Patrick McHenryChairman

Washington, May 12, 2011 -

Today at The Bottom Line we welcome a guest blogger, Phillip Swagel. Phillip is a Professor of International Economic Policy at the University of Maryland and a former Assistant Secretary for Economic Policy at the Treasury Department.  His blog post is on the importance of Treasury continuing to require Fannie Mae and Freddie Mac to make dividend payments to taxpayers.

A reduction in the dividend payments that Fannie Mae and Freddie Mac make to the federal government would serve no policy purpose and amount to a gift from taxpayers to the investors who owned Fannie and Freddie when the firms required a $150 billion taxpayer bailout.  It is important to return Fannie and Freddie back to private hands in the future and have market participants rather than the government as the main provider of housing finance.  But there are ways to do this that do not involve a windfall for the old shareholders, who were appropriately wiped out when the two firms went bust.

The federal government now stands behind the financial obligations of Fannie Mae and Freddie Mac, the two government-sponsored enterprises involved with housing finance that were placed into conservatorship in September 2008. Taxpayers are on the hook for their losses, with some $150 billion committed so far to make good on the government backstop.

Taxpayers effectively own these two companies.  As part of the agreement with the firms when they were put into conservatorship, the U.S. government gained control of 79.9 percent of the common stock, and received preferred shares with a 10 percent dividend payment in exchange for capital injections to maintain a positive net worth for the two firms.  With $150 billion of taxpayer capital injected already, the 10 percent rate means that Fannie and Freddie make huge dividend payments each year. 

The 79.9 percent figure for the common stock component was chosen because an 80 percent stake would have triggered government accounting rules that put the firms’ assets and liabilities onto the public balance sheet.  This is mainly a symbolic distinction, since the terms of the so-called “keepwell” agreements made between the firms and the Treasury mean that the government covers the firms’ net gains and losses even if their assets and liabilities are not formally on the public balance sheet.  Still, a concern in the fall of 2008 was that market participants and rating agencies might not understand the situation and respond poorly to $5 trillion of GSE obligations coming onto the federal balance sheet—even those these obligations were matched by nearly an equivalent value of assets and taxpayers had committed to cover the difference between assets and liabilities regardless of whether these were formally on the federal balance sheet.

In recent quarters, the large dividend payments on the government-owned preferred shares have given rise to the seemingly unusual situation in which Fannie and Freddie are now profitable in their operations but usually still make net losses because of the payments to the government.  As a result, the two firms take more government capital in order to turn around and pay some of the money back to the Treasury as dividends.  As discussed by Daniel Indiviglio of The Atlantic [LINK = http://www.theatlantic.com/business/archive/2011/05/fannie-needs-another-85-billion-from-taxpayers-but-freddies-okay/238618/], Freddie actually reported a profit in the first quarter even including its $1.6 billion quarterly payment to the Treasury, but the firm notes that this profit situation is not likely to continue into the future.  Fannie needed another $8.5 billion from the Treasury, including money to cover its $2.2 billion quarterly payment.  The dividend payments appear to be crushing the firms and preventing their return to profitability.

This is by design.  The steep payments on the dividends make it so that the remaining 20.1 percent of GSE common shares and the pre-conservatorship preferred shares have no value because the GSEs will never earn high enough profits to redeem the government’s preferred shares.  This is both intentional and appropriate.  Fannie and Freddie were deeply insolvent in September 2008 when they required a bailout.  With the housing market weak and credit markets strained in the fall of 2008, Treasury did not want to put the two firms into receivership and wind them at that moment, but it also wanted to make sure that the equity holders of the firms received nothing.  The preferred shares accomplish this while not crossing the accounting threshold.  Fannie and Freddie shareholders have not been abused—they got exactly what happens to shareholders of insolvent firms:  a loss of their investment.

Some people want to reduce these payments or take other steps to the advantage of the owners of the common shares.  In an April 11 letter to Committee Chairman Bachus and others [LINK = http://nader.org/uploads/gse.pdf], for example, Ralph Nader decries the treatment of common shareholders, including the delisting of the firms’ shares.   Others note that a lower dividend rate would allow Fannie and Freddie to build up retained earnings rather than relying on additional government capital to keep them solvent.

But reducing the dividend would simply transfer value from the government to pre-conservatorship shareholders.  This would be a pure gift from taxpayers to investors, without a public policy rationale.

There are better ways to restore Fannie and Freddie to private hands in the future that recoup as much of the bailout as possible without providing a windfall to investors.  One approach would be to split the firm into two companies each.  So-called “good companies” would have clean balance sheets with the valuable assets of Fannie and Freddie’s computer systems and networks through which to acquire mortgages from originators throughout the United States.  These would be profitable firms and perform the socially valuable tasks of securitizing and guaranteeing conforming mortgages.  The legacy mortgage-backed securities (MBS), guarantees, and debt would remain with the two “bad companies,” which would continue to have their net worth kept positive by the Treasury while their assets and liabilities run off.  The 79.9 percent share of common stock and the $150 billion of senior preferred shares held by the Treasury would likewise remain with the bad firms, which in turn would own the two new good firms.

The separation of Fannie and Freddie into "good" and "bad" firms would in effect leave the government providing a ring-fence around the legacy assets and liabilities.  The two good firms could then be sold back to private investors as profitable companies with clean balance sheets and functioning business systems.  Taxpayers would realize all of the proceeds of these two IPO’s, because these funds would go to the bad firms and thus to the government as dividends on the Treasury preferred shares as the old Fannie and Freddie are wound down.  Even so, it is unlikely that the proceeds of the public offerings of the two good firms would recoup all of the $150 billion in taxpayer money paid out to stabilize Fannie and Freddie.  The remaining net loss after the initial public offering and including any additional future capital needed to stabilize the firms would constitute the overall cost of the GSE bailout. 

Since the government is not likely to recoup its investment in the firms, this means that pre-conservatorship common and preferred stockholders will realize no value from their holdings.  This is appropriate, since the two firms were deeply insolvent when they were put into conservatorship.   This differs from the situation with AIG, where AIG was illiquid but not insolvent and thus pre-crisis shareholders will come out with some value, even though for holders of common stock this value will be greatly diluted by the government stake acquired in the rescue of that company.  Again, this is an appropriate distinction to make between AIG on the one hand and Fannie and Freddie shareholders on the other.  The GSEs were insolvent while AIG was not.

It is vitally important to move forward with GSE reform to ensure that the U.S. housing market is supported by private capital rather and so that the securitization and guarantee functions performed by Fannie and Freddie benefit from private sector incentives and innovation.  While an eventual path for GSE reform is discussed, it is equally important to avoid taking steps that transfer value from taxpayers to private investors without appropriate compensation.  This would be the effect of proposals to reduce the dividend payments made by Fannie Mae and Freddie Mac on the capital invested in the two firms by the United States Treasury.

Phillip Swagel is a professor of international economic policy at the University of Maryland School of Public Policy.  He was formerly Assistant Secretary for Economic Policy at the Treasury Department from December 2006 to January 2009. 

As a guest, his views do not necessarily reflect the views of Members of the Committee.