Could Fannie & Freddie Have Paid the Taxpayers Back?

Those who support the speculators in the common and junior preferred stock of failed GSEs Fannie Mae and Freddie Mac often suggest that if the government not changed the deal in 2012, both would have by now paid back their taxpayer bailout. The latter is in the form of $189 billion in senior preferred stock held by the Treasury.

In a recent example, Gretchen Morgenson wrote in the New York Times that "Initially, Fannie and Freddie paid interest on the taxpayer loan. But in August, 2012, the Treasury and the companies' conservator, the Federal Housing Finance Agency, amended the deal to sweep all the companies' earnings in to the Treasury." By now, she continued, Fannie and Freddie have paid the Treasury "more than they borrowed from the taxpayers."

A few technical financial corrections: Fannie and Freddie did not get a loan from the taxpayers, but an equity investment in senior preferred stock (otherwise they would have remained hopelessly insolvent). They did not pay interest, but dividends, originally at the rate of 10% per year. The 2012 amendment changed the definition of the dividend from 10% of the senior preferred stock per year to all the profits, whatever those might be.

Whether we are considering a loan or preferred stock, however, paying interest on the loan or dividends on the stock never reduces the principal amount. Every borrower and every lender knows this. If for example, you paid 10% interest on an interest-only loan for ten years, you would have paid an amount equal to the original loan. But you would still owe the entire original amount-your reduction of principal would be exactly zero. This is obvious.

But it is worth considering this hypothetical case: What if the 2012 change had not been made, and the original deal had continued. What if Fannie and Freddie had kept paying the 10% dividend, continued to pay nothing for the Treasury's credit backup, and then been allowed to use any remaining profits to retire some of the senior preferred stock at par? Would this have resulted in paying off all the taxpayers' investment? Nope: some of it, but by no means all of it.

Here is the simple arithmetic. The table assumes that any post-2012 dividend payment to the Treasury in excess of 10% was used to retire preferred stock. At the end of 2014, there would still have been $46 billion of the taxpayers' senior preferred outstanding. That's a long way yet from having been paid off.

Hypothetical Continuation of Original Fannie and Freddie Deal($ billions)

Source: Fannie Mae and Freddie Mac Forms 10-K, AEI calculations

Let us suppose this hypothetical process continues until the entire principal amount of the senior preferred stock is retired. What then?

Fannie and Freddie would still have zero capital, since the taxpayer investment only brought them up to zero. They would still be utterly dependent on the credit backstop of the Treasury, which they would still hope to get for free, to support the risks of their massive $5.2 trillion in assets. They would need to begin building capital-a lot of it.

The minimum acceptable capital for such systemically risky institutions as Fannie and Freddie is 5% of assets. That means that before they could consider paying even a penny of dividends to their junior preferred and common shareholders, they would first have to retain earnings (or raise new capital) of the very substantial amount of $260 billion. Fannie and Freddie combined made net profit of $21.9 billion in 2014-at that rate, it would take them 12 more years after retiring all the senior preferred to accumulate the required retained earnings.

In the meantime, Treasury should exercise on behalf of the taxpayers the warrants it already has to obtain ownership of new shares equal to 79.9% of Fannie and Freddie's common stock. This will cost it essentially nothing-the warrants were part of the payment for the original bailout investment. So when in some pretty distant day there might again be dividends paid on Fannie and Freddie's common stock, 79.9% of them would go to the Treasury anyway.