Last week Fannie Mae and Freddie Mac completed their fifteenth year of conservatorship. By any definition or measure, they have been “conserved.” Their combined net income over the past 20 quarters (or five years) has averaged $25.0 billion per year, and the extremely high credit quality of their current $7.56 trillion books of single- and multifamily mortgages (close to half of the $15.9 trillion in residential mortgage debt outstanding) enabled them to survive the 38 percent drop in home prices assumed in their 2023 Dodd-Frank severely adverse stress tests without the need for any initial capital. The only reason they remain in conservatorship is that neither Congress nor any administration has made it a priority to confront and resolve two policy decisions made over a decade ago—agreeing with what I call the Financial Establishment that Fannie and Freddie must hold 4 percent-plus “bank-like” capital irrespective of the risks of the mortgages they guarantee, and the August 17, 2012 agreement between Treasury and the Federal Housing Finance Agency (FHFA) to change the dividend on the companies’ Treasury senior preferred stock from 10 percent per year to “an amount equal to the incremental increase in [their] net worth during the immediately prior fiscal quarter,” known as the net worth sweep.  

The decisions to deliberately overcapitalize Fannie and Freddie and impose the net worth sweep (preventing them from retaining capital by moving $242 billion from their balance sheets to Treasury’s coffers between December 31, 2012 and June 30, 2019) were made at a time when the consensus goal of policymakers was to “wind down and replace” them with some unspecified alternative assumed to be superior. No such alternative emerged (or indeed exists), yet the net worth sweep and gross overcapitalization of Fannie and Freddie persist, and in fact were “hard wired” into January 2021 letter agreements between former FHFA Director Calabria and former Treasury Secretary Mnuchin, specifying that neither can be released from conservatorship until they hold “tier 1 capital” (core capital, less junior preferred stock and a percentage of their deferred tax assets) equal to 3.0 percent of adjusted total assets. Combined, Fannie and Freddie were short of this “release point” by a staggering $382 billion at June 30, 2023, because their tier 1 capital was a negative $133 billion due to the net worth sweep, and 3.0 percent of their adjusted total assets ($249 billion) is far higher than warranted by the risk of the mortgages they finance. The net worth sweep and Treasury’s liquidation preference also block the companies’ access to the capital markets, and even at $25 billion per annum, filling a $382 billion capital shortfall with retained earnings alone would leave them in conservatorship for another 15 years.  

It may well be, however, that the net worth sweep and the companies’ overcapitalization both experienced “tipping points” on Monday, August 14. That day a jury hearing the case of Berkley Insurance Co. versus FHFA (formerly Perry Capital versus FHFA) in the United States District Court for the District of Columbia found that FHFA “wrongly amended” the Senior Preferred Stock Purchase Agreements when it agreed with Treasury to impose the net worth sweep, and awarded damages of $612.4 million (to be paid by the companies). August 14 also was the deadline for comments on FHFA’s request for input on Fannie and Freddie’s capital and pricing, and the submissions from the most influential and respected voices in the industry were sharply and persuasively critical of the structure and capital requirements of the Enterprise Regulatory Capital Framework (ERCF), made final by Calabria in December of 2020. The jury verdict in the DC District Court easily could prod Treasury to focus more intently, and analytically, on an “exit strategy” from a dilemma with the net worth sweep of its own making, while the chorus of criticism about the excess amounts of conservatism and non-risk-based elements in the ERCF will make it difficult for FHFA to continue to ignore the blatant inconsistency between the capital required of Fannie and Freddie by the ERCF and the results of their annual Dodd-Frank stress tests.

