The ruling by the U.S Court of Appeals for the D.C. Circuit on February 21 that the net worth sweep falls within the statutory powers granted to the Federal Housing Finance Agency (FHFA) by the Housing and Economic Recovery Act of 2008 removed any chance for quick administrative action on mortgage reform by the Mnuchin Treasury. A ruling remanding the sweep to the lower court for review, or reversing it, would have provided impetus for settlement negotiations between plaintiffs and the government, which is a requisite first step toward reforming and recapitalizing the companies. With the sweep effectively upheld by the D.C. court, however—and no developments in other courts posing any imminent threat to it—at the moment neither the government nor the plaintiffs has incentive to initiate settlement discussions. Thus, administrative mortgage reform is stalled.

Probably not coincidentally, two days after the appellate court decision Mnuchin publicly pushed back his timetable for dealing with Fannie and Freddie. Speaking on Fox Business, he reiterated his personal interest in resolving the eight-year impasse with the companies, saying, “Housing reform is a priority for me. It’s something I know a lot about; I’ve been involved in this business for a long period of time.” But he went on to say, “This is something that’s going to take us a little bit more time. It’s not something we’re going to deal with as quick as taxes, which is our number one priority, but we’re committed to a solution.” With tax reform first in the queue, and the amount of time it should take to agree on a reform package, most observers now believe housing reform won’t be taken up until this fall at the earliest.

Putting housing reform behind tax reform also adds a complication to the task of ultimately recapitalizing the companies, should that be what Mnuchin chooses to do (as I believe it will be). Reducing the corporate tax rate is a key objective of tax reform. A cut in the corporate tax rate is a long-run positive for Fannie and Freddie because it will lower the taxes they pay, but in the short run it will reduce the value of their deferred tax assets (DTAs). DTAs arise when a company pays taxes in cash to the IRS before it can expense them on its income statement. If the corporate tax rate is cut, a company with DTAs will have paid some (or perhaps a lot) of its taxes at what will turn out to be “too high” a rate, and will have to write off the difference between what it paid in cash and what it now can deduct on its books.

At December 31, 2016 Fannie had $33.5 billion in net DTAs (that is, deferred tax assets less deferred tax liabilities), while Freddie had $15.8 billion. Should those amounts remain unchanged, a cut in the corporate tax rate from 35 percent to 25 percent would cause Fannie to write off $9.6 billion of its DTAs, while Freddie would have to write off $4.5 billion. A cut to a 20 percent rate would result in write-offs of $14.4 billion and $6.8 billion, respectively.

Both companies might be able to absorb a DTA write-off from a cut in the corporate tax rate to 25 percent if Treasury and FHFA allow them to skip their scheduled net worth sweep payments to Treasury in March and June. But the opinion from the D.C. Circuit Court of Appeals last week makes that alternative much less likely. Even should he wish to, Secretary Mnuchin does not have a defensible public rationale for allowing Fannie and Freddie to retain funds that an appellate court has just opined belong to the government.

Still, there is a step the Mnuchin Treasury could take that would help the companies reduce their DTAs, and also increase their retained earnings to aid in an ultimate recapitalization. It could, and should, abandon the policy of the Obama Treasury of having FHFA manage Fannie and Freddie with the objective of weakening them to make it seem more feasible or desirable to wind them down and replace them. If Mnuchin is serious about using the companies as the basis of the future mortgage finance system, he should want them to be run in a way that maximizes their value as stand-alone entities, and should permit Fannie and Freddie’s management to make their own decisions on business matters, as well as accounting policies.

The size and composition of the companies’ DTAs are determined largely by their accounting choices. Since the conservatorship—and in Fannie’s case several years before that—those have been made not by company management, but by FHFA.

Because Fannie’s DTAs are more than twice the size of Freddie’s, it’s instructive to focus on the history of that company’s DTAs. In the 1990s, Fannie had a relatively simple business: it earned a spread between the yield on the mortgages in its portfolio and the cost of the debt it used to fund them, and earned fees on mortgages it guaranteed as mortgage-backed securities. It also had relatively simple accounting, and as a result the cash taxes it paid closely matched the liability for income taxes it recorded on its books. As of December 31, 2000, Fannie had no DTAs.

That changed in 2001, with the adoption of FAS 133, accounting for derivatives. FAS 133 required the company to put its “derivatives in loss positions” on its balance sheet, resulting in a net DTA of $3.8 billion that year. As Fannie’s use of derivatives to hedge its portfolio increased, so did its DTAs. By the time of Fannie’s 2003 annual report—the last one I prepared for the company—its derivatives-related DTAs had risen to $8.1 billion, pushing its total net deferred tax assets to $9.1 billion.

The next phase of Fannie’s DTAs began following the special examination of Fannie conducted by its then regulator, the Office of Federal Housing Enterprise Oversight (OFHEO) in 2004. In that examination, OFHEO aggressively challenged a number of the accounting treatments Fannie was using, most prominently its application of FAS 133. After the chief accountant of the SEC agreed with OFHEO that Fannie had not applied FAS 133 correctly—and said that as a consequence it would have to restate its earnings—both Fannie’s CEO Frank Raines and I were asked to leave the company, and OFHEO gained enhanced regulatory control over it.

