Fannie Mae and Freddie Mac are government-sponsored enterprises (GSEs) that help finance the majority of mortgages in the United States. They purchase mortgages that meet certain standards from banks and other originators in the secondary (or resale) market; pool those loans into mortgage-backed securities (MBSs), which they guarantee against losses from defaults on the underlying mortgages; and sell those securities to investors. The two GSEs also buy mortgages and MBSs to hold in their investment portfolios.
How Did the Relationship Between the Federal Government and the GSEs Change During the Financial Crisis?
In September 2008, as the global financial crisis intensified, the government placed Fannie Mae and Freddie Mac under federal conservatorship because of their risk of insolvency in the face of the large losses that they were projected to incur on their outstanding mortgage guarantees and investments. The prospect of the GSEs’ becoming insolvent not only created uncertainty about their ability to continue to provide a stable source of funding for residential mortgages but also raised concerns about the spillover effects that their insolvency would have on investors and the economy.
At that time, using the authority granted to it under the Housing and Economic Recovery Act of 2008 (HERA; Public Law 110-289), the Department of the Treasury signed senior preferred stock purchase agreements with the two GSEs that included two main provisions. First, in any quarter in which Fannie Mae’s or Freddie Mac’s net worth becomes negative, the Treasury is obligated to purchase enough senior preferred stock (subject to limits) from the GSEs to restore them to positive net worth. Second, the GSEs must pay dividends to the Treasury on the government’s holdings of their senior preferred stock. (Like dividends paid on junior preferred and common stock, those payments do not reduce the outstanding amount of such stock.) Together, HERA and the senior preferred stock purchase agreements ensure that Fannie Mae and Freddie Mac maintain a positive net worth and that the government retains control and effective ownership of the two GSEs.
Between November 2008 and March 2012, the Treasury purchased $187 billion of senior preferred stock from the two GSEs to cover their losses and ensure that they could continue to operate in the secondary market. The GSEs returned to profitability in 2012 as the economy and housing markets stabilized, and, consequently, they have not needed to draw on additional federal funds since then. As of September 30, 2016, $258 billion of Treasury assistance remains available under the agreements to purchase additional senior preferred stock. That undrawn amount serves as an effective capital cushion and ensures that, under most circumstances, the GSEs would be able to pay investors who held their debt and mortgage-backed securities. Without that backstop, the value of the GSEs’ equity and debt (including the government’s holdings of senior preferred stock) would be much lower.
Under the current terms of the agreements, when Fannie Mae’s or Freddie Mac’s net worth exceeds a specified threshold (set to decline to zero in 2018), the GSE must pay dividends to the Treasury in the amount of that surplus. Essentially, the current agreements require the GSEs to pay all of their profits to the Treasury. As of the end of September 2016, the GSEs had paid about $250 billion in dividends to the Treasury. Under current law, CBO projects, they would pay an additional $180 billion from 2017 through 2026.
The future of Fannie Mae and Freddie Mac is uncertain. The Administration announced that it intended to wind them down, but lawmakers have not agreed on what new structure for housing finance should be implemented.
What Policy Option Did CBO Analyze?
The policy option that CBO analyzed would not restructure the housing finance market; rather, it would allow the GSEs to retain some of their profits and thus increase their capital. Because several bills have been introduced in the Congress with different approaches to building the GSEs’ capital, CBO analyzed an illustrative option rather than a specific legislative proposal. Under the illustrative option, each GSE would be allowed to retain an average of $5 billion of its profits annually and would thus increase its capital by up to $50 billion over 10 years. The government’s commitment to purchase more senior preferred stock from Fannie Mae and Freddie Mac if necessary to ensure that they maintain a positive net worth would remain in place. In addition, the GSEs would invest the profits that they retained under the option in Treasury securities, and returns on those securities would raise the GSEs’ income. Through its holdings of senior preferred stock, the government would continue to have a claim to the GSEs’ net worth ahead of other stockholders.
What Effects Would the Policy Option Have?
The policy option would affect the financial position of the GSEs, the stability of the mortgage market, and the federal budget. Specifically, implementing the option would have the following effects:
- Essentially convert a potential draw on federal funds (which would occur only in the event that the GSEs suffered a quarterly loss) into an immediate draw on those funds (in the form of forgone dividends to the Treasury);
- Increase the explicit federal backstop for the GSEs—and thus the risk to taxpayers—by the amount of the earnings that the GSEs retained (up to $100 billion over 10 years);
- Reduce the likelihood of the Treasury’s needing to purchase additional shares of senior preferred stock in the future, and thus lower the risk of the GSEs’ exhausting the Treasury’s support and disrupting the market;
- Diminish the government’s net financial position (as measured by the market value of its assets and liabilities), but by much less than the amount of dividend payments forgone; and
- Result in a budgetary cost of about $10 billion under CBO’s approach to accounting for the GSEs, which measures the market value of the government’s increased risk exposure.
Because the GSEs are, in CBO’s view, effectively federal entities, the budgetary cost of the policy option would be the estimated market value of the increase in the government’s exposure to losses on the GSEs’ mortgage guarantees and investments. The Administration treats the GSEs differently—as private companies that are outside the government. Consequently, its deficit projections reflect the cash transactions between the Treasury and the GSEs, whereas CBO treats such transactions as intragovernmental transfers that have no net impact on the deficit. Under the Administration’s budgetary treatment, the policy option would have a budgetary cost that was significantly larger than CBO’s estimate, roughly $85 billion over 10 years.