How the $187 Billion GSE 'Bailout' Went Awry
Most sophisticated investors recognize that a bank's solvency can change dramatically on a future date, when loans are taken off the books, and accounting provisions are reconciled with actual loan recoveries. And until that future date, there’s no reason to buy senior preferred shares prematurely, and pay a 10% annual dividend prior to that date of reckoning.
Fannie Mae by the Numbers
Let's walk through Fannie Mae's numbers, which are substantially similar to Freddie’s numbers. At yearend 2008, Fannie's single-family mortgage portfolio totaled $2.73 trillion. That $2.73 trillion was comprised of loans segmented by vintage in its Dec. 31, 2008 Credit Supplement. Five years and nine months later, in its Credit Supplement for Sept. 30, 2014, Fannie discloses the cumulative default rates by vintage. So, looking at the pre-2009 years, we can calculate a cumulative default rate of 6.6%, or about $181 billion of the $2.73 trillion total. Multiplied by a conservative loss severity rate of 37%, those defaults translate into cumulative credit losses of about $74 billion.
From 2008 and 2011, Fannie recognized single-family credit expense of about of $153 billion. That’s $153 billion (loss provisions plus foreclosure costs) versus $74 billion in actual credit losses to date.
Because Fannie's credit losses were presumed to be so high during 2008 through 2012, virtually all of its deferred tax assets were presumed by accountants to be worthless. (Deferred tax assets measure GAAP loan loss provisions recorded before troubled loans are liquidated, when a tax deduction may be recognized.) By yearend 2011, $64 billion in deferred tax assets were offset by a deferred tax "valuation allowance" which represented a $64 billion reduction of shareholder equity.
If you appreciate the difference between cash items and non-cash charges, the FHFA's decision to draw down taxpayer funds to supplant the loss of deferred tax assets seems especially foolish. Compared to all the other assets on Fannie's balance sheet — anything from office supplies to real estate acquired through foreclosure proceedings — deferred tax assets are unique. Every other asset is convertible into cash. So, any reduction in value of those other assets translates into a reduced ability to pay down debt. But deferred tax assets are never convertible into cash, unless the company starts making so much money that it starts paying cash income taxes. Which is why, in the history of modern accounting, no deferred tax asset had ever been used to pay down a debt.
Beginning in 2012, the housing market had reached an inflection point, and prices started rising again. That year, Fannie started reversing those loan loss reserves and started earning profits. For fiscal year 2012, Fannie earned $17.2 billion in income before taxes, which was more than enough to pay down $11.7 billion in cash dividends, or 10% of the $117.1 billion in senior preferred stock owned by Treasury.
But 2013 proved to be an earnings bonanza, thanks in large part to prior period accounting adjustments. In 2012, Fannie's single-family credit expense was about $1 billion. In 2013, some loan loss provisions from prior years were reversed, so that credit "expenses" added back $11.2 billion to corporate income.
Fannie earned $38.6 billion before taxes in 2013. But there was a double accounting whammy. Since it was obvious to everyone that Fannie might start paying income taxes in the future, a $45.4 billion "tax benefit," which was the reversal of a valuation allowance, caused Fannie to report $84 billion in net income for that year.
Let's do some math. Take $84 billion in net income 2013; then add back $30 billion in senior preferred cash dividends paid during 2009-2012. That would have been $114 billion available to boost retained earnings, which is pretty close to $117 billion drawn down by FHFA to "bail out" Fannie.
And even today it looks like Fannie's loan loss provisions are excessively high. Remember, Fannie incurred $153 billion in credit expense during 2008-2011 versus $74 billion in actual credit losses to date.
So guess how much of that $84 billion in 2013 net income was used to boost Fannie's net worth. Almost none of it. In mid-2012, the FHFA and the Department of Treasury decided that it was best for everyone if the GSEs paid Treasury cash dividends equal to 100% of net income. Which is why, in 2013, Fannie paid Treasury cash dividends totaling $82.5 billion.
That's right. Most of Fannie’s earnings in 2013 were comprised of reversals of non-cash provisions from prior periods. But those non-cash gains were used to justify cash dividend distributions to the government.
None of it seems to make any sense. Under federal statute, the FHFA, as conservator, must, "take such action as may be necessary to put the regulated entity in a sound and solvent condition." No one has ever given a cogent explanation as to how the original cash drawdowns, and the subsequent cash distributions, including a 100% dividend sweep, serves that goal.