After receiving thoughtful inquiries from two diligent readers (to whom, many thanks) about our calculation of the U.S. Treasury’s internal rate of return (IRR) on its senior preferred stock investment in Fannie Mae, we have carefully gone back over all the numbers starting with 2008, found a couple of needed revisions, and recalculated the answer.
The result is that Fannie has indeed reached its “10 percent moment.” Even after its fourth quarter 2017 loss, and counting the resulting negative cash flow for the Treasury in 2018’s first quarter, we conclude that Treasury’s IRR on Fannie is 10.04 percent. Freddie, as we previously said, was already past 10 percent and remains so.
So the 10 percent Moment for both Fannie and Freddie has arrived. We believe the stage is thus set for major reform steps for these two problem children of the U.S. Congress, but that the most important reforms would not need congressional action. They could be taken by agreement between the Treasury as investor and risk taker, and the Federal Housing Finance Agency (FHFA) as conservator and regulator of Fannie and Freddie.
Since Treasury has received in dividend payments from both Fannie and Freddie the economic equivalent of repayment of all of the principal of their senior preferred stock plus a full 10 percent yield, it is now entirely reasonable for it to consider declaring the senior preferred stock retired—but only in exchange for three essential reforms. These could be agreed between Treasury and the FHFA and thus be binding on Fannie and Freddie. The Congress would not have to do anything in addition to existing law.
These reforms are:
- Serious capital requirements.
- An ongoing fee paid to Treasury for its credit support.
- Adjustment of Fannie and Freddie’s MBS guarantee fees in compliance with the law.
CAPITAL: Fannie and Freddie’s minimum requirement of equity to total assets should be set at the same level as for all other giant, too-big-too-fail regulated financial institutions. That would be 5 percent.
CREDIT SUPPORT FEE TO TREASURY: Neither Fannie nor Freddie could exist for a minute, let alone make a profit, without the guarantee of their obligations by the Treasury (and through it, the taxpayers), which, while not explicit, is entirely real. A free guarantee is maximally distorting and creates maximum moral hazard. Fannie and Freddie should pay a fair ongoing fee for this credit support, which is essential to their existence. Our guess at a fair fee is 15 to 20 basis points a year, assessed on total liabilities. To help arrive at the proper level, we recommend that Treasury formally request the Federal Deposit Insurance Corp. apply to Fannie and Freddie their large financial institution model for calculating required deposit insurance fees. This would give us a reasonable estimate of the appropriate fee to pay for a government guarantee of institutions with $2 and $3 trillion of credit risk, entirely concentrated in real estate exposure and, at the moment, with virtually zero capital. It would thus provide an unbiased starting point for negotiating the fee.
ADJUSTMENT OF MBS GUARANTEE FEES: Existing law, as specified in the Temporary Payroll Tax Cut Continuation Act of 2011, requires that Fannie and Freddie’s fees to guarantee mortgage-backed securities be set at levels that would cover the cost of capital of private regulated financial institutions engaged in the same risk—this can be viewed as a private sector adjustment factor for mortgage credit. Whether you think this is a good idea (we do) or not, it is the law. But the FHFA has not implemented this clear requirement. It should do so in any case, but the settlement of the senior preferred stock at the 10 percent moment would make a good occasion to make sure this gets done.
These three proposed steps treat Fannie and Freddie exactly like the giant, too-big-to-fail, regulated, government guaranteed financial institutions they are. Upon retirement of the Treasury’s senior preferred stock with an achieved 10 percent return, the reformed Fannie and Freddie would be able to start accumulating retained earnings again, building their capital base over time. As their equity capital grows, the fair guarantee fee to be paid to the Treasury would decline.
The 10 percent moment is here. Now a deal to move forward on a sensible basis can be made.