On the plane ride back from the Booth Investment Management Conference in Chicago on Sunday, I read the great new book by veteran financial journalist Bethany McLean, Shaky Ground: The Strange Saga of the US Mortgage Giants. The book tells the story of Fannie Mae and Freddie Mac, the two massive GSEs (government sponsored enterprises) that buy, package, and sell pools of mortgage loans. It’s a fascinating, if distressing history. Unfortunately, because our government failed to do away with Fannie and Freddie during the 2008 financial crisis, that history is still unfolding.
Fannie Mae was a government agency until 1968, when it was “privatized” by President Johnson, partly to pay for the Vietnam War. Freddie was created by Congress in 1970 to both compete with and complement Fannie. As with so many government programs, the initial purpose of Fannie and Freddie was laudable—to help increase homeownership. But, as with so many government programs, those good intentions have had disastrous unintended consequences.
By early 2008, Fannie and Freddie were guaranteeing 80 percent of all US mortgages, up from 40 percent just a few years earlier. All told, the two GSEs had packaged and sold over $5 trillion of outstanding mortgage debt. Roughly 20 percent of that securitized debt was held by foreign investors, with the central banks of China and Japan owning about $1 trillion between them.
At the time, Fannie and Freddie only had a sliver of capital—about $84 billion—so when the financial crisis exploded and homeowners defaulted on their mortgages in record numbers, both firms quickly required an immediate bailout. The path not taken (and the correct path, in my opinion) would have been to put them into bankruptcy, or receivership. For years, smart folks on the left and the right had wanted to wind down Fannie and Freddie. (In 2011, former Federal Reserve head Paul Voelker said the financial crisis “was the opportunity to get rid of institutions that shouldn’t exist.”) But then-Treasury Secretary Henry Paulson was concerned that if foreign buyers of GSE securitized paper were burned, they might stop buying US Treasury debt (which we need to fund our $18 trillion federal debt) so he opted for conservatorship instead.
The terms of the deal were complicated. The government injected over $200 billion, and took 79.9 percent of both companies. Dividends on Fannie and Freddie preferred shares were suspended, and it was implied that if either company paid these dividends again, the funds would go to the US Treasury. This is where it gets interesting, because both entities are making sizable profits again. As of earlier this year, they had paid $231 billion back to the US Treasury. You’d think their stocks would be climbing back towards pre-crisis highs. Instead, they’re barely above $2. Why? In 2012, the federal government changed the bailout terms and is now directing all of those profits to Washington.
Last week, an article in Fortune magazine dubbed this rule switch a de facto nationalization of Fannie and Freddie. To which I say: so what? Government created these monsters. If it’s not willing to kill them off entirely, why shouldn’t it use their earnings to help pay back some of the staggering national debt?
Not surprisingly, some people on Wall Street see things differently and want those profits transferred from the US Treasury to their own pockets. A handful of a high-profile, multi-billion dollar hedge fund managers sensed an opportunity when the preferred stocks of Fannie and Freddie were trading for pennies. Now, they’re clamoring for the companies’ dividends to flow back to them. Pershing Square’s Bill Ackman has even claimed that Washington has “stolen” those funds. Multiple lawsuits have been filed. Some have already been thrown out and are working their way up the appeals system. If successful, these actions could result in what Bloomberg called “one of the biggest potential payments in history.”
While this saga is far from over, I find it disturbing that these money managers–a number of whom probably agree that Fannie and Freddie should not exist–are legally pursuing a Quixotic quest to enrich themselves at the expense of American taxpayers. I also find it curious, and worth noting, that many of these same managers are also huge investors in Valeant, which we now know has been overcharging taxpayer-funded Medicare and Medicaid for years. Putting these issues aside, I believe ordinary investors should avoid buying the stocks, preferred stocks, or debt of Fannie Mae and Freddie Mac. There are easier ways to make money.