Government mortgage insurers Fannie Mae (FNMA) and Freddie Mac (FMCC) have been in the news quite a bit lately. Last week it was the most recent multi-billion dollar payment to the US Treasury; today it is reports that Bill Ackman's Pershing Square Capital Management hedge fund has just purchased nearly 10 percent of the common shares in each entity. Other hedge funds are looking to restructure and recapitalize the mortgage giants as well.
For now, Fannie and Freddie remain under government conservatorship, an arrangement resulting from a $116 billion federal bailout during the housing crisis of 2008.
The case illustrates some important points regarding the interaction of government, subsidies, and private markets.
1) Absent a bankruptcy, equity rights should not be wiped out. The government did not push the housing giants into bankruptcy, but took a conservatorship position instead. That action stripped shareholders of the right to receive a return on their investment, but it did not wipe out equity rights entirely. Now that housing markets have recovered and both FNMA and FMCC are profitable, it is not reasonable for equity holders to be forever stripped of returns. Changing that situation, however, will not be easy.
Welcome to the world of government-controlled cash cows, a structure all too prevalent with nationally-owned oil companies around the world. The politicians want to forever divert the cash flows -- to their government, to pet projects, or in some countries, to their friends and family. It is hard to ensure money is properly used.
The entrance of a number of hedge funds into concentrated equity positions (both preferred and common) in Fannie and Freddie makes an equitable resolution of how future returns are distributed much more likely. This is a good thing.
But that correction should not happen prematurely, either. First, taxpayers need to get an appropriate return for the risk we took on. And the appropriate return is much higher than merely a positive return (see item 2 below).
2) When taxpayers take large risks in private companies, or to provide complex goods and services to private companies, they should be appropriately compensated. An LA Times article covering the recent payment to Treasury from Fannie Mae picks up key themes that plague public discourse on government subsidies to industry. Consider the quote below:
Seized mortgage finance giant Fannie Mae posted its seventh-straight quarterly profit in the July-through-September period and will pay the government $8.6 billion in dividends, bringing it close to offsetting the cost of its 2008 bailout, the company said Thursday.
With the latest dividend payment, due by the end of the year, Fannie will have sent $114 billion to the Treasury Department. The company has received $116.1 billion in taxpayer money, though under terms of the complicated bailout the dividend payments do not reduce the amount owed to the government.
"We are quickly approaching the point when taxpayers will receive a positive return on their investment in this company," Fannie Mae Chief Executive Tim Mayopoulos told reporters during a conference call. "That’s obviously very good news for taxpayers."
Mayopoulos said he was confident Fannie ultimately would end up returning more in dividends to taxpayers than the amount of money they pumped into the company, and that actions the company has taken under government conservatorship "have righted the ship."
The paper conflates paying back $114 billion on a $116.1 bailout as offsetting its cost. Fannie Mae CEO Tim Mayopoulos is a bit more cautious, focusing on the start of a "positive return". But the subsequent paragraph (paraphrasing Mayopoulos) again focuses on whether nominal inflows of cash will be more or less than what the Treasury put out.
Here's the thing though. The bailout was in 2008, and the return cash flows 4-5 years later. If you were to offer me $116 billion and I only had to pay back that same amount five years later, I'd be a rich man. Even a 1% yield on that gift would make me a billionaire multiple times over.
This is basic finance: there's a time value of money, and at the very least taxpayer returns need to have an imputed interest rate. But that's not all: taxpayer money went into the firms at an extremely risky time. There was no guarantee that we'd get back even half of the funds invested. In return for taking on this risk, taxpayers deserve much more than mere interest on their investment: they should earn a return commensurate with the risk they took on. Not sure how to calculate how big that should be? Maybe the terms Warren Buffet set for his 2008 cash recapitalization of Goldman Sachs would provide some insights.
This issue, as well, is endemic in the world of energy subsidies. Taxpayers finance massively complicated infrastructure to extract, move, or refine energy around the world; or to store radioactive wastes for decades or centuries on behalf of private power generators. But there is no real rate of return ascribed to these investments, and the entities are expected to run at breakeven (or below). It's similar with the government's financing activities: we put up enormous amounts of credit to finance complex and risky private ventures, charge low cost Treasury bond rates, and pat ourselves on the back if the loan doesn't go bust. In all of these cases, the resultant services end up being heavily subsidized, mucking up energy economics in all sorts of ways.
Nominal break-even is not the time to free the equity. Back to Fannie and Freddie: the government should release its hold on equity interests at some point. But that point in not when dividend payments pass the $116 billion pumped in. Instead, equity holders should again get a stake in returns only after taxpayers have earned a Warren Buffet-like return on the hundred billion dollar cash infusion they made to keep these entities a going concern.