Capital Buffer Deal May Buy Enough Time to Get Down to Business on Fannie Mae Reform

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The announcement today that Federal National Mortgage Association (OTCMKTS:FNMA) and Freddie Mac (OTCMKTS: FMCC) will begin maintaining a $3-billion capital baseline is the first tangible demonstration in five years that officials in Washington actually want to protect taxpayers and end the stalemate on reforming the government sponsored enterprises.

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Beginning next year, Fannie and Freddie were to have had their capital buffers wiped out completely, courtesy the Net Worth Sweep imposed on them in 2012. Under the arrangement worked out between the Treasury Department and the Federal Housing Finance Agency, the dividend payments Fannie and Freddie are required to make to Treasury each quarter will be based on the GSEs maintaining a capital buffer of $3 billion. Therefore, the $4.7 billion-dollar payment Freddie was to make for third quarter earnings will be reduced to $2.3 billion and Fannie’s scheduled $3 billion dividend payment will be pared back to $600 million. This will create a thin buffer from market fluctuations for the GSEs and perhaps buy a little time before taxpayers would again be on the hook to cover quarterly losses at the enterprises.

The arrangement is a far cry from having the GSEs keep all of their earnings once they paid back Treasury the $187 billion in emergency funds received nine years ago -  which they did, plus an additional $90 billion, courtesy the Net Worth Sweep.  Had the law been followed, the GSEs would have been operating on sound and solvent footing, thus ending the conservatorship and facilitating meaningful and needed reform in a manner that honored shareholder rights.

Nonetheless, the deal signals that the Administration recognizes the fact that running the companies with no reserve capital to cover losses is untenable and the day of reckoning is about to arrive. To that extent, it is a vindication for FHFA Director Mel Watt, who has been warning for a year that dwindling capital reserves poses a risk taxpayers. It is also a sign that Treasury Secretary Steven Mnuchin recognizes the urgency of the situation and has resolved to act sooner than later.

“Treasury’s first duty is to ensure that taxpayers are being protected,” Mnuchin said. “This agreement balances the concerns of the FHFA with compensation for taxpayers. The Administration looks forward to working with Congress on comprehensive housing finance reform, a top priority in the year ahead.”

The Administration will have to act quickly to truly protect taxpayers in the coming months.  The deal comes just hours after Congress cleared a historic tax reform and reduction bill that will have major implications for Fannie and Freddie’s balance sheets.  With the reduction in the corporate tax rate from 35 percent to 21 percent, the value of some $23 billion in deferred tax assets will evaporate, dramatically increasing the likelihood of another taxpayer bailout. This would saddle the Administration with politically unpopular reality and give critics of the tax bill fresh ammunition about its unintended consequences and overall fairness.

Watt is keenly aware of this, saying in a statement, "While it is apparent that a draw will be necessary for each Enterprise if tax legislation results in a reduction to the corporate tax rate, FHFA considers the $3 billion capital reserve sufficient to cover other fluctuations in income in the normal course of each Enterprise's business," Watt wrote. "We, therefore, contemplate that going forward Enterprise dividends will be declared and paid beyond the $3 billion capital reserve in the absence of exigent circumstances."

If “exigent circumstances” could be perceived as Watt keeping his options open it is also safe to assume Mnuchin has attached strings of his own.  The Treasury statement noted, "…any failure by Fannie Mae or Freddie Mac to declare and pay a full quarterly dividend will result in the automatic, immediate termination of its capital buffer."

In the nine years since the financial crisis promoted the creation of the conservatorship, FHFA has implemented a number of changes to operate the GSEs more prudently. However, the Obama Administration’s Net Worth Sweep and inaction by Congress have mostly made the situation worse for taxpayers, the housing finance market, and of course, shareholders.

It is too early to say that this very limited step announced today is the beginning of the end of this long and dismal saga. However, to paraphrase Churchill, it might be better than merely the end of the beginning.

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