Of the two impediments to the companies’ exit from conservatorship, the net worth sweep is the more important, and has been the more intractable. From the time the sweep was imposed on Fannie and Freddie, Treasury has insisted that it was designed to benefit them by preventing a “death spiral” of borrowing to pay the 10 percent after-tax dividend on their outstanding senior preferred stock, and also that it was fair compensation for having saved them from failing during the financial crisis. Many (including me, in an amicus curiae brief for the Collins case decided at the Supreme Court in June of 2021) have pointed out that the facts do not support Treasury’s version of and justification for the sweep, to no avail. But the August 14 jury verdict in the D.C. District Court will be harder for Treasury to ignore, and it also opens the door for more “truth telling” about its and FHFA’s treatment of Fannie and Freddie, most notably the internal memos among senior Treasury officials admitting that they did know Fannie and Freddie were about to enter a period of “golden years of earnings” because of the reversal of their non-cash expenses, and that Treasury intended the net worth sweep to keep them from retaining those earnings to recapitalize. While these memos were not admitted as evidence in the Berkley Insurance case because Treasury was not a defendant in it and the judge ruled them to be hearsay, the memos do exist, and they will be very difficult for Treasury to defend.

The posture of Treasury on the net worth sweep during the Biden administration has been to ignore it. This Treasury has no prospect of receiving any income from it, because of the clause in the January 2021 letter agreements permitting Fannie and Freddie to retain their earnings, with equal dollar increases in Treasury’s liquidation preference, until “the last day of the second consecutive fiscal quarter during which [they have] had and maintained capital equal to or in excess of all of the capital requirements and buffers under the Enterprise Regulatory Capital Framework,’’ at which point the sweep will be turned back on. But that will be far in the future. In the meantime, since both of Treasury’s options for ending the sweep—converting the companies’ senior preferred stock to common stock, or deeming the senior preferred to have been repaid with a 10 percent dividend (as it has been) and cancelling it—carry potential market or political consequences, the easiest and simplest thing for Treasury to do about it has been nothing.

Until now. The jury verdict in the Berkely Insurance case, and a likely follow-up spotlight on Treasury’s true motivations for imposing a net worth sweep that has kept Fannie and Freddie in conservatorship for 15 years, and could do so for another 15 years, changes the risk calculus on Treasury’s attempting to “stick with its story” about the sweep indefinitely. Treasury knows it has not been telling the truth about the sweep, even if the media and the public do not, and sooner or later someone there (or at a senior economic policy level outside of Treasury) will realize that the surest way to avoid getting caught in their false story is to end the sweep. And as they then begin to investigate alternative ways to do this, it will become apparent to them that there is an easy way out of both the net worth sweep and the conservatorships that demonstrably produces the best result for all stakeholders—the administration, Treasury, the mortgage finance system, homebuyers, and investors. 

Senior economic officials (whether in this administration or a future one) first will have to agree on the desired status of Fannie and Freddie once the conservatorships are ended. There really are only two options: returning them to their former states of shareholder-owned companies—ideally with agreed-upon utility-like return targets as a condition of their release, and reasonable capital requirements that allow them to price their business on an economic basis—and formal nationalization. With the latter option, the net worth sweep and Treasury’s liquidation preference could stay in place, but neither political party favors nationalization. That means the only realistic option for Fannie and Freddie’s future requires the sweep and the liquidation preference to be eliminated. Treasury is more likely to embrace this reality when it understands that there is a politically acceptable way to do so that allows it to maintain its pledge to get maximum value on behalf of taxpayers for its “investment” in the companies, while also restoring their access to the capital markets.

Treasury has three types of claims on Fannie and Freddie: (a) warrants for 79.9 percent of their shares of common stock outstanding on a fully diluted basis on the day of exercise, which today would be 4,688 million shares of Fannie common and 2,584 million shares of Freddie common; (b) holdings of senior preferred stock of $120.8 billion in Fannie and $72.6 billion in Freddie, and (c) liquidation preferences of $185.5 billion for Fannie and $111.7 billion for Freddie as of June 30, 2023, increasing each quarter with their net income. Setting aside whether all of these claims were properly or deservedly awarded (by Treasury to itself), what jumps out about them is that their aggregate potential value dwarfs the companies’ current book and market values. At June 30, 2023, Fannie’s book value (or net worth) was $69.0 billion, while Freddie’s book value (net worth) was $42.0 billion. More significantly, both companies’ market values—that is, their share prices times their fully diluted shares of common stock outstanding—are far lower; at their September 8 closing stock prices, Fannie’s market value was only $4.3 billion and Freddie’s market value only $2.2 billion, for a combined aggregate value of $6.5 billion.