OFHEO’s charges of accounting improprieties subjected me to eight threatened or actual legal actions. While preparing for the defense of one of them (I don’t recall which), I was shown a copy of a memo the Director of OFHEO, Armando Falcon, had sent to his Chief Compliance Examiner, Chris Dickerson, recapping a meeting he’d had with the Chairman of the SEC, Bill Donaldson. In it, Falcon said he had told Donaldson that in the special examination he was going to require Fannie to comply not just with GAAP but with “the most conservative form of GAAP.” Accordingly, when Fannie’s restated earnings for 2002-2004 were published in December 2006 the company and its new auditor, Deloitte and Touche, had changed more than fifty of the accounting treatments used by previous management. (Fannie described all of these changes as “corrections of errors,” but in a subsequent deposition Deloitte declined to endorse that characterization.)

“The most conservative form of GAAP,” of course, is one that defers the recognition of income and accelerates the recognition expense by as much as the accounting standard setters permit. Deferral of revenue and acceleration of expense (relative to the time frames used by the IRS for required cash taxes) create deferred tax assets, and in the wake of Falcon’s accounting directive Fannie’s DTAs more than doubled, reaching $20.6 billion at June 30, 2008.

In conservatorship Fannie’s DTAs then tripled. OFHEO by that time had been replaced by FHFA and, in consultation with Treasury, FHFA added massive amounts of non-cash expenses to Fannie and Freddie’s books in the 2008-2011 period, with the intent of forcing the companies to take non-repayable senior preferred stock from Treasury on which they would be obligated to pay a 10 percent after-tax dividend in perpetuity. The large majority of these non-cash expenses fell outside the bounds set by the IRS for the deductibility of expenses for cash tax purposes. At the end of 2011, Fannie’s net DTAs were an astounding $64.5 billion, reflecting over $180 billion of accelerated expenses or deferred revenues.

Fannie’s net DTAs have been worked lower since that time, primarily because most of its non-cash expenses either reversed or became deductible for book purposes. Yet at $33.5 billion they remain extremely high. With a much smaller mortgage portfolio, only $3.0 billion of that total is due to “debt and derivatives instruments,” the category that made up almost all of Fannie’s DTAs before then-OFHEO now-FHFA began to dictate Fannie’s choice of accounting treatments. Today, Fannie’s two largest sources of DTAs are “Mortgages and mortgage-related assets” ($17.1 billion) and “Allowance for loan losses and basis in acquired property, net” ($9.5 billion).

In my view, excessively conservative accounting—deliberately chosen by FHFA (and Treasury) to make Fannie look less profitable than it truly is—is the reason for most of the company’s DTAs. Although I’ve been away from Fannie for over a dozen years now, I strongly suspect that it could lower its DTAs significantly by changing from “the most conservative form of GAAP” to more mainstream accounting treatments that better align with both the economic realities of the company’s business and the timings used by the IRS. Were I CFO of Fannie, I certainly would ask my accounting team to take a close look at this. The impending write-down of the company’s DTAs if and when tax reform is enacted puts a hard dollar cost on the accounting choices that drive those DTAs. Fannie and Freddie should try to reduce that cost by as much as they can by moving to what in their judgment are the best accounting treatments, not ones mandated by a conservator trying to make them look less profitable.

Fannie and Freddie would need Treasury and FHFA’s approval to make any changes in their accounting that lower their DTAs. But the companies have nothing to lose in asking for that approval, and I believe the Mnuchin Treasury would grant it. If it did, FHFA almost certainly would as well. And there would be deserved justice in this. The bulk of Fannie and Freddie’s DTAs stem not from their own accounting choices but from ones mandated by the government, so it is only fitting that the government permit them to try to reduce the adverse impact of tax reform on those DTAs.

Fannie and Freddie also should request of the Mnuchin Treasury more independence in making their business decisions. Both companies routinely state in their 10Ks that constraints imposed upon them by their conservator may have adverse effects on their business and financial results (as indeed they do). Easing or removing those constraints would increase their profitability, helping them to recapitalize both directly—through higher retained earnings—and indirectly, through the effect of higher earnings on their stock price, and thus their ability to raise capital efficiently once they are permitted to.

An early indication of whether Fannie and Freddie do have more independence in their business decision-making will be whether they continue their credit risk transfer programs. Again focusing just on Fannie, it currently pays an estimated $750 million per year in interest on Connecticut Avenue Securities (CAS) mezzanine tranches for which it will receive little if any benefit. If Fannie stops issuing CAS immediately, the dollar amount of its CAS interest payments should decline fairly rapidly, because prepayments on the collateral the CAS are “insuring” have averaged over 15 percent per year since the program’s inception, and the mezzanine tranches are beginning to pay down quickly.

Both Fannie’s CAS and Freddie’s STACRs are tremendously uneconomic and are significant drains on their earnings. While stopping CAS and STACR issuance won’t have the same near-term impact on the companies’ bottom lines as winding down their DTAs, over time the cumulative impact will be greater. The Mnuchin Treasury and FHFA must “remove their feet from the companies’ air hoses” and allow each of these benefits, and others, to assist Fannie and Freddie in preparing for an eventual release from conservatorship.