Taxpayers are the GSEs' true stockholders

A recent comment from a Freddie Mac legacy preferred stockholder calling on the government-sponsored enterprises to “keep what is rightly earned, recapitalize, and exit conservatorship” is wrong on so many levels.

The statement, by Fairholme Capital Management’s chief investment officer, Bruce Berkowitz, in a shareholder letter calls for an exit strategy for Freddie and Fannie Mae since they “earned and paid $300 billion” to the Treasury Department, “which is $24 billion more than promised” since their 2008 federal conservatorship.

However, Freddie was on the ropes in its competition with Fannie Mae before conservatorship, and with no easy way out.

Given this, the true value of stock held by legacy preferred shareholders prior to Freddie’s conservatorship would have likely been zero. Hard to have “rightly earned” anything subsequent to conservatorship, given this fact.

Second, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992 warned all investors in Freddie securities, including investors in shares of preferred stock, that they “not be construed” in thinking that the GSEs would “honor, reimburse, or otherwise guarantee any of their obligations or liabilities.”

Because of this, the original preferred stockholders or their successors, including Fairholme, have hardly “rightly earned” anything. Without the taxpayer's gratuitous bailout, their investment would have been worthless.

In addition, when the GSEs were placed into conservatorship in September 2008, they were simultaneously bailed out by means of what has since become a series of massive capital infusions. Once again, the original preferred stockholders or their successors had no right to this bailout.

Also, the Treasury and the GSEs simultaneously entered into the senior preferred stock purchase agreements, as amended.

These agreements might best be described as unconditional, irrevocable taxpayer-backed lines of credit. It is only this ongoing taxpayer backing that allows the GSEs to continue operating, to sell trillions of dollars in mortgage-backed securities at advantageous rates, and be in a position to make any profits. Once again, the original preferred stockholders or their successors have little claim, or interest in these “profits.”

Lastly, each senior preferred stock purchase agreement provided for a “periodic commitment fee” meant to fully compensate the Treasury for the ongoing support it provided since its December 2009 commitment. To date, not a single penny of such fee has been paid to taxpayers.

This fee is clearly “rightly earned” by the Treasury. The appropriate amount of such fee is quite large, given the roughly $5 trillion in mortgage pools backed by the GSEs at the benefit of taxpayer-backed periodic commitments. At a conservative 16 basis points per year, taxpayers would earn some $7 billion annually after taxes, according to one estimate.

Prior to a third amendment to the senior preferred stock purchase agreement, the periodic commitment fee was routinely waived by Treasury and the Federal Housing Finance Agency. The third amendment provided for the sweep of virtually all GSE profits as dividends to the Treasury Department; and also suspended the payment of the fee so long as the dividend sweep remains in effect.

The real value of the periodic commitment is, as the saying goes, priceless.

Any analysis purporting to weigh what has been “rightly earned” must give equal consideration as to what the taxpayers have rightly earned. For example, if a fair analysis finds that the full dividend sweep meets that standard, then it must be recognized as fair.

Fairholme’s desire for the GSEs to be recapitalized and released from conservatorship conveniently ignores the taxpayer’s priceless support in such a proposal.

Taxpayers have a right to expect that any plan to recapitalize the GSEs to then exit conservatorship would provide for at least the following:

First, if the dividend sweep were to be reversed, a minimum 10% dividend should be paid to taxpayers and continue to be paid on the Treasury’s outstanding senior preferred stock.

Second, there should be retroactive payment of the waived past periodic commitment fees — $8 billion or $9 billion per year for the GSEs combined.

Third, the GSEs should pay a periodic commitment fee of perhaps, 16 bps or 18 bps levied on the total amount of GSE outstanding assets, regardless of whether they’re in conservatorship.

Fourth, prior to the release of Fannie or Freddie from conservatorship, each would need to meet levels of capital that appropriately reflect the risk of loss, as well the cost of capital allocated to similar assets held by regulated private financial institutions. This would include appropriate too-big-to-fail capital buffers.

Finally, there should be a full recognition of the value of the taxpayer’s warrants, which provide the right to purchase an amount slightly under 80% of each of the GSE’s common stock. The government would be free to sell the common stock, as it deems appropriate, in order to gain the maximum taxpayer value.

Only under these terms would both the taxpayers and investors receive what each has rightly earned.