules. The corporations would have to lower their risk standards to promote homeownership affordability for low- and moderate-income households. This series of mandates led to an unprecedented mortgage boom that reached its natural limit during 2007-08. The resulting bust left Fannie and Freddie dangerously undercapitalized, putting bondholders at risk of not being paid. Mortgage defaults and foreclosures were beginning to pile up.
In July 2008, Congress, recognizing the possibility of a collapse of these companies, and indeed the mortgage industry itself, created a new independent regulator known as the Federal Housing Finance Agency (FHFA) to replace HUD. Major financial houses were headed toward oblivion. Bear Stearns already had become history only months earlier; Merrill Lynch and Lehman Brothers were on the verge of the same fate. The liquidity crisis worsened. That September, FHFA seized Fannie Mae and Freddie Mac, placing them under conservatorship. Until the crisis blew over, the government would run the show. The flip side of the implied “too big to fail” federal guarantee was becoming evident: “Too big to succeed on their own.”
To make sure that Fannie Mae and Freddie Mac met their commitments to bondholders, the U.S. Treasury fronted the corporations a combined $187.5 billion in loans. The bailout came with severe strings attached. The companies had to hand over senior preferred stock carrying a 10 percent dividend rate (12 percent if with payments in kind) plus warrants to own 79.9 percent of all common stock at a nominal price. There would be no opportunity to buy back the shares. Yet as the companies were repaying debts, a funny thing happened to the housing market in 2011: It began to rebound. Lenders, having grown cautious in the face of foreclosure rates not seen since the Great Depression, loosened their credit terms. The trough period was over. The Treasury Department, meanwhile, saw an opportunity to capture larger portions of Fannie Mae/Freddie Mac profits.
The eventual result was the Treasury Department’s “third” or “sweep” rule. Announced on August 17, 2012, the regulation mandated that Fannie Mac and Freddie Mac surrender all profits. The rule superseded the “10 percent” dividend rule. Other than through stock prices – which remained depressed – stockholders now had no way of realizing a return. The government justified the move as a way to hasten its collection of Fannie Mae and Freddie Mac debt. Yet the passage of time has rendered this rationale suspect. For not only have these corporations paid back their loans, they have more than paid them back. By the end of Second Quarter 2014, they had forwarded to the Treasury the combined sum of $213.1 billion, or about $25 billion above the $187.5 billion they had received. And early this month, Fannie Mae and Freddie Mac reported that Second Quarter profits will provide another combined $5.6 billion to the Treasury by the close of September. This would bring captured profits to $218.7 billion.
So why won’t the Treasury Department let Fannie Mae and Freddie Mac operate on their own? The answer lies in the close relationship between the department and leading financial firms. Fitfully, and in the face of strong opposition from the government, the facts of this relationship have come out or will do so in the near future. On July 16, a U.S. Court of Federal Claims, in a procedural ruling, held that shareholder-plaintiffs in one of the shareholder lawsuits, Fairholme Funds Inc. et al. v. United States, are entitled to know material facts surrounding the sweep rule. The Treasury Department and FHFA were ordered to release documents related to matters affecting the value of Fannie Mae and Freddie Mac stock. National Legal and Policy Center summarized that case at length.
Two weeks later, on July 30, the cause of transparency won another, if less official victory. An anonymous source, likely within the Treasury Department, leaked a confidential 52-page pitch department document, via the Web, indicating that the department, more than a year prior to issuing the sweep rule, had been shopping around the GSEs to at least one corporate suitor and possibly others. Dated June 13, 2011, the materials bear the imprint of The Blackstone Group, a New York City-based equity fund/corporate turnaround consultant, and Blackstone’s law firm, Skadden Arps. Apparently well-connected to certain Treasury officials, Blackstone made its case for buying large stakes in the GSEs. A chart on page 28, “Improving Fundamentals,” indicated that net (pre-dividend) income for each corporation had improved since the great plunge. Whereas Fannie Mae in 2008 and 2009 lost a respective $58.7 billion and $72.0 billion, it lost only $6.5 billion in First Quarter 2011. Freddie Mac in those dark years of 2008-09 had experienced net losses of $50.1 billion and $21.6 billion, but registered a gain of $0.7 billion in First Quarter 2011.
All this is significant in a policy context. Back in 2009, noted the document, the White House had laid out six potential courses of action for the future of the companies: liquidation; replacement with a covered bond market; nationalization; restoration of prior GSE status; conversion to public utility status; and breakup into smaller regional institutions. Pursuant to these options, the Treasury Department recommended winding down the companies with one of three alternatives: no government role; contingent government role; and backstop insurance role. Blackstone envisioned a system of private insurance resembling the eventual Johnson-Crapo legislation now before Congress. The section of the report titled “Potential Value Creation Opportunity” (Part IV, pp. 34-40) is the heart of the proposal. With sufficient capital build-up, something already in the process of happening, the document envisioned a government selloff of its 79.9 percent stake in Fannie Mae/Freddie Mac preferred stock. Blackstone laid out three courses of action – Public Preferred Conversion, Public Preferred Repurchase and Public Preferred Roll-Up – summarizing the pros and cons of each.
Privatization per se is not the issue here. The White House, the Treasury Department and other federal agencies can’t be faulted for trying to wean the mortgage industry away from the government. The issue is that the government, in its desire to cut a deal with an outside investor – i.e., Blackstone – back in June 2011 seemed unconcerned about the consequences for existing shareholders. As this was 14 months prior to the promulgation of the sweep rule, the rule itself appears motivated by something other than a desire to protect the public interest. A large Blackstone equity stake in the GSEs might well improve the bottom line of each company, but achieving this outcome must proceed from rule of law. That is, it can’t bypass the legitimate interests of Fannie Mae/Freddie Mac investors whose equity is now indefinitely locked up. While the conservatorship instituted six years ago was never meant to be permanent, any alternative arrangement must respect shareholder rights. As for an alternative, here’s one: Rescind the sweep rule and let Fannie Mae and Freddie Mac operate on their own without any too-big-to-fail government guarantee.