Why Fannie and Freddie’s failed stress test proves nothing

A stress test analysis of the solvency of Fannie Mae and Freddie Mac, the Government-Sponsored Entities (or GSEs) charged with providing liquidity to the mortgage market to boost home ownership, showed that neither has enough capital to withstand another severe financial blow of the sort that occurred during the 2008 financial crisis.

The results of this exercise suggest that a recurrence would cost the Treasury roughly the same amount of money as it put into the GSEs after the last crisis, which is somewhere in the vicinity of $190 billion.

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Treasury officials—such as Michael Stegman, the department’s counselor for housing finance, suggested that these results buttress Treasury’s 2012 decision to sweep the entire net worth of the two entities into their coffers each quarter: The argument is that if Treasury is the backstop of two entities that apparently need one, it’s only right that they—and not any of the other shareholders—get paid for assuming that risk.

It’s a logical sleight of hand about as compelling as the guy who kills his parents and then asks the court for mercy because he’s recently become an orphan.  Fannie Mae and Freddie Mac have insufficient capital because of Treasury’s expropriation of their net wealth, and to suggest that their lack of capital justifies Treasury’s profit sweep defies logic.

A brief recap is in order: Fannie Mae and Freddie Mac made lots of money in the early 00’s buying, repackaging and selling home mortgages to investors. When interest rates started to go up in 2004, many fewer mortgages were issued and their profits fell. To avoid such a fate they began both buying up riskier mortgages and also retaining some of these mortgages to assemble a portfolio of investments on their own—which they leveraged to the hilt by dint of their ability to borrow at the same rates as the federal government.

When the housing market crashed, they were left with a lot of worthless mortgages, their losses amplified by their leverage. In September 2008, Treasury placed the two into conservatorship, assuming just less than 80% ownership of each as well assigning itself an annual 10 percent dividend. Over the subsequent three years it injected $187.5 billion into the GSEs.

At the time Treasury deliberately chose not to put the two into receivership, for a number of reasons—the most potent of which was that receivership would have forced the government to put the cumulative debts of the two ($5 trillion) onto its balance sheet.

Shareholders were led to believe by Treasury officials that their ownership stake in the GSEs would be respected. Many dumped their stock after the takeover for a pittance. Many were community banks that were essentially compelled to invest in Fannie and Freddie by their regulators to shore up their balance sheet.  It wasn’t the last time federal regulators would steer banks wrong.  But some shareholders kept their stock, and others decided to jump in, reasoning that low interest rates and housing prices could bring boom times to the GSEs. Which it did.

By 2010 the real estate market as well as the broader economy turned around and Fannie and Freddie began earning profits again, hand over fist. It appeared that the stock would once again be worth something—until the government amended its original ownership stake from the ten percent dividend and 80% stock share to the entire net wealth of Fannie Mae and Freddie Mac, which is “swept” into Treasury coffers quarterly. The other shareholders, who had been led to believe that their ownership share would be honored, were out of luck.

Several of those stockholders have sued to force the Treasury to honor the terms of the original agreement.  There’s a decent chance they might win, which is one reason Treasury has trumpeted the results of the stress test—their argument being that if they can’t withstand another financial shock it’s incumbent on the government to continue to oversee the GSEs and take every last dime of profits they earn for their yeoman’s work.

But the stress test results are completely dictated by the sweep: if the government expropriates all capital then of course Fannie and Freddie will have insufficient capital. Why even bother with the rigmarole of a stress test?

The FSOC reports that its goal is to reduce the government’s footprint in the housing market. Having the federal government assume more than $5 trillion of debt from Fannie Mae and Freddie Mac while squeezing out private investors seems to be the antithesis of that hollow sentiment.

Brannon is fellow at the George W. Bush Institute and president of Capital Policy Analytics, a consulting firm in Washington, DC.