Fannie & Freddie: No Looting Here
The Wall Street Journal
By
John Carney
Oct. 5, 2014 4:12 p.m. ET
Why would any company agree to surrender all profits to the U.S. government?
That question lies at the heart of the continuing legal dispute between some shareholders in Fannie Mae FNMA +25.17% and Freddie Mac FMCC +22.30% and the government—even after some investor actions suffered a blow last week in the court of U.S. District Judge Royce Lamberth.
The answer explains why the investors’ suits are flawed and hopes the companies’ shares have value are likely to be dashed. In short, the profit-sweep agreement wasn’t an illegal taking. It was a second bailout of the mortgage giants.
Consider that even after being taken over by the government in 2008, the companies ended up on a death march. And that had grave implications for the financial system.
In the original bailout, Treasury agreed to provide each company with up to $100 billion. As losses mounted, that was increased to $200 billion.
In return, Treasury received warrants to purchase common stock along with senior preferred stock. The latter paid annual dividends of 10%. This rose to 12% if the payment couldn’t be made in cash.
Each quarter, the Federal Housing Finance Agency determined whether their liabilities exceeded their assets. If so, the companies would draw funds and the value of the preferred would rise, dollar for dollar. By the end of 2009, draws were $125 billion—requiring annual dividends of $12.7 billion.
Because that was more than they could afford, the companies had to draw funds to pay dividends. This increased future dividends, requiring more draws because the companies posted losses until 2012.
At the end of the second quarter of 2012, the companies were on the hook for $19 billion of dividends annually. Fannie had never earned enough in a single year to pay its $11.7 billion dividend in cash. Only once had Freddie earned enough to pay its dividend.
In August 2012, Fannie’s finance chief said he couldn’t imagine his company would ever make enough money to cover the dividend payments.
That raised the prospect Fannie and Freddie would eventually need to draw down all the government commitment. Doing so, though, would destabilize the companies.
At that point, they would each owe over $20 billion in dividends—an amount they would never be able to pay in perpetuity. So, cash payments would stop, forcing them to pay 12%, digging the dividend hole deeper, faster.
More important, hitting the funding limit would undermine market confidence. With no capital, the firms’ ability to sell securities and finance themselves was dependent on access to Treasury cash.
With each draw moving the companies closer to the limit, investors would inevitably balk at some point. That could have led to their second collapse.
Worse, it would raise doubts about the mortgage securities the companies guarantee. That could again undermine the U.S. housing-finance system.
While some investors argue the companies should have paid a noncash dividend at 12%, that, too, would have undermined market confidence.
Raising the funding cap was a political nonstarter in gridlocked Washington and Treasury lacked the authority to do so unilaterally.
Given that, Treasury and the FHFA amended the bailout agreement to do away with the fixed, 10% dividends, replacing them with sliding payouts that matched the companies’ profits. The result: Fannie and Freddie only draw funds to cover actual losses; those draws don’t raise the dividend. In bad quarters, Treasury might get less than 10% or nothing at all. In good quarters, the net-worth sweep rewards the Treasury for taking this additional risk.
Whether the firms’ later improved financial results merited this response isn’t the issue. It is whether the move was rational for the government and FHFA.
Clearly, it was. That is why investors face an uphill battle in the courts. John Carney
