Admittedly not the most captivating read, but interesting to learn how the GSEs are treated at Treasury…
November 17, 2014
- INVESTMENTS IN GOVERNMENT SPONSORED ENTERPRISES
Congress established Fannie Mae and Freddie Mac as GSEs to support the supply of mortgage loans. A key function of the GSEs is to package mortgages into securities, which are subsequently sold to investors, and guarantee the timely payment of principal and interest on these securities.
Leading up to the financial crisis, increasingly difficult conditions in the housing market challenged the soundness and profitability of the GSEs, thereby undermining the entire housing market. This led Congress to pass the Housing and Economic Recovery Act (HERA) (P.L. 110-289) in July 2008. This act created FHFA, with enhanced regulatory authority over the GSEs, and provided the Secretary with certain authorities intended to ensure the financial stability of the GSEs, if necessary. In September 2008, FHFA placed the GSEs under conservatorship, and the Department entered into a Senior Preferred Stock Purchase Agreement (SPSPA) with each GSE. These actions were taken to preserve the GSEs’ assets, ensure a sound and solvent financial condition, and mitigate systemic risks that contributed to market instability. The SPSPAs were amended in August 2012 (the amended SPSPAs) which changed, among other things, the basis for determining quarterly dividends that are paid by the GSEs to the U.S. government. The dividend change in the amended SPSPAs became operationally effective commencing with the quarter ending March 31, 2013.
The actions taken by the Department are intended to provide financial stability to the U.S. economy. The purpose of the Department’s actions is to maintain the solvency of the GSEs so they can continue to fulfill their vital roles in the home mortgage market while the Administration and Congress determine what structural changes should be made. Draws under the SPSPAs result in an increased investment in the GSEs as further discussed below.
Under the SPSPAs, the Department initially received from each GSE: (i) 1,000,000 shares of non-voting variable liquidation preference senior preferred stock with a liquidation preference value of $1,000 per share, and (ii) a non-transferrable warrant for the purchase, at a nominal cost, of 79.9 percent of common stock on a fully-diluted basis. The warrants expire on September 7, 2028. Under the amended SPSPAs, the quarterly dividend payment changed from a 10.0 percent per annum fixed rate dividend on the total liquidation preference (as discussed below) to an amount equivalent to the GSE’s positive net worth above a capital reserve amount. The capital reserve amount was initially set at $3.0 billion for calendar year 2013, and declined to $2.4 billion on January 1, 2014, and will continue to decline by $600 million at the beginning of each calendar year thereafter until it reaches zero by calendar year 2018. The GSEs will not pay a quarterly dividend if their positive net worth is below the required capital reserve threshold. Cash dividends of $72.5 billion and $95.7 billion were received during fiscal years ended September 30, 2014 and 2013, respectively. Dividends received in fiscal years 2014 and 2013 were primarily attributable to a federal income tax benefit that was recognized in the earnings of one GSE in fiscal year 2014 and the earnings of the other GSE in fiscal year 2013.
The SPSPAs, which have no expiration date, provide for the Department to disburse funds to the GSEs if, at the end of any quarter, the FHFA determines that the liabilities of either GSE exceed its assets. Draws from the Department under the SPSPAs are designed to ensure that the GSEs maintain positive net worth. The maximum amount available to each GSE under this agreement was previously based on a formulaic cap which ended December 31, 2012, at which time, the maximum amount became fixed effective December 31, 2012 (refer to the “Contingent Liability to GSEs” section below). Draws against the funding commitment of the SPSPAs do not result in the issuance of additional shares of senior preferred stock; instead, the liquidation preference of the initial 1,000,000 shares is increased by the amount of the draw. There were no payments to the GSEs for the fiscal years ended September 30, 2014 and 2013.
Entity Transactions― If the Department estimates a contingent liability to the GSEs, this liability will be accrued and reported on the Department’s Consolidated Balance Sheets pursuant to the SPSPAs and funded through the Department’s direct appropriations. The liability accrual will be reflected at its gross amount as an “entity” cost on the Department’s Consolidated Statements of Net Cost, within the line item, “Cumulative Results of Operations” on the Department’s Consolidated Balance Sheets, without considering the increase in senior preferred stock liquidation preference/fair value adjustments, and future dividend receipts from the GSEs.
Non-Entity Transactions― If actual payments are made to the GSEs, they will result in increases to the U.S. government’s liquidation preference in the GSEs’ senior preferred stock, and thus represent General Fund exchange revenue reported on the
Department’s Consolidated Statements of Net Cost as “GSEs Non-Entity Cost (Revenue).” Changes in the fair valuation of the GSE preferred stock and common stock warrants, and related dividends received, are General Fund-related costs and revenues that are likewise reported as “GSEs Non-Entity Cost (Revenue).”
INVESTMENTS IN GSES
As of September 30, 2014 and 2013, the Department’s investments in the GSEs consisted of the following (in millions):
SENIOR PREFERRED STOCK AND WARRANTS FOR COMMON STOCK
In determining the fair value of the senior preferred stock and warrants for common stock, the Department relied on the GSEs’ public filings and press releases concerning their financial statements, as well as non-public, long-term financial forecasts, monthly summaries, quarterly credit supplements, independent research regarding preferred stock trading, independent research regarding the GSEs’ common stock trading on the OTC Bulletin Board, discussions with each of the GSEs and FHFA, and other information pertinent to the valuations. Because of the nature of the instruments, which are not publicly traded and for which there is no comparable trading information available, the fair valuations rely on significant unobservable inputs that reflect assumptions about the expectations that market participants would use in pricing.
