The administration will soon announce plans to release Fannie Mae and Freddie Mac from government conservatorship, and potentially recapitalize them with private investment.
Those who care about property rights should look closely at how the plan treats Fannie’s and Freddie’s private shareholders.
In September 2008, the Federal Housing Finance Agency placed Fannie and Freddie into conservatorship. Whether this was warranted is subject to debate. Whether the government has made money from Fannie and Freddie is not.
The FHFA entered into a funding arrangement with the Treasury Department that provided for Treasury to receive senior preferred stock with a guaranteed 10% dividend on its investment, plus an extra $100 million as the price of admission for Treasury’s funding commitment.
In addition, Treasury received warrants to purchase 80% of the common stock of each enterprise for virtually nothing. The private shareholders continued to own their preferred and common stock, but subject to Treasury’s new shareholder rights.
These were exceptionally generous terms for the Treasury but then again, it was September 2008 and the risk of systemic collapse arguably justified extraordinary measures. One need not second-guess these terms to recognize that something very different, and totally unjustifiable, happened four years later.
By August 2012, Fannie and Freddie were poised to make huge profits, enough to pay Treasury its 10% dividend with money left over for private shareholders, or to further strengthen the government-sponsored enterprises. Instead of celebrating the good news, the government pounced.
Soon after, the FHFA and Treasury altered the senior agreements to require Fannie and Freddie to deliver nearly all of their profits to the Treasury Department in an effort to repay taxpayers, leaving the GSEs with an incredibly small capital cushion of $3 billion each.
This quarterly “net worth sweep” ensured that no matter how much money Fannie and Freddie made, none of it would ever be available to fund the enterprises or to be paid to private shareholders. All of it — every penny — would go to Treasury.
The net worth sweep nullified the property rights of millions of investors. Some of those were small investors who put their life savings in Fannie and Freddie stock. Many had invested in new stock issuances during 2007 to provide the enterprises financing as the housing markets began to falter. Others were Fannie and Freddie employees who devoted their lives to the mission of these enterprises and were compensated in part through shares.
All of them had a right to expect that once the Treasury was repaid according to the terms of the September 2008 deal, any remaining value would be available for the enterprises and their private shareholders. The August 2012 action nullified those reasonable expectations, in violation of both the shareholder contracts and the Takings Clause of the Constitution’s Fifth Amendment.
The question is how to remedy this. It is obvious that no one will invest in Fannie and Freddie so long as they are required to sweep their net worth to Treasury each quarter. So for “recap and release” to work, the net worth sweep must end.
But that leaves open many questions, such as what happens to Treasury’s senior preferred stock; how much capital to raise from private markets; and how to treat existing shareholders?
First, Treasury should treat the payments it received in excess of the 10% dividend it was originally promised as a buy-down of principal in its senior preferred stock. That would result in its senior preferred stock being fully redeemed, with Treasury still holding over $18 billion in cash beyond the repayment of its principal, plus its 10% dividend. Treasury should return that excess amount.
Second, Treasury should exercise its warrants to acquire 80% of the common stock in the enterprises. That will ensure taxpayers obtain the maximum return on Treasury’s investment in the manner originally agreed, rather than through an unlawful appropriation.
Third, there should be an explicit deal under which the enterprises pay an insurance premium to the Treasury each year in exchange for Treasury holding open its current funding commitment (limited to $200 billion) as a liquidity line of last resort. This converts the nebulous “implicit government guarantee” into something explicit, clear and limited.
Fourth, the enterprises should rebuild capital. This should be possible through a new share issuance and through retaining earnings for a few years, if necessary.
Fifth, the government should not play favorites among private shareholders. There have been rumors about allowing preferred shareholders to convert into common stock, or allowing a limited rights offering to certain shareholders. This will lead to disputes and delay.
The contractual and legal rights of all shareholders should be left in place and respected equally. Anything else will be seen as playing favorites to Wall Street hedge funds that have invested disproportionately in the junior preferred stock. The contractual rights of those shares should be respected, but not favored over those of common shareholders.
Following these five steps will show that the government respects private property rights. It will also promote the confidence investors need to invest in Fannie and Freddie at a good price. That in turn will boost the value of the common stock held by Treasury, which will benefit taxpayers lawfully. And it will delineate explicitly the role of government and the private markets in funding these two institutions.
Fannie and Freddie exist to promote homeownership. The American dream, at the heart of which is owning private property. Corporate stock is also property, and close to the American Dream. Dear administration: You have a great opportunity to send a powerful message about the sanctity of private property rights and to make a profit while doing so. Don’t blow it.
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