Another U.S. Government Ponzi Scheme Exposed: Fannie Mae and Freddie Mac

by The Curmudgeon and Victor Sperandeo

Introduction:

The CURMUDGEON has called the Fed's QE a Ponzi scheme from its inception. That's because the U.S. government (e.g. the Fed) is purchasing its own debt, which would otherwise have to be funded by private entities, foreign central banks or the public. In addition, the Fed pays the Treasury approximately 94% of the interest on that debt, which helps reduce the U.S. budget deficit. The remaining 6% of the Fed's earnings are paid as a dividend to its shareholders (who they are is a deep, dark secret). For reference, please see Is the Fed a No Risk Hedge Fund or a Ponzi Scheme?

But there's another U.S. government Ponzi scheme(s) that is not as well known or obvious to observe: the profits Freddie Mac and Fannie Mae are returning to the U.S. Treasury department. We maintain that's a double Ponzi scheme, based on accounting tricks and a housing recovery aided and abetted by the Fed. It also takes money out of circulation which retards economic activity and therefore hurts the real economy.

Background:

Prior to the 2008 mortgage meltdown, Freddie and Fannie were two Government Sponsored Enterprises (GSEs), which were mostly owned by private shareholders. They issued hundreds of billions of dollars of bonds that investors bought because it was assumed that the government implicitly backed their bonds. With that money, Fannie and Freddie bought mortgages from lenders, packaged them into securities, and sold them to investors.

On September 6, 2008, Fannie and Freddie were saved from collapse (and from pushing U.S. and the world into a global depression) when the U.S. Treasury invested more than $188 billion in the two giant GSEs and placed them under "conservatorship" of the Federal Housing Finance Agency (FHFA). The upshot was that the U.S. Treasury created a “special senior preferred” class of stock that paid a 10% dividend and awarded themselves warrants for up to 80% of the firm's common shares. Since Fannie and Freddie together buy or guarantee most U.S. mortgages, the U.S. government takeover of those firms greatly expanded its role in housing since the crisis ended in early 2009.

The 10% dividend was replaced under a 2012 agreement under which Fannie and Freddie's profits are returned to the Treasury in the form of quarterly dividends.

Fannie and Freddie Profits Reduce the Budget Deficit through Fake Accounting:

Already, payments from these two GSE's reduced the 2013 federal deficit by more than $146 billion, even though they were really just paying back the Treasury's $188 billion loan! Yet there are no provisions for the two GSE's to ever buy back the government's senior preferred shares in their companies.

Third-quarter profit rose sharply at both GSEs, permitting Freddie to finish reimbursing taxpayers for its bailout and bringing Fannie within about $3 billion of repaying what it received. Let's take a closer look...

Fannie Mae reported $8.7 billion in net income during the third quarter of 2013 and $8.6 billion in comprehensive income. That compares very favorably to the third quarter of 2012, when the mortgage financier reported $1.8 billion in net income and $2.6 billion in comprehensive income. As a result, it will pay the U.S. Treasury $8.6 billion of its profit (as a special dividend) in December. After that payment, Fannie Mae will have paid the Treasury a total of $114 billion of the U.S. Treasury's $117.1 billion holding in the company.

“Overall I’d say that the increase in interest rates and the lack of refi activity doesn’t have a very big impact on our revenues. Most of our revenues come from two sources: guarantee fees off of book of business and second from the carry we get from certain investment portfolios we have,” CEO Mayopoulos said. “If home prices do not continue to rise and let’s say plateau or even decline, we’d clearly see less release from loan loss reserves and that would moderate our earnings,” he added.

Freddie Mac reported its own third quarter net income was $30.5 billion, which includes $23.9 billion from a tax windfall. The company will pay $30.4 billion to the Treasury in December, bringing its own Treasury pay-back total to $71.3 billion of its $72.3 billion holdings.

"It's going to challenge the convictions of policymakers about reforming Fannie and Freddie,'' said Tim Rood, a former Fannie Mae executive who is a partner at a Washington-based consulting firm that helps businesses work with the mortgage entities and the government. "You can have all the principles in the world, but with legislators flipping couch cushions looking for change, it's hard to shoot the two-headed monster that's spitting out $10 bills."

Victor Sperandeo wrote in a recent Curmudgeon post: "When the federal government funds Fannie Mae (and Freddie Mac), its spending is off- budget and not counted in the budget as an expense. But when Fannie Mae (or Freddie Mac) remits a dividend payment to the U.S. Treasury, it's counted as revenue." That's what we mean by phony accounting!

