Treasury and Conservatorship by Timothy Howard Jan 11 2015
To understand what happened, it is useful to think of Fannie Mae’s earnings as having three basic components: (a) revenues from the company’s two businesses, portfolio investments and credit guarantees, (b) annual expenses, principally administrative costs and credit losses, and (c) accounting gains or losses. During the eight years between 2003 and 2011, the combined revenues from Fannie Mae’s portfolio investments and credit guarantees grew irregularly but strongly, rising by almost 60 percent. The $162 billion in losses the company recorded from 2008 through 2011 was not due to a lack of revenue. Indeed, the $74 billion Fannie Mae booked in combined net interest income from its mortgage portfolio and guarantee fees from its mortgage-backed securities during the 2008- 2011 period was more than enough to cover not only the huge $62 billion spike in its actual credit losses (charge-offs net of recoveries, plus foreclosed property expense) but also its cumulative $9 billion in administrative expenses during that time. Put another way, all of Fannie Mae’s GAAP losses from 2008 through 2011 stemmed from accounting entries and judgments: principally the exceptionally large $70 billion increase in its reserve for future loan losses, and significant write-downs of a number of items on the company’s balance sheet (which are not possible to calculate precisely because of the complexity of Fannie Mae’s GAAP accounting). Many of the write-downs were made near the low points of asset values and were subject to upward revision in future periods, while the loss reserve similarly was predicated on pessimistic projections of future home prices, loan defaults and loss severities. The turning point for both sets of accounting decisions came during the first half of 2012. After falling by almost 24 percent from the third quarter of 2006 to the first quarter of 2012, Fannie Mae’s index of home prices rose by 3.2 percent in the second quarter of 2012. This jump in home prices, together with a sharp rise in the prices received for sales of foreclosed homes and a further decrease in Fannie Mae’s single-family serious delinquency rate, convinced the company that it could begin to use its ample loss reserve to absorb current-period credit losses. Doing so meant that nearly all of Fannie Mae’s $5.8 billion in pre-tax revenues reached its bottom line in the second quarter, since tax loss carry-forwards made its federal income tax liability zero. The company was able to make its $2.9 billion quarterly dividend payment to Treasury and still add $2.5 billion to its net worth. With a positive net worth, strong revenues, a declining loss reserve, the tax loss carry-forward, and the likelihood of upward asset price revaluations and the successful resolution of loan repurchase claims over the next several quarters, it suddenly became apparent that Fannie Mae would not need any further draws from Treasury for quite a long period of time. And if that were the case, the decision Treasury and FHFA had made in 2008 to establish a valuation reserve for Fannie Mae’s deferred tax assets soon would be reversed, adding even further to the company’s profits, retained earnings and capital. 6
Treasury, of course, knew all this; it was the one that had engineered Fannie Mae’s accounting losses and excessive loss reserving in the first place, following the roadmap of the March 2008 paper, “Fannie Mae Insolvency and its Consequences.” Treasury and FHFA agreed to the third amendment to the senior preferred stock agreement—in which Fannie Mae and Freddie Mac would be required to give all of their future profits to Treasury instead of paying a quarterly preferred stock dividend—so that the government, and not the company’s shareholders, would reap the benefits of the now-imminent reversal of many of the earlier accounting-related write-downs. It was even less difficult for Treasury to get FHFA to agree to the third amendment in 2012 than it had been in 2008 getting director Lockhart to agree to reduce Fannie Mae and Freddie Mac’s surplus capital percentage, or to reverse his previous public position that the companies were safe and sound and adequately capitalized. In 2012 the acting director of FHFA was Ed DeMarco, who from 1993 to 2003 had worked at Treasury as director of the Office of Financial Institutions Policy.
Treasury insists that the third amendment was essential to prevent the companies from having to undertake an endless cycle of borrowing in order to continue to make their dividend payments. But with the third amendment coming only after Fannie Mae had begun to rebuild its capital—and with the reversal of its reserve for deferred tax assets having become a virtual certainty—this rationale crumbles in the face of the factual record.