Liquid courage
To sell Fannie and Freddie, Trump must answer a $7trn question
Investor optimism means the duo are outperforming Nvidia
A woman toting an umbrella passes Fannie Mae headquarters in Washington, USA. / Photograph: Reuters“Nothing is so permanent”, noted Milton Friedman, “as a temporary government programme”.
Friedman died in 2006, a couple of years before Fannie Mae and Freddie Mac, two enormous government-sponsored enterprises (GSEs) that provide liquidity to the American mortgage market, were bailed out during the global financial crisis.
The firms were taken into “conservatorship”, a form of temporary government control.
It has now been in place for almost 17 years.
The temporary measure may at last be coming to an end, however.
President Donald Trump’s team is looking into plans to return the government’s stake in the GSEs to the private sector via an initial public offering.
Investors in the duo’s battered stocks have already made enormous returns in anticipation of such a sale, enjoying gains of over 2,000%.
Even buyers of Nvidia may look on with envy.
In reality, any privatisation will be extravagantly difficult.
Returning the GSEs to private hands will mean unpicking knotty inconsistencies in the bail-outs that followed the financial crisis, which other administrations have avoided touching.
It may also mean resolving questions about American housing policy that date back to the 1930s.
And it will mean clarifying exactly what the Trump administration hopes to achieve with the process.
The first challenge is the companies’ insufficient capital.
Fannie and Freddie have vast balance-sheets, holding more than $7trn in mortgage debt.
As private institutions, they would face shortfalls of “Tier 1” capital, as required by regulators, of $188bn and $139bn, respectively.
Issuing such a large amount of equity in one go would be a ludicrous undertaking.
To put it in context, the IPO of Saudi Aramco in 2019, the biggest ever in nominal terms, raised $26bn.
The amount could be negotiated down during the privatisation.
But even raising smaller sums in chunks over a period of years would prove tough.
Although lowering capital requirements might speed things up, it would raise the risk of another blow-up.
Capital punishment
The second, related question is what role the government will play in the firms’ future.
So far, the administration’s approach has been confusing.
Bill Pulte of the Federal Housing Finance Agency, which oversees Fannie and Freddie, has suggested they might remain in conservatorship even after an IPO begins.
Yet conservatorship means purchasers of any stock would lack the ordinary rights of shareholders.
Good luck finding buyers for billions of dollars in newly issued equity who are willing to accept continued government control.
How will the Treasury deal with its own financial interest?
It has invested $193bn in the companies, in the form of senior preferred shares which used to pay a dividend of 10%.
A tweak to the rules in Mr Trump’s first term allowed the firms to skip the dividends and retain earnings, building up their capital.
In exchange, the government gained a “liquidation preference” (money owed if the GSEs are ever sold).
This had risen to $355bn by the end of June.
Owners of the private stakes, who include Bill Ackman, a competitive tennis player and sometime investor, think that the government has made quite enough money from the firms already.
He notes the Treasury was paid more than $300bn in dividends before the end of 2019.
In his proposal for privatisation, the government would combine Fannie and Freddie as a single entity, and would in effect write down its own holdings.
That would be great news for owners such as Mr Ackman, whose firm does not disclose the size of its stake in the GSEs.
But American taxpayers may disagree that leaving hundreds of billions of dollars on the table makes sense.
The last, and perhaps largest, challenge is what to do about the government’s implicit guarantee of the GSEs.
The idea that the state will come to their aid in a crisis, which proved to be true in 2008, has underpinned their cheap funding and high credit rating.
Without it, the duo might be downgraded by credit-rating firms.
Ultimately, the lack of a government-backed player could raise mortgage rates across the country, as holders of mortgage-backed securities demand higher returns to compensate for the additional risk.
Mr Trump, no fan of subtext, pledged to keep the arrangement in a social-media post in May: “I want to be clear, the US Government will keep its implicit GUARANTEES.”
Small-government types have long wanted Fannie and Freddie returned to private hands, hoping to spark more competition in mortgage finance.
John Cochrane of the Hoover Institution, a think-tank, has noted that GSE rules on asset purchases in effect prevent new types of home lending from emerging.
But Fannie and Freddie would have to lose their guarantees, in effect a subsidy, to encourage such innovation.
With Mr Trump’s promise of state support, it is not entirely clear what problem privatisation is intended to solve.
Taxpayers would yet again be left on the hook in the case of any future blow-up.
Government intervention in the mortgage market would continue, just in a new form.
Public risk would enable private gain.
There is a reason why no administration since the bail-out of Fannie and Freddie has found the time, or made the effort, to end the temporary fudge which governs the pair.
The benefits of returning the GSEs to private hands are far from certain, and doing so will create a group of losers.
Despite investors’ excitement, it is far from clear the Trump administration has an appetite for the immensely difficult task.
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