The Treasury Department and the Federal Housing Finance Agency struck a deal last week amending how Fannie Mae and Freddie Mac’s profits are sent to Treasury as dividends on their senior preferred stock.

But no one pretends this is anything other than a patch on the surface of the Fannie and Freddie problem.

The government-sponsored enterprises will now be allowed to keep $3 billion of retained earnings each, instead of having their capital go to zero, as it would have done in 2018 under the former deal. That will mean $6 billion in equity for the two combined, against $5 trillion of assets — for a capital ratio of 0.1%. Their capital will continue to round to zero, instead of being precisely zero.

Signage in front of the Fannie Mae and Freddie Mac headquarters.
Fannie and Freddie have yet to be reformed following their 2008 bailout, but 2018 could prove the year to do so. Bloomberg News

Fannie and Freddie’s top regulator, Mel Watt, had worried about their running with exactly zero capital going forward, so any quarterly losses, perhaps from the vagaries of derivatives accounting, would force renewed bailout investments from the Treasury. That would have looked bad.

Additional bailout investments may well be necessary anyway, as Treasury and the FHFA admit, because by dropping the corporate tax rate, the new tax reform law implies major write-downs in Fannie and Freddie’s deferred tax assets. That will look bad, too.

Here we are in the tenth year since Fannie and Freddie’s creditors were bailed out by Treasury. Recall the original deal: Treasury would get dividends at a 10% annual rate, plus — not to be forgotten — warrants to acquire 79.9% of both companies’ common stock for an exercise price of one-thousandth of one cent per share. In exchange, Treasury would effectively guarantee all of Fannie and Freddie’s obligations, existing and newly issued.

The reason for the structure of the bailout deal, including limiting the warrants to 79.9% ownership, was so the Treasury could keep asserting that the debt of Fannie and Freddie was not officially the debt of the United States, although de facto it was, is, and will continue to be.

Of course, in 2012 the government changed the deal, turning the 10% preferred dividend to a payment to the Treasury of essentially all Fannie and Freddie’s net profit instead. To compare that to the original deal, one must ask when the revised payments would become equivalent to Treasury’s receiving a full 10% yield, plus enough cash to retire all the senior preferred stock at par.

The answer is easily determined. Take all the cash flows between Fannie and Freddie and the Treasury, and calculate the Treasury’s internal rate of return on its investment. When the IRR reaches 10%, Fannie and Freddie have sent in cash economically equivalent to paying the 10% dividend plus retiring 100% of the principal.

This I call the “10% Moment.”

Freddie reached its 10% Moment in the second quarter of 2017. With the $3 billion dividend Fannie was previously planning to pay on December 31, the Treasury’s IRR on Fannie would have reached 10.06%.

The new Treasury-FHFA deal will postpone Fannie’s 10% Moment a bit, but it will come. As it approaches, Treasury should exercise its warrants and become the actual owner of the shares to which it and the taxpayers are entitled. When added to that, Fannie reaches its 10% Moment, then payment in full of the original bailout deal will have been achieved, economically speaking.

That will make 2018 an opportune time for fundamental reform.

Any real reform must address two essential factors. First, Fannie and Freddie are and will continue to be absolutely dependent on the de facto guarantee of their obligations by the U.S. Treasury, thus the taxpayers. They could not function even for a minute without that. The guarantee needs to be fairly paid for, as nothing is more distortive than a free government guarantee. A good way to set the necessary fee would be to mirror what the Federal Deposit Insurance Corp. would charge for deposit insurance of a huge bank with 0.1% capital and a 100% concentration in real estate risk. Treasury and Congress should ask the FDIC what this price would be.

Second, Fannie and Freddie have demonstrated their ability to put the entire financial system at risk. They are with no doubt whatsoever systemically important financial institutions. Indeed, if anyone at all is a SIFI, then it is the GSEs. If Fannie and Freddie are not SIFIs, then no one is a SIFI. They should be formally designated as such in the first quarter of 2018, by the Financial Stability Oversight Council —and that FSOC has not already so designated them is an egregious and arguably reckless failure.

When Fannie and Freddie are making a fair payment for their de facto government guarantee, have become formally designated and regulated as SIFIs, and have reached the 10% Moment, Treasury should agree that its senior preferred stock has been fully retired.

Then Fannie and Freddie would begin to accumulate additional retained earnings in a sound framework. Of course, 79.9% of those would belong to the Treasury as 79.9% owner of their common stock. Fannie and Freddie would still be woefully undercapitalized, but progress toward building the capital appropriate for a SIFI would begin. As capital increased, the fair price for the taxpayers’ guarantee would decrease.

The New Year provides the occasion for fundamental reform of the GSEs in a straightforward way.