Bill Ackman — who may or may not have manipulated [7] some stocks — is confident that the “truth will prevail [8]” as it relates to Fannie and Freddie, and the truth will supposedly show that the government is engaged in an unconstitutional confiscation of money that rightfully belong to shareholders. This stems from the Treasury’s 2012 move to sweep 100% of the companies’ profits. That arrangement replaced the old, some say inefficient, arrangement whereby Fannie and Freddie owed the Treasury a dividend on the government’s preferred shares but didn’t make enough money to cover it so, not wanting to lose out, the Treasury would then take the logical step of loaning the GSEs the money they needed to make the payment.
As the Treasury correctly noted when it changed the rules, this practice was rather circular and probably made very little sense (and that’s coming from the people who issue US government debt who most certainly know something about ridiculous circular funding schemes that make no sense):
“The agreements will replace the 10 percent dividend payments made to Treasury on its preferred stock investments in Fannie Mae and Freddie Mac with a quarterly sweep of every dollar of profit that each firm earns going forward. This will help achieve several important objectives, including ending the circular practice of the Treasury advancing funds to the GSEs simply to pay dividends back to Treasury.”
Of course that was then, and this is now, and thanks to $80 billion in “income” from non-recurring sources in 2013 and another $10 billion in maybe-not-real profits last year, these bastions of profitability are now throwing off cash and several billionaires plus a long line of BTFDers want their cut.
The problem with this, to let the FHFA tell it, is that Fannie and Freddie may well go broke again, at which point taxpayers would once again be on the hook for subsidizing their own bad mortgage debt, and so ultimately, the “truth” Bill Ackman is looking for here might be that these two firms are destined, by design, by decades of reckless behavior, and by Treasury decree, to be insolvent most of the time and that is one rather inconvenient truth. Here’s more from the FHFA [9]:
To meaningfully discuss the sustainability of future earnings by the Enterprises, OIG separated nonrecurring events out of the income from the single-family, multifamily, and portfolio investment business segments. Analyzing the earnings reported by the Enterprises in 2012, OIG found that non-recurring earnings contributed $1 billion— 3.6%—of the $28 billion in net income. OIG found that, for 2013, non-recurring events accounted for $79 billion—60%—of the $132.6 billion in net income. Results for 2014 reflect that non-recurring sources comprise 45% of net income. Figure 2 illustrates that non-recurring sources contributed significantly to the Enterprises’ financial performance in 2013 and 2014.
[10]
Historically, net interest income from the Enterprises’ retained portfolios has been their primary source of revenue (see Figure 4).15 Net interest income is the difference, or spread, between the interest income earned on the assets in the retained portfolio and the interest expense associated with the debt that funds those assets. The Enterprises’ retained portfolios grew over 700% between 1992 and 2008, and net interest income became the largest source of earnings. The Enterprises’ combined retained portfolios were $192 billion as of the end of 1992, and grew to $1.6 trillion as of 2008.
While in conservatorship, the Enterprises are required to reduce the size of their retained portfolios in accordance with a designated schedule, and these mandatory reductions will reduce earnings from these portfolios in the future. The PSPAs require the Enterprises to reduce the size of their retained portfolios by 15% per year until they reach $250 billion by 2018.16 Since the conservatorships began in 2008, the size of the Enterprises’ retained portfolios has declined dramatically. Fannie Mae’s total mortgage related investment portfolio was $413.3 billion as of December 31, 2014; Freddie Mac’s comparable portfolio was $408.4 billion. The Enterprises have cautioned that any income growth from guarantee fees may not completely offset the loss in income from the retained portfolios.
[11]
And then, because no story about insolvent institutions is complete without a discussion of giant losses on a mountain of derivatives, there’s this…
The Enterprises, like many financial institutions, use derivatives to hedge against various risks, such as fluctuating interest rates. They use a variety of derivative instruments, including interest rate swaps, as an integral part of their interest rate risk management strategies. Derivative instruments are recorded at fair value and marked-to-market in the Enterprises’ financial statements to reflect changes in the value of these instruments due to changes in, for example, short-term and long-term swap rates.17 The Enterprises report changes in the value of their derivatives portfolios as fair value gains or losses, and the impact of those changes affects financial performance. For example, Fannie Mae reported fair value gains on derivatives of $3.3 billion in 2013, and fair value losses of $5.8 billion in 2014, a swing of more than $9 billion.
Under the PSPAs, losses from derivatives could require a draw if they cause an Enterprise’s liabilities to exceed the assets on its balance sheet and the Enterprise’s losses exceed the applicable capital reserve amount. Stated differently, if derivatives losses, expenses, and other adjustments exceed revenues and applicable capital reserve amount, a draw from Treasury would be required to cover the negative net worth amount.
… which when combined with the fact that the Fed MBS put is almost a memory...
It is uncertain when the FOMC will cease investing in MBS. The Mortgage Bankers Association suggests that the Federal Reserve, which has been the single largest purchaser of MBS over the past few years, will likely exit the MBS market in mid-2015.28 The ramifications of the FOMC’s decision to end the asset purchase program will not be clear until the market adjusts to the changed environment.
There is no obvious single player prepared to take over the Federal Reserve’s position as the dominant purchaser. Investors in MBS have different incentives for holding these instruments, and their investment strategies are influenced by a variety of factors, including regulatory capital and liquidity standards (e.g., Basel III and liquidity requirements); risk appetite and return objectives; and access to funding at favorable rates. The Mortgage Bankers Association estimates modest gains in demand for MBS issuance in 2015 and expects total mortgage production to remain low. This lack of production combined with factors beyond FHFA and the Enterprises’ control create uncertainty about the future source of capital to fund the housing mortgage market and who the holders will be of MBS.
[12]
... you end up with a rather large problem…
[13]
…and so in the end shareholders may well find themselves in a familiar position…
