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Editor’s note: This post is in response to Jon Entine’s piece on AEIdeas.
Fannie Mae and Freddie Mac, operating entirely as an arm of the government, entirely dependent on the credit of the government, and getting huge subsidies and favors from the government, have begun making large profits, all of which they are paying to the US Treasury. Speculators in the old, junior preferred stock and common stock of Fannie and Freddie are objecting that this is unjust.
The government’s, thus the taxpayers’, senior preferred stock of Fannie and Freddie had its dividend changed by a deal between the Treasury and their regulatory conservator from 10% of par per annum, to 100% of net profits. Now a participating preferred stock is hardly a revolutionary idea, but a 100% participation does get your attention. Expensive lawyers are arguing that this change was illegal.
Viewing the question as a matter of equity, or fairness, we need to ask: what proportion of Fannie and Freddie’s post-crisis profits are due to the resources provided by the government, and what proportion due to the old preferred and common stock? The answer is more than evident: 100% of the profits are derived from the government, and 0% from the old stock.
Fannie and Freddie’s most important business is guaranteeing mortgage-backed securities (MBS). Even with the government’s $187 billion investment in them, their net worth has been zero, without it, hugely negative. What is the value of a guaranty from a guarantor with hugely negative capital? Zero. It is solely the fact that the government guarantees Fannie and Freddie’s obligations that gives this business any revenue or profit at all.
Fannie and Freddie’s MBS are now issued at very favorable prices. This reflects not only the government guaranty, which is necessary for them to be issued at all, but also the fact that the Federal Reserve, another arm of the government, is buying up their MBS to the tune of $1 trillion. This artificially raises their value and promotes a government MBS monopoly.
Fannie and Freddie also borrow money cheaply to make a spread on their investments. There would certainly be no spread for them, if they could borrow at all, based on their own negative capital, without the government guaranty. Of course, they pay no fee for this guaranty—it’s free. At the same time, another arm of the government, the Consumer Financial Protection Bureau (CFPB), gives them a free pass on onerous regulations it imposes on everybody else, reinforcing their monopoly advantages.
What a mess. It would have been better, as Peter Wallison says, to have put Fannie and Freddie into receivership in the first place, and it is certainly not desirable to have their status quo continue. But maybe the speculators’ arguments could trigger healthy changes, even if not exactly the payday they are seeking. Could a deal on the government’s senior preferred stock be part of a restructuring of this unattractive government MBS monopoly, after which the old preferred and common stock holders could end up with some equitable claim on Fannie and Freddie’s profits? Yes, it could.
Let’s suppose we wanted to find a way to set the dividend on the senior preferred stock back to 10% per annum, the original deal. What would make this defensible as a policy?
First, since the government guaranty of Fannie and Freddie cannot be eliminated any time soon, it should definitely cease to be free. They should without question have to pay to the Treasury a user fee for this highly valuable backing, just as banks have to pay for the government for deposit insurance. I propose Fannie and Freddie should pay a fee of 0.17% per annum assessed on all their liabilities which the government guarantees, that is, all of them. This is about the rate banks in the aggregate pay on their insured deposits. Fannie and Freddie have about $5.3 trillion in liabilities, so this would be a combined fee of $9 billion a year.
The next required use of Fannie and Freddie’s profits would be to pay the restored 10% dividend to the Treasury. Dividend payments, like interest payments on a loan, of course do not reduce the principal amount.
Then, Fannie and Freddie would have to meet a sensible capital requirement. They are in fact, although not officially, “Systemically Important Financial Institutions” (“SIFIs”), which have demonstrated the ability to put the global financial markets in peril. SIFIs will have to hold a 5% equity to total assets ratio, and so should Fannie and Freddie. That means once the user fees and dividends to the government are paid, all their profits need to go to building their capital up to 5%, not counting the government’s senior preferred stock. On their current $5.3 trillion in assets, this means their currently nonexistent capital would have to get up to $265 billion before they ceased to be undercapitalized. While setting the required capital ratio, Congress should also direct the regulators to designate Fannie and Freddie as the SIFIs they so obviously are.
Next, all Fannie and Freddie’s special regulatory free passes from the CFPB and any other regulators, must be eliminated. This includes any special treatment they get in banking regulations.
Once the user fees and dividends are paid to the government, and the capital requirement is met, any remaining available profit would have to be devoted to paying down the government’s senior preferred stock at par. When this is retired down to zero, voila! Profits would then be available to declare dividends to the holders of the old junior preferred and common shares. But not before.
Such a restructuring would not create the ideal solution, but would be a lot better than the status quo we have got.
Alex J. Pollock is a resident fellow at AEI. He was President and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.
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