The challenge Treasury has in getting what it thinks to be fair value for its claims on Fannie and Freddie, therefore, is that today the market puts a price-earnings (P/E) multiple of just 0.26 on their $25 billion in annual earnings, compared with a P/E of 25 times earnings, nearly 100 times greater, for the average stock in the Standard & Poor’s 500. And there is no mystery why. It’s because of what Treasury (also FHFA, but mainly Treasury) has done to the companies since 2008. From (i) requiring FHFA to put them in conservatorship when each exceeded their statutory capital requirements, to (ii) throwing them “concrete life preservers” of senior preferred stock at a 10 percent after-tax dividend, repayable only with the permission of Treasury (which has never been given), that Fannie and Freddie could be forced to take by having FHFA load up their income statements with anticipated or estimated non-cash expenses, and then (iii) with FHFA, imposing the net worth sweep the moment those non-cash expenses ran out and began to reverse, turning into a torrent of what otherwise would have been retained earnings, Treasury has treated the companies with a unique degree of antagonism and unfairness.

As Treasury evaluates ending the net worth sweep and allowing Fannie and Freddie to exit conservatorship, it will need to determine which of its claims on them have the most value. And that will not be hard. To get value out of its $120.8 billion of senior preferred stock in Fannie and $72.6 billion of senior preferred in Freddie, Treasury will have to convert them into each company’s common stock. Yet the very act of doing so will reinforce investors’ strong views of unfair treatment. They know Fannie and Freddie have repaid their senior preferred, with dividends; it’s just that Treasury has used its non-repayment provision as a reason not to count net worth sweep remittances as repayments. Treasury’s insisting that its senior preferred be converted to common would be requiring the companies to repay their senior preferred twice. If it does, how many investors would choose to buy Fannie or Freddie common stock again—including the stock Treasury would need to sell to get value from converting its senior preferred—and how much would they be willing to pay for it?

Now consider the alternative: making Treasury’s warrants for 79.9 percent of Fannie and Freddie’s existing common stock more valuable by making the companies more valuable. Here, Treasury would work with FHFA and the administration’s senior economic team to negotiate a recapitalization and release agreement that includes retroactive cancellation of the non-repayment provision of the senior preferred and a recasting of the companies’ remittances under the net worth sweep as repayments of the senior preferred stock (which would pay all of it off for both). Fannie and Freddie, in return, would agree to accept utility-like return targets on their credit guaranty business, benefitting homebuyers. Then, for its part, the administration would acknowledge the criticisms made by commenters on FHFA’s request for input on Fannie and Freddie’s capital and pricing, and strongly encourage (or require) FHFA to remove the excess and unwarranted conservatism in the ERCF, to have it more closely reflect the true risks of Fannie and Freddie’s business.

Splitting the difference between the negative 13 basis points of total assets required by the companies’ 2023 Dodd-Frank severely adverse stress tests and the ERCF’s risk-based capital requirement for them at June 30, 2023 of 3.72 percent of adjusted total assets (or 4.08 percent of total assets) would put their required capital at about 2.0 percent. While that’s very likely too low for FHFA to consider (even though it would be over four times the 45 basis points required on the companies’ credit guarantees prior to the financial crisis), the recommendations I made in my comment to FHFA on its request for input, and in Capital Fact and Fiction, are not: first, to drop the “prescribed leverage buffer” Calabria added to the 2.5 minimum capital requirement FHFA set for the companies in its 2018 capital standard, and then remove enough of the non-risk-based minimums and buffers in the ERCF’s risk-based component to reduce it to below the 2.5 percent minimum, which would become the companies’ binding capital requirement for the foreseeable future.

