The year 2008 was full of nasty surprises. One of the biggest was the government takeover of twin mortgage giants Federal National Mortgage Association (FNMA, or Fannie Mae) and Federal Housing Lending Mortgage Corporation (FHLMC, or Freddie Mac).
The takeover happened almost overnight. Homes values were sinking fast. Between the two companies, they guaranteed most of the $7 trillion of home mortgages outstanding. At one point, almost 30% of homes with mortgages were underwater.
The situation seemed dire. So, the U.S. Treasury “offered” to lend the mortgage companies tens of billions of dollars, which later became an open-ended line of credit.
The Treasury demanded three things in exchange.
The companies would go into conservatorship – meaning they could continue to operate, but only with the Treasury there to offer support.
They would issue the Treasury $1 billion in preferred stock with a 10% dividend.
Finally, they’d issue warrants for up to 79% of the companies to the Treasury.
The boards had no choice. They agreed and were promptly dismissed.
All told the U.S. Treasury extended $187.5 billion in loans to Fannie Mae and Freddie Mac. Part of that was just so they could make good on their required dividend payment back to the government.
When housing turned up again, these two companies started earning profits. By the end of 2014 they had paid the U.S. Treasury almost $230 billion, or $40 billion more than the loans they’d received.
But here’s a little-known part of the deal – the mortgage giants still owe the U.S. Treasury the original $187.5 billion in loans. The government does not consider any of the $230 billion as repayment of debt or retirement of shares outstanding.
All of it is simply profit to the government. How convenient.
Now that it effectively controls the two entities, the government can decide how to treat the money that rolls in. Since it’s shown little interest in letting go of the cash cows, it will likely continue holding that $187.5 billion over their heads.
Treasury officials claimed that since they hold almost 80% of the stock through warrants which have not been exercised, they are free to change whatever terms they want. In fact, in 2012 the government changed the nature of the bailout from a payment of interest at a set rate to a sweep of all profits earned.
So now the two companies reconcile their books each quarter and cut the U.S. government a check for whatever used to pass for profit.
In the first quarter of 2015, Fannie Mae earned $1.9 billion and Freddie Mac earned $746 million. While $2.65 billion per quarter won’t make or break the U.S. government, an extra $10 billion per year can fund a fair number of pet projects.
With a cash flow like that, the government won’t take steps to shut them down, even though that’s exactly what they said they would do.
When the government first took over the companies, part of their stated purpose was to wind down their operations in an orderly fashion. The goal was to have private companies pick up the slack in the mortgage business once the economy recovered.
But there’s a problem with this goal. Right now Treasury officials claim that private lenders aren’t up to the task because they would charge borrowers higher interest rates than Fannie and Freddie.
Well, of course they would! Banks don’t hold onto the mortgages. They bundle them and sell them to investors.
When the securitized loans are backed by people paying their mortgages, then there’s some risk of non-payment.
When the securitized loans are backed by two wholly-owned government subsidiaries, which are in turn backed by the full faith and credit of Uncle Sam, then the investments are seen as risk-free.
This will never change. Which means the private sector will never be up to the task!
Besides, under the current model, the U.S. Treasury can just sit back and collect mailbox money once a quarter. Can’t beat that.
If all of this sounds fishy, that’s because it is.
That’s why a Federal Claims judge recently ordered a release of all the documents detailing the conservatorship just last week.
This follows several years of debate over whether the takeover was necessary, mostly led by Fannie and Freddie shareholders whose investments basically became worthless after the restructuring.
Prior to the latest court order, several of these large shareholders who had challenged this arrangement in court were shot down. Maybe they’ll fare better once they get hold of the documents pertaining to the Treasury’s takeover.
Of course, the investors who owned General Motors and Chrysler bonds also got shot down in court when they complained that they got the short end of the stick in the government bailout of the automakers.
There’s a theme here. When the government bails out private sector entities, it picks winners and losers. If you want to know which one you are, ask yourself this:
Can you send the government billions of dollars per quarter in free cash like the mortgage giants?
Can you provide politicians with hundreds of thousands if not millions of votes in an election, like the unions that jumped ahead of bondholders in the auto deals?
If not, then you’ll likely end up losing.
P.S. U.S. stocks are up again today. Don’t let this deter you from our long-term predictions. Like Harry said yesterday, we could see another rally in stocks before the whole thing comes tumbling. But it could just mean the last dying breath of a bull market.
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