Documents Undercut U.S. Case for Taking Mortgage Giant Fannie Mae’s Profits via Gretchen Morgenson, The New York Times

On a Friday in August 2012, the federal government changed the terms of its bailout of Fannie and Freddie, sending all the mortgage finance giants’ profits to the Treasury. The surprise decision prompted a lawsuit from shareholders, who argued that the collection of profits was an improper taking of private property without compensation.

As the lawsuit proceeds through Federal Claims Court, documents unsealed in the case on Monday undermine an important defense made by the United States government. Lawyers for the Justice Department maintained early on in the litigation that Fannie Mae and Freddie Mac were in a death spiral and financially weak. Funneling all their profits to the Treasury was a way to protect taxpayers from future losses at the government-sponsored enterprises, the Justice Department said.

In a deposition taken last July, for example, Susan McFarland, Fannie’s former chief financial officer, said she told high-level officials at the Treasury on Aug. 9, 2012, that the company was, in fact, “now in a sustainable profitability, that we would be able to deliver sustainable profits over time.”

The mortgage finance giants Fannie Mae and Freddie Mac remain wards of the state years after the credit crisis receded into memory. Under their original rescue, in 2008, they were required to pay a 10 percent dividend on the money they had drawn from the Treasury.

The revised deal, under which their profits are swept every quarter into the Treasury’s general fund, prompted shareholders to sue in Federal Claims Court. Fairholme Funds, a mutual fund company that owns shares in Fannie Mae and Freddie Mac, filed the suit in 2013.

Among the documents unsealed by Margaret M. Sweeney, the judge presiding over the litigation, are excerpts from three depositions taken in the case by lawyers for Fairholme. Those depositions center on what the government knew about Fannie’s and Freddie’s financial position in 2012; this is an important question because the government had justified the taking of profits as a way to protect taxpayers who had extended bailout money to the companies.

In addition to telling Treasury officials in early August 2012 that Fannie would be able to sustain profits, Ms. McFarland said that Fannie could soon reap about $50 billion in income because of the reversal of an accounting entry, known as a deferred tax asset, required under accounting rules when the company began earning profits again.

A copy of the presentation that Ms. McFarland made to the Treasury was also unsealed. It contains 10 years of internal financial projections from Fannie, indicating that the company would not require further assistance from taxpayers.

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Fannie Mae “In A Sustainable Profitability” PDF

Fannie Mae

Q: At the risk-free rate of debt, but then they would layer on top of that some risk premium for credit risk?

MR. LAUFGRABEN: Objection; form, foundation.

A. I would say my experience not just at Fannie Mae but over the course of career with financial services, that’s a normal construct for providers of funds, to — to come up with a price point —

Q. (BY MR. THOMPSON) Yes.

A. — that they would be willing to provide those funds.

Q. Yeah. And I am trying to figure out how they would come up with that price point. They would look at interest rate risk, among others things, right?

MR. LAUFGRABEN: Objection.

A. I can’t sit here and tell you what each entity specifically did.

But I think if you look academically at, you know, the buildup of rates, you’re looking at a risk-free rate and then building something on for risk. And then you can make your list of what risks you think you need to build into the price and how much price you think you need to build for each of those types of risks.

But, you know, on an individual entity-be-entity basis, you would have to ask them how they built their rate structure.

Q. (BY MR. THOMPSON) And that’s fair enough.

I was trying to get inside Fannie Mae’s head, when they’re doing projections into the future and trying to think about, “What is our funding expense going to be?”

Did you-all try to build that expense in the same way where you made an estimate of, “Here’s what we think the risk-free rates will be, and here’s what we think our funding sources will require as a risk of premium”?

MR. LAUFGRABEN: Object to the form of 15 the question.

MR. BARTOLOMUCCI: Objection; form.

A. We — there’s a lot of history that exists, and so there was a lot of — the more — the funding markets, by the time I was there, were performing fairly effectively with one exception. When the debt ceiling debates occurred, and there were challenges with the debt ceilings, we saw some interesting things go on within the debt markets for short periods of time around those debates.

Outside of that, it — the pricing wasn’t that crazy or volatile. In other words, you could kind of almost trendline out the correlations that existed in the recent past to continue to exist on a go-forward basis.

Q. (BY MR. THOMPSON) Now, if you’re — we’re looking at the cost of funding for Fannie Mae, is one of the variables — is it true to say that all other things being equal, if Fannie Mae had more capital, it would pay less in funding than if it had less capital?

MR. LAUFGRABEN: Objection; calls for speculation, calls for an expert opinion.

A. Capital exists for unexpected losses. Your expected losses should be reserved for and already reflected in your financials.

If someone is building up a price point, taking a risk-free rate and then building onto something for risks, one would then assess what the capacity that the entity has to absorb those risks. Capital could be one place a company could absorb some of those risks.

So it would not — it would make sense to me that entities would look at capital levels in consideration, as one factor in determining a company’s capacity to absorb risks, and that could influence their pricing.

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