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Fannie and Freddie reform is necessary, but not at expense of private sector investment

Housing-Market / US Housing Mar 12, 2014 - 03:48 PM GMT

By: Ronan_Keenan

Housing-Market

Private investors and the government don’t always make easy bedfellows and nothing exemplifies this more than the case of Fannie Mae and Freddie Mac. After verging on collapse in 2008, the government-backed mortgage groups are now turning significant profits, but investors are not happy.

Since their inception, the structure of Fannie and Freddie has been a point of contention. Established by government charter, the entities are owned by private shareholders and guarantee the vast majority of US mortgages, buying and selling loans from financial institutions to provide money for the banks to facilitate lending to home buyers. For much of their existence the groups’ configuration has drawn criticism as private investors enjoyed the profits while losses were felt by taxpayers. Things have changed since then.


Even after receiving a $188 billion government bailout during the height of the financial crisis in 2008, the future of Fannie and Freddie seemed precarious. The common shares of both entities, which traded at $60 in 2007, declined sharply and were delisted from the New York Stock Exchange in 2010. By mid-2012 shares were worth just $0.14. But some investors had faith in the companies and as loan delinquencies declined and house prices rose, profits were generated.

Fannie and Freddie shares have now jumped more than 1,000% over the last 12 months. Fannie had a net income of $84 billion in 2013, while Freddie's was $48.7 billion. Yet investors are not reaping any profits. And that’s because the government changed the rules.

During the 2008 bailout the government took preferred shares carrying a dividend of 10%, along with almost 80% of common stock. It also placed Fannie and Freddie in “conservatorship”, meaning the government had administrative powers for the foreseeable future. Nobody seemed to care too much at the time, but interest picked up once the entities started making money. In 2012 the government used its conservatorship powers to change the bailout terms to ensure that all profits from Fannie and Freddie went to the Treasury.

Fannie and Freddie have now paid back more in dividends than they received in the 2008 bailout. Understandably chagrined, investors have launched a myriad of lawsuits against the government alleging that the 2012 amendments constitute a taking of private property without any compensation. A recently revealed 2009 Treasury memo stated that the conservatorship of Fannie and Freddie “preserves the status and claims” of preferred and common shareholders. But illogically, the government doesn’t seem to think future earnings are a claim for shareholders.

Regardless of arguments about the efficiency of Fannie and Freddie (some laud their ability to facilitate 30-year mortgages, others denounce their facilitation of reckless greed), or that most shareholders are hedge funds, it cannot be overlooked that investors who backed the companies’ survival are now being punished. Private investment in government-backed initiatives cannot be discouraged. The government was not in a position to nationalize Fannie and Freddie, the $4.9 trillion obligations were understandably too large, so it had to rely on investors to keep the mortgage groups alive.

Profit-saga aside, there is still the issue of deciding what to do with Fannie and Freddie. The Obama administration has rightly voiced support for overhauling the entities and it is true that the historic structure can no longer work; in the boom times it was overly imbalanced in favor of private investors and now the roles are reversed. Several reform bills are sitting in Congress, with some calling for a complete dissolution of Fannie and Freddie. An alternative proposal was made by a group of hedge funds and private equity companies late last year in which the entities would be replaced with two private firms, backed with an initial capitalization of $50 billion. Yet neither proposal is expected to gain widespread approval.

In reality, the most efficient solution involves a scenario in which the balance of responsibility is shifted so that private investors carry the larger share of the burden. On Tuesday the Senate Banking Committee released a bipartisan plan to unwind the mortgage companies and create a new system in which the private sector would be required to take the first 10% of losses before any government guarantee would be triggered. This is a step in the right direction, allowing the government to take the position of secondary guarantor and spare itself from the role of loss-absorber to private sector bets.

Yet the proposal does not include any provision for investors to share in the companies’ profits. Investors did not back Fannie and Freddie for the good of the US mortgage system; they bought shares with future profits in mind. Even so, private investment is needed for such government-backed entities to function efficiently and should not be discouraged.

This post originally appeared on Ronan Keenan’s MacroWatcher blog

© 2014 Copyright Ronan Keenan - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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