Why Fannie Mae, the most profitable company in the world, should bail out Detroit

Ok that headline may take a minute or two to digest, so I am going to split this post into sections.

1. Net profit of largest companies

In 2012 the most profitable companies in the world, as measured by net income, were Exxon Mobil (XOM), at $45 billion, followed by Apple (AAPL) at $42 billion, while Fannie Mae (FNM)’s net income was $17 billion.

But in the first half of 2013 net income of both XOM and AAPL was around $16 billion, while FNM reported net income of $69.6 billion, boosted by a tax benefit of $50.6 billion. Even excluding that, net income of $19 billion still comfortably beat that of XOM and AAPL.

2. FNM’s “dividends” to the US Government

Fannie Mae was bailed out in 2008, receiving a total of $117 billion of funding. By the end of 2012, as profitability returned, FNM had repaid some $36 billion. So far, so good. But in August 2012 the Government changed the rules. Rather than receiving interest on its preferred stock the new terms state that: “dividends each quarter equal the amount, if any, by which the company’s net worth as of the end of the preceding quarter exceeds an applicable capital reserve amount. The applicable capital reserve amount is $3.0 billion for each quarter of 2013 and will be reduced by $600 million annually until it reaches zero in 2018.”

Bear with me, this is important. These quarterly dividends “cannot be used to offset prior Treasury draws”. What this means is that however much FNM pays the Government, it cannot reduce the principal amount it owes. Basically, the Government gets virtually all the net income but the debt remains outstanding.

Let’s make this personal. Imagine that you take out a $250,000 mortgage at say 5%. For 2-3 years you make the regular monthly payments, and then you get a letter stating that in future you need to submit a tax return and pay all your income for the year except for a tiny amount that you are allowed to keep. And you still owe $250,000 or thereabouts. Does that sound like the free world to you? Didn’t think so.

Based upon its net income in just the first half of 2013 (including the tax credit), FNM will pay to the Government the astounding sum of $69 billion, taking total payments to $105 billion.

It gets worse. One of the big drives post the financial near collapse has been to increase the amount of capital that banks must hold in relation to its assets. Whereas in the past a bank might have to have say $5 in capital for every $100 in assets, now they must have say 10%. More capital = less risk of being badly hurt, or worse, by a recession.

But the Government is (a) preventing FNM from building reserves at all, and (b) going further and forcing its net worth to ZERO by 2018.

3. Why does FNM matter? Didn’t it cause the problem in the first place?

First, let’s be clear what FNM (and its smaller sibling Freddie Mac, FRE) actually does. It does not issue mortgages. What it does is to buy mortgage that are issued by banks, thereby freeing up the banks’ capital enabling them to make more loans. To fund these purchases, FNM bundles the mortgages it buys into pools that are then sold in the public markets, mainly to financial institutions

Despite the Government’s stated intent of reducing FNM’s market share, according to the company’s latest report: “Fannie Mae provided approximately $3.7 trillion in liquidity to the mortgage market from January 1, 2009 through June 30, 2013 through its purchases and guarantees of loans, which enabled borrowers to complete 11.4 million mortgage refinancings and 3.1 million home purchases, and provided financing for 1.9 million units of multifamily housing.”

So why does the Government want to shut down FNM? In a recent speech President Obama said he wanted to get the Government out of the mortgage business and shift the burden to private investors. This is not the place to go into the causes of the housing bust, which anyway are many and complex, but we all know that our members of Congress love to have a scapegoat.

At this distance it does seem as though Congress has said that FNM’s dominance is bad, so we are going to force it to shrink by denying it capital. It would be comforting to think that there was a plan to replace FNM (and Freddie) but none is currently on the table.

4. What’s all this got to do with Detroit?

As you can see from the above, the Government has basically helped itself to a huge windfall in taking FNM’s (and FRE’s) net income. And these funds are being used to reduce the budget deficit, for which no doubt Congress will take credit.

In just the Second Quarter of 2013 FNM and FRE will pay more than $14 billion to the Government. And, by the way, FRE has strongly indicated that it will book a tax credit of more than $28 billion before the end of the year – and yep, that too will head to Washington.

These numbers are huge, even if they appear to be the result of confiscation of profits. It does seem to me that  a more honorable – and more profitable – way would be for the Government to reverse the 2012 change in terms, and allow FNM/FRE to retain their profits. And then sell their shares, just as they have done with the banks, GM, AIG, etc. I am not a FNM analyst, but at a run rate of $10 billion a quarter, or $40 billion a year, FNM could have a value in the stock market of what, $250 billion? And the Government would get its money legitimately rather than by confiscation. And not have to figure out what the heck they are going to do to replace FNM/FRE. And fulfill the President’s wish of getting the Government out of the mortgage business.

And so, finally, to Detroit. Most reports suggest that Detroit’s total deficit – including future liabilities – is around $18 billion. That’s a little more than the Government will pick up from FNM/FRE from just three months of earnings, or a little less than half the likely dividend from FRE when it recognizes its deferred tax asset later this year.

5. Should Detroit be bailed out?

Opinions of the causes of Detroit’s problems range from all over the place, frequently reflecting the speaker’s political views more than anything else. Like the housing crash, there is no simple answer.

But I believe that it is unacceptable to stand by and let major cities descend into a morass of crime and poverty.

Or to roil the municipal bond market by allowing an Emergency Manager to declare that general obligation bonds, issued bearing the “full faith and taxing authority” of the issuing authority, will be treated as unsecured debt. Note that since Detroit’s bankruptcy filing three Michigan cities have had to postpone debt issues. There are more than 1 million different municipal bonds outstanding with a principal amount of $3.7 trillion.That’s huge market, used extensively to finance the workings of municipalities across the country.

As parents we know that our children have a chance of getting into serious trouble at some stage in their lives. How we react will have a strong bearing on their future behavior. If we just take care of the problem, with no penalty to the child, history suggests that the likelihood of the child repeating the offense is high. If we forgive, but impose a penalty, there is much less chance that we will have to face the same problem again.

So with Detroit. The city has spectacularly failed to deal with its myriad of issues over many years. Providing access to financing – maybe the Treasury could use some of its FNM/FRE dividends to invest in new bonds – and appointing a new Board to oversee the City (akin to what happened in New York in the 1970s) – could provide a blueprint to help turnaround cities like Detroit, which is not the only US city facing problems. There will be a cost to the city but at least a revitalization plan would offer that most precious of commodities – hope.

6. So, yes, FNM – or its profits – should be used, not to bail out Detroit, but to finance the revitalization of that City under the control of an external board.



If you are considering buying or selling a home and have questions about the market and/or current home prices, feel free to contact me on 781.631.1223 begin_of_the_skype_highlighting 781.631.1223 FREE  end_of_the_skype_highlighting or andrew@HarborsideRealty.com