How Did Fannie and Freddie Realize Huge Profits?

It was the Fed, which artificially propped up the real estate market and enabled the GSE's to realize locked in profits. The Fed drove mortgage interest rates down through QE, Operation Twist and ZIRP. In particular, the Fed has been buying ~$40 billion per month of mortgage backed securities (MBS) which put a floor under MBS prices and stabilized the housing market. Hedge funds, other financial institutions, and even wealthy individuals began to borrow at ultra-low interest rates to buy foreclosed houses and other properties to turn them into rental homes. Housing prices rebounded dramatically and foreclosures slowed considerably.

To recap, the two GSE mortgage giants owe their profitability to the Fed juiced recovery in the housing market and refinancing boom in the past two years, which dramatically lifted sales and prices and sharply increased the fees they earn for packaging individual mortgages into mortgage-backed securities. The end result has been increased profits for Fannie and Freddie, which then pay it back to the U.S. Treasury. And "presto," the budget deficit has been lowered. That creates the false perception that government spending cuts aren't as urgently needed as before- when the annual deficit was much higher.

In a November 7th blog post, Shah Gilani describes How American Socialism “Works” by analyzing the government control of these two GSEs.

Taxpayers are Being Ripped-Off while Real Economy is Hurt:

What few people realize is that Fannie and Freddie's profit (and subsequent dividend payment to the U.S. Treasury) come from the private sector. They are derived from mortgage payments to banks which sold private residential mortgages to Fannie or Freddie. Effectively, the dividend payments to the U.S. government from Fannie and Freddie represent dollars taken from taxpayers that flow through to the U.S. Treasury! In fact, the money used to make those mortgage payments reduces the money supply. So the Fannie and Freddie “cash cow dividends" for the government are really taking money from taxpayers out of circulation.

So while the dividend payments from Fannie and Freddie reduce the budget deficit through phony accounting, they also reduce the money supply, which hurts the real economy. That's a double whammy for the U.S. taxpayer!

A Sound Recommendation:

In an August 16, 2013 blog post, Matthew Yglesias wrote something that we very much agree with:

"Rather than paying dividends to the Treasury, the GSEs (Fannie and Freddie) should pay dividends to the American people—writing checks to you and me. That way, conservatives can stop grousing that the reverse bailout is an Obama plot to make the deficit look small. More importantly, the profits can recirculate through the economy rather than sitting inert in the vault. People with more cash in their pockets will buy more goods and services. Firms facing increased demand will boost production and hiring. The increased tax revenue and decreased social service payments associated with a greater level of economic activity will partially offset the lost money to the Treasury."

Closing Comment by Victor Sperandeo:

The method of "Thinking in Principles" is certainly applicable here, as this kind of government corruption cannot be sustained (i.e. think of the collapse of the USSR). But it can go on for a long time.

Printing and borrowing money to fund GSE's (as well as Social Security and Medicare) is a favorite method used by controlling collectivist U.S. politicians to get their way. That's all this is. Their "state planned" ways for deferring failure can make one think all is well. But it is not! For example, having cancer can only be known if you look inside and study the patient to understand they are dying.

The schemes to paint the system as OK are a facade. The principle that must be considered is that all centrally planned entities must fail - sooner or later. [Reference: "The Road to Serfdom" by Frederick von Hayek.] Meanwhile, timing the end of the cover-up is impossible. The moral is enjoy it while it lasts, but prepare for the worst. [That's especially true for stock market participants, as we've repeatedly cautioned.]

The words of a young Chinese woman philosophical thinker should be a guide: "a Chinese philosopher once said there are four stages of recognition, in the following progression....

· unconscious ignorance (most people are probably here)

· conscious ignorance

· conscious knowledge

· unconscious knowledge (true master)! “

Why hasn't the mainstream media exposed this GSE Ponzi scheme and taxpayer rip-off? It's likely that the corporate interests who own the media don't want to disrupt what is a very good thing for the U.S. government and a great environment for those who own common stocks (which have become dependent/addicted to QE). That's why the major newspapers and TV news programs don't reveal these important facts.

As Thomas Jefferson once wrote: "I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around the banks will deprive the people of all property - until their children wake-up homeless on the continent their fathers conquered."

Till next time........................

The Curmudgeon
ajwdct@sbumail.com

Curmudgeon is a retired investment professional.  He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996.  He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.

Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1979) to profit in the ever changing and arcane world of markets, economies and government policies.  As President and CEO of Alpha Financial Technologies LLC, Sperandeo overseas the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.