Fannie, Freddie Permitted by U.S. to Keep $3 Billion Buffers

(Bloomberg) -- The Federal Housing Finance Agency and U.S. Treasury Department said they have agreed to let mortgage giants Fannie Mae and Freddie Mac retain capital buffers of $3 billion apiece, marking the first changes to their bailout arrangements in five years.

The change, announced Thursday, came after months of warnings by FHFA Director Mel Watt, who said having no buffers at the government-controlled companies risked disrupting the mortgage market if they had to take more bailout money from the U.S. Treasury. Some Democratic senators had also called for Fannie and Freddie to keep buffers, while some Republicans said such a change was unnecessary.

The agreement between Watt and Treasury Secretary Steven Mnuchin is likely to cheer those Democrats, as well as small lenders, affordable-housing advocates and others who have urged them to act. Private shareholders of the companies have also said the companies should retain earnings, and they hope such a step will put the companies on a path to leaving government control.

“I commend Director Watt for his longstanding effort to ensure the stability of Fannie and Freddie by permitting them to retain some capital, and appreciate that Secretary Mnuchin responded to the concerns raised by Director Watt and members of Congress,” said Senator Sherrod Brown of Ohio, the top Democrat on the Senate Banking Committee.

The decision was derided by Representative Jeb Hensarling, the Texas Republican who leads the House Financial Services Committee. “There is simply no good reason, policy or otherwise, why we should be putting the GSEs’ balance sheets ahead of the interest of taxpayers,” Hensarling said in a statement.

Fannie Mae shares rose 1.3 percent to $2.77 at 1:54 p.m. in New York, while Freddie Mac shares were flat at $2.63.

Government Control

The government took control of the two companies in 2008, eventually injecting them with more than $187 billion during the financial crisis. Their bailout agreements originally called for Fannie and Freddie to pay a 10 percent dividend each quarter to the Treasury, but in 2012 the government changed the the terms to sweep nearly all of the companies’ profits.

Initially, the companies were allowed to keep capital buffers of $3 billion each, but that amount fell by $600 million per year and had been due to reach zero in 2018. As that point approached, Watt and other FHFA officials began to argue that the companies should be able to keep some capital.

Together, Fannie and Freddie have about $258 billion in remaining funds to draw on from the Treasury, and FHFA officials feared that as the amount fell, mortgage bond investors might begin to doubt the safety of the companies’ guarantees, leading to higher mortgage rates.

Under the agreements announced Thursday, the amount of a senior preferred stock of Fannie and Freddie that is owned by the Treasury will increase by $3 billion each. If they fail to pay the full dividend owed to the government in a particular quarter, their capital reserves automatically revert to zero. A senior Treasury official, who requested anonymity to discuss the matter, said such a move provides a strong disincentive for Watt or another director to withhold future dividends.

Protecting Taxpayers

Officials from FHFA and the Treasury Department said they view the new buffers as a way to protect against small operating losses rather than as a step toward full recapitalization.

“Treasury’s first duty is to ensure that taxpayers are being protected,” Mnuchin said in a written statement. “This agreement balances the concerns of the FHFA with compensation for taxpayers. The administration looks forward to working with Congress on comprehensive housing finance reform, a top priority in the year ahead.”

Fannie and Freddie are expected to need bailout money soon a result of a quirk in the tax law just passed by Congress that would lead them to write down the value of assets they hold. The companies both own billions of dollars worth of assets that allow them to offset future taxes.

Tax Hit

Since the tax bill would reduce the corporate tax rate to 21 percent from 35 percent, the values of those assets drops, resulting in a loss for Fannie and Freddie for the quarter in which the bill is signed. Bloomberg Intelligence analysts pegged those writedowns at nearly $19 billion.

Watt acknowledged the potential need for more bailout money, but said the $3 billion buffers in the future should be enough to cover income fluctuations.

“We, therefore, contemplate that going forward enterprise dividends will be declared and paid beyond the $3 billion capital reserve in the absence of exigent circumstances,” Watt said in a written statement.

Fannie and Freddie are set to pay dividends to the U.S. Treasury on Dec. 29, but because of the changes, they’ll pay less than announced previously. Rather than a combined $7.7 billion, the companies will pay about $2.9 billion.

Cowen & Co. analyst Jaret Seiberg said in a research note on Thursday that he didn’t expect the change to herald a permanent end to the sweep of Fannie’s and Freddie’s profits or to affect some lawmakers’ efforts to pass housing legislation.

“We do not see it changing the calculus for GSE reform or leading to other changes” in the bailout agreements, Seiberg wrote.

To contact the reporter on this story: Joe Light in Washington at jlight8@bloomberg.net.

To contact the editors responsible for this story: Jesse Westbrook at jwestbrook1@bloomberg.net, Gregory Mott

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