Today, I’m turning my column space over to someone else because I think the message that Tom Forrester, one of the best-regarded financial officers in the country, has to deliver is important and timely.
It involves Fannie Mae and Freddie Mac, the two government-sponsored mortgage insurers that received 12-digit federal-bailout loans in 2008 to forestall their collapse but have since become immensely profitable and now pour billions of dollars a year into the Treasury.
Forrester approached me recently to discuss a Fannie and Freddie problem that I didn’t realize existed. As is typical for him, Forrester also had ideas about how to fix things before they turn toxic.
Forrester has a great record of seeing and solving financial problems. He did that at Progressive Insurance, which he helped turn into a powerhouse, and at Fannie Mae, which he helped to fix itself after the government asked him to come out of retirement, join Fannie’s board and chair its audit committee.
Forrester wanted to write down his thoughts, which I encouraged him to do. After I saw Forrester’s manuscript, which he revised several times and which I’ve edited a bit, I thought it was more effective for you to see what Forrester has to say rather than my paraphrase of what he has to say. And here it is. — Allan Sloan
by Tom Forrester
Four years ago, the Treasury changed its agreement with Fannie Mae and Freddie Mac and began taking for itself all the profits made by the two companies, which had been placed in government conservatorship in 2008. As part of the 2012 changes, both companies’ capital is being gradually reduced and will reach zero at the end of 2017.
Things look fine for Fannie and Freddie now. But as a former insurance company chief financial officer who served as a Fannie director from the early days of the conservatorship through this past May, I can tell you that stripping the firms of their profits and their capital poses a huge risk. A risk far greater for the companies — and our financial system — than almost anyone recognizes. That’s because it won’t take another housing collapse to cause major problems for Fannie and Freddie. All it would take is a modest increase in mortgage rates coupled with one quarter of less-than-optimal profits.
Let me explain. As of June 30, Fannie and Freddie owned a combined $400 billion of mortgages. That’s in addition to having guaranteed $4 trillion of mortgages — more than 40 percent of the total residential mortgages in the country.
When mortgage rates rise, which they inevitably will, the decline in the value of Fannie’s and Freddie’s mortgage holdings could well exceed their operating earnings for a given quarter, creating an overall loss.
Under the companies’ agreement with the Treasury, they are required to borrow money to cover the loss. That will likely trigger headlines along the lines of, “They’re Back! Fannie and Freddie Get Another Bailout.”
And that will attract the attention of the markets, which will begin to focus on the companies’ lack of capital, realize that the Treasury’s support is not open-ended and possibly start a panic.
The prevailing market view is that the $4 trillion of Fannie and Freddie mortgage-backed securities have an explicit federal guarantee. But they don’t — hence the potential for trouble.
The Treasury has limited the amount it would lend each company to $200 billion — not $200 billion at one time, but $200 billion total.
Fannie Mae borrowed $117.1 billion during its difficult period, which ran from 2008 to 2011, leaving it with $82.9 billion of remaining guarantees. Even though Fannie has fully repaid the $117.1 billion (and remitted an additional $34.3 billion), the government is obligated to cover only $82.9 billion of additional losses. If Fannie were to require a draw, the remaining guarantee would drop by the amount of the draw, even if Fannie repays the draw in full the following quarter.
Two immensely problematic outcomes could ensue. First, investors could get spooked and focus on the lack of capital supporting their Fannie- and Freddie-backed mortgage securities. A flight from those would create a liquidity crisis. Second, skittish markets and shrieking headlines would likely lead Congress to demand immediate action. Given Congress’s sorry record, we’ll probably see a knee-jerk reaction that is more likely to destabilize than fix the companies.
The irony will be that without any help from Congress, the companies have already been reformed and de-risked. In 2008, more than 90 percent of the companies’ revenue came from risky investments involving borrowed money. Today, their revenue come primarily from guarantee fees, which are reliable and stable.
Both companies have new management and boards and have changed how they do business. They’re now focused on safety and soundness but haven’t forgotten their mission to provide liquidity for moderate- and low-income borrowers.
Both companies possess strong financial fundamentals, are solidly profitable and will likely turn over tens of billions of dollars to taxpayers over the next eight to 10 years. Credit this remarkable turnaround to a dedicated management team and the Federal Housing Finance Agency, particularly Director Mel Watt.
Congress needs to do two things to defuse the potential market time bomb.
First, allow each company to keep at least $3 billion in capital and make their profit sweeps to the Treasury annual rather than quarterly. That will stop a quirky quarter from generating a paper loss and requiring a Treasury drawdown.
Second, create a path to end conservatorship. It would be simple for Congress and the next administration to draw up a plan that maximizes taxpayer value, liberates Fannie and Freddie and eliminates taxpayer risk. Conservatorship has been a huge success. Let’s quit while we’re ahead.