At June 30, 2023, minimum capital for Fannie and Freddie of 2.5 percent of total assets (not “adjusted total assets,” a measure contrived by Calabria that FHFA should drop) would be $189.4 billion. And with their senior preferred stock deemed to have been repaid, their adjusted total capital would jump from a negative $99.5 billion to a positive $101.7 billion, leaving a capital shortfall of $87.7 billion, compared with $408 billion were the net worth sweep and the ERCF to be left as they are.

A capital gap for Fannie and Freddie of only $87.7 billion, along with $25 billion in annual earnings, will give Treasury, FHFA and their and the companies’ financial advisors a lot to work with in devising a viable plan for recapitalizing and releasing Fannie and Freddie relatively quickly, and returning them to a position where they once again could provide properly priced mortgage credit to low- and moderate-income homebuyers on a large scale. As an interim step, they could be released under consent decrees upon completion of initial equity offerings of specified dollar amounts (to reach a target capital percentage), with each then being allowed to decide what mix of retained earnings, additional offerings of equity, and issuance of noncumulative junior preferred stock to employ to eliminate their remaining capital gaps, and obtain relief from all elements of their consent decrees.

Developed and announced as a package, such a plan also would give the market a reason to fundamentally reassess the valuation of the companies’ common stock—and the value of the warrants Treasury would need to exercise before any new issuance of equity by Fannie or Freddie could take place—for the first time since the conservatorships were imposed. Where that value might end up is not easy to predict, given the history of the companies’ ill-treatment by Treasury and FHFA over the last 15 years, which won’t be forgotten even if the regulators do right by them going forward. Still, their valuation has tremendous room for improvement from today’s average P/E ratio of 0.26:1—barely 1 percent of the S&P 500—and there are benchmarks from prior periods as to where that relative P/E might go.

I was Fannie’s CFO during throughout the 1990s, when it established a record of consistent and predictable earnings and a reputation for prudent management of its interest rate and credit risks. Reflecting this, its P/E relative to the S&P 500 rose from about 55 percent at the end of 1990 to about 85 percent at the end of 1998. Then, after FM Watch was formed in early 1999, relentless (and false) criticisms of the company caused investors to become increasingly concerned about its “political risk,” and by the time I left at the end of 2004 Fannie’s relative P/E had fallen to about 45 percent. Today the company’s earnings and risk management are even better than in the 1990s (and it’s not taking interest-rate risk on nearly $1 trillion of mortgages in portfolio), leaving its main risk as political. Thus, if this or a future administration turns around on the way it treats Fannie and Freddie, even given the history of the past fifteen years a P/E relative to the S&P 500 of 50 percent would seem to be attainable, and one higher than that would not be out of the question. A relative P/E of 40 percent would put the market value of Fannie and Freddie at around $250 billion, which would be split among Treasury, existing shareholders, and whatever new investors are needed to help the companies meet their new, more reasonable, capital requirements (with Treasury’s percentage being inversely related to the amount of new equity issued).

Fannie and Freddie’s $25 billion in annual earnings, high-quality books of business, and results of their last three years of Dodd-Frank stress tests highlight the fact that there is no reason for them to have been kept in conservatorship for 15 years, and certainly none to keep them there for another 15 years. The net worth sweep and the unreasonable capital requirements of the ERCF prevent the companies from getting out on their own. But here, the August 14 verdict against FHFA in the Berkley Insurance case involving the sweep and the pointed criticisms of the ERCF in response to FHFA’s request for input on Fannie and Freddie’s capital and pricing give the current administration, or a future one, legitimate reasons to question both. Whichever one does will discover that there is an easy way out of the conservatorships that is a win for all parties—the administration taking the action, its Treasury, the mortgage finance system, homebuyers, and the new and existing investors that supply the private capital Fannie and Freddie need to carry out their missions.