The fair value of the senior preferred stock considers the amount of forecasted dividend payments. The fair valuations assume that a hypothetical buyer would acquire the discounted dividend stream as of the transaction date. The fair value of the senior preferred stock decreased at September 30, 2014 when compared to 2013 primarily due to lower forecasted dividends as a result of lower forecasted GSE earnings to be derived from guarantee fees, coupled with one-time benefits recognized in the GSEs’ historical earnings that contributed to the higher fair value of these investments at the end of 2013 but which did not recur at the end of 2014.
The fair value of the warrants is impacted by the nominal exercise price and the large number of potential exercise shares, the market trading of the common stock that underlies the warrants as of September 30, the principal market, and the market participants. Other factors impacting the fair value include, among other things, the holding period risk related directly to the assumption of the amount of time that it will take to sell the exercised shares without depressing the market. The fair value of the warrants increased at the end of fiscal year 2014 when compared to 2013 primarily due to increases in the market price of the underlying common stock of each GSE.
CONTINGENT LIABILITY TO GSES
As part of the annual process undertaken by the Department, a series of long-term financial forecasts are prepared to assess as of September 30, the likelihood and magnitude of future draws to be required by the GSEs under the SPSPAs within the forecast time horizon. The Department used 25-year financial forecasts prepared through year 2039 and 2038 in assessing if a contingent liability was required as of September 30, 2014 and 2013, respectively. If future payments under the SPSPAs are deemed to be probable within the forecast horizon, the Department will estimate and accrue a contingent liability to the GSEs to reflect the forecasted equity deficits of the GSEs. This accrued contingent liability will be undiscounted and will not take into account any of the offsetting dividends that would be received, as the dividends would be owed directly to the General Fund. Such recorded accruals will be adjusted as new information develops or circumstances change.
Based on its annual assessment, the Department estimated no probable future funding draws as of September 30, 2014 and 2013, and thereby accrued no contingent liability. At September 30, 2014 and 2013, the maximum remaining contractual commitment to the GSEs for the remaining life of the SPSPAs was $258.1 billion which, as discussed above, was established as of December 31, 2012.
In assessing the need for an estimated contingent liability, the Department relies on the GSEs’ public filings and press releases concerning their financial statements, monthly summaries, and quarterly credit supplements, as well as non-public, long-term financial forecasts, the FHFA House Price Index, discussions with each of the GSEs and FHFA, and other information pertinent to the liability estimates. The forecasts prepared in assessing the need for an estimated contingent liability as of September 30, 2014, include three potential wind-down scenarios, with varying assumptions regarding the timing as to when new guaranteed mortgage backed securities would cease being issued by the GSEs. The forecasts also assume a continued gradual wind-down of the retained portfolios (and corresponding net interest income) through 2018, as directed under the amended SPSPAs for each GSE to reduce the maximum balance of its retained mortgage portfolio by 15.0 percent per annum beginning December 31, 2013. The maximum balance of the GSEs’ retained mortgage portfolio was initially set at $650 billion as of December 31, 2012, and is required under the amended SPSPAs to be reduced to $250.0 billion by December 31, 2018.
The Department’s forecasts of potential future draws by the GSEs may differ from actual experience. Potential future actual draw amounts will depend on numerous factors that are difficult to predict including, but not limited to, changes in government policy with respect to the GSEs, the business cycle, inflation, home prices, unemployment rates, interest rates, changes in housing preferences, home financing alternatives, availability of debt financing, market rates of guarantee fees, outcomes of loan refinancings and modifications, new housing programs, and other applicable factors.
FINANCIAL PERFORMANCE OF THE GSES
The summarized unaudited aggregated financial condition of the GSEs as of September 30, 2014 and 2013, along with their summarized unaudited aggregated financial operating results for the nine months ended of September 30, 2014 and 2013 were as follows (in millions):
The above information was taken directly from the quarterly reports filed with the SEC, which are publicly available on the SEC’s website (www.SEC.gov) and also the GSE investor relations websites.
The decline in the GSEs’ combined net income for the nine months ended September 30, 2014 compared to the same period in 2013 was primarily attributable to one-time federal income tax benefits that were recognized in their 2013 earnings that did not recur in 2014.
GSES NON-ENTITY REVENUE
For the fiscal years ended September 30, 2014 and 2013, GSEs Non-Entity Revenue consisted of the following (in millions):
A provision within the Dodd-Frank Act required the Secretary to conduct a study and develop recommendations regarding the options for ending the conservatorship of the two GSEs. In 2011, the President delivered to Congress a report from the Secretary that provided recommendations regarding the options for ending the conservatorship and plans to wind down the GSEs. To date, Congress has not approved a plan to address the future of the GSEs, thus the GSEs continue to operate under the direction of their conservator, the FHFA, whose stated strategic goals for the GSEs are to: (i) maintain foreclosure prevention activities and credit availability; (ii) reduce taxpayer risk through increasing the role of private capital in the mortgage market; and (iii) build a new single-family securitization infrastructure.
The Temporary Payroll Tax Cut Continuation Act of 2011 was funded by an increase of ten basis points in the GSEs’ guarantee fees (referred to as “the increased fees”) which began in April 2012, and is effective through October 1, 2021. The increased fees are remitted to the Department and not retained by the GSEs. Accordingly, the increased fees do not affect the profitability of the GSEs. For fiscal years 2014 and 2013, the GSEs remitted to the Department the increased fees totaling $1.9 billion and $946 million, respectively, which are reported within the line item entitled “Fines, Penalties, Interest and Other Revenue” on the Department’s Statements of Custodial Activity.