That Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) are profitable has become one of the truisms of the debate over the future of the government sponsored enterprises, or whatever Federal agency replaces. But that narrative is based on Office of Management and Budget (OMB) accounting, the executive agency that helps the president prepare his budget. According to the Congressional Budget Office, Fannie Mae and Freddie Mac are actually losing money and will continue to be a drag on the budget for the next ten years, even though they are cash flow positive.
CBO treats Fannie Mae, Freddie Mac as part of the Federal government
“The premise of CBO’s scoring and fair value is that the government basically owns the GSE’s now,” explained Deborah Lucas, a professor of finance at the MIT Sloan School of Management and former assistant director of the CBO at a conference earlier this week. “They collect fees, but they also take on the liabilities of new guarantees. So the CBO conclusion is that the net value is slightly negative because the fee income in the future doesn’t quite cover the cost of those new guarantees.”
The fundamental difference between the OMB and CBO approaches is that the OMB views Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) as third party entities, so whenever they send cash to Treasury (such as the income sweeps that began more than a year ago) the OMB records that as a receipt to the government, while the CBO simply sees an intergovernmental transfer.
“The cash that they’re receiving is flowing off the assets that the government already owns,” says Lucas. “It’s coming from this existing book of mortgages, but the government already owns that value.”
Cash flow accounting is backward looking
Lucas contends that accounting on a cash flow basis doesn’t give a full economic picture of what’s really happening because the method is backward looking. The inflows that Fannie Mae and Freddie Mac are getting now flow from guarantees that were made in the past, so their present cash flow position doesn’t necessarily tell you what’s happening right now. It also ignores the time-value of money and the cost of market risk, which seems unreasonable when determining the value of 30-year mortgage guarantees.
Since the Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) are offering guarantees below market rates, fair value accounting simply marks that as a loss because it’s looking at the long-term expected impact of guarantees made this year, instead of the cumulative flows caused by all guarantees that have been made in the past. (Intuitively, the GSEs must be offering a discount to competitive rates, because otherwise private capital would move into the secondary mortgage market.)
“Almost any credit activity by the government when accounted for on a cash basis is gonna look pretty profitable, so it’s not a very telling way to look at it,” says Lucas. “This fair value approach offers lawmakers and the public the most comprehensive and transparent treatment that’s out there in terms of how to include them in the budget.”