I recently wrote an article in which I analyzed insurance giant AIG. There was something about telling the story of AIG that gave me a sense of nostalgia for the good ole days of 2008 and 2009 when the economy was in a tailspin, the Dow Jones was in the process of plummeting 50%, big banks were failing left and right, and the U.S. government was dishing out hundreds of billions of dollars of bailouts.You know, the good ole days?
Since I couldn't shake the warm fuzzy feeling I got from my AIG analysis, I decided to take a "where are they now?" look at another couple of companies that found themselves at the epicenter of the financial crisis: Fannie Mae (NASDAQOTCBB: FNMA ) and Freddie Mac (NASDAQOTCBB: FMCC ) .
Ahhh, the good ole days
During most of the financial crisis, I knew next to nothing about the secondary mortgage market, including how it worked and what purpose it served. Even though I was hearing about Fannie Mae and Freddie Mac on TV on a daily basis, I didn't understand the role the two entities played in the whole mess until the dust started to settle.
Let's take a quick overview of the way the mortgage business works:
1. A mortgage originator creates a new mortgage. These mortgage originators are typically banks such as Wells Fargo or JP Morgan Chase, but can also be thrift banks or other mortgage specialists.
2. A mortgage aggregator, such as Fannie Mae or Freddie Mac, buys the mortgage from the originator, bundles it in a pool of other mortgages, and creates from those bundles the infamous mortgage-backed security (MBS).
3. Investors buy the MBS from from the aggregator and receive payments (plus interest) on the MBS over time.
In theory, this system works, and everyone profits along the way. Wells Fargo and other originators charge an origination fee on the mortgage then sell it to aggregators such as Fannie and Freddie. This sale provides cash the originators can use to make more mortgage loans.
Fannie and Freddie then create MBSes, sell them to investors, and charge the investors a guarantee fee (g-fee), which guarantees the investors will receive the payments they are due.
Finally, investors profit from owning a security that pays an interest-like yield and is theoretically guaranteed by the aggregator. Since Fannie and Freddie are Government Sponsored Enterprises (GSE) they have the implicit backing of the U.S. government, which gives investors confidence in the guarantees.
The Wild West: Pre-crisis Fannie and Freddie
Fannie and Freddie have two-pronged business models: guarantees (described above), and fixed-income arbitrage (FIA).
In a nutshell, the FIA portion of the business revolves around Fannie and Freddie's position as GSEs. The GSEs can borrow money from the government at extremely low interest rates, then turn around and buy MBSs with much higher yields than the interest they are paying on their government debt.
Before the financial crisis, Fannie and Freddie held more than $1.5 trillion of mortgage-related assets on their balance sheets. Unfortunately, as we now know, many of these MBSs were comprised of extremely high-risk sub-prime mortgages.
In 2006, Fannie and Freddie's combined pre-tax income from the FIA business was about $3 billion.
By comparison, the two companies' single-family guarantees business generated about $5 billion in pre-tax income in 2006.
By 2008, the sub-prime mortgages had hit the fan. That year, Fannie and Freddie suffered combined pre-tax income losses of $37 billion on their guarantees business and losses of $47 billion on their FIA business.
Where are they now?
In September of 2008, Fannie and Freddie were placed under government conservatorship, and since then the U.S. Treasury has been steering the ship and "unwinding" the GSEs.
As of 2013, Fannie and Freddy's combined mortgage-related investment asset holdings have shrunk from the pre-crisis level of over $1.5 trillion to $952 billion.
Despite the unwinding, the performance of the GSEs themselves has been on the upswing.
In fact, due to the recovery of the GSEs in the years since the crisis, the government's $187 billion bailout of Fannie and Freddie has now generated a profit for U.S. taxpayers.
By 2011, the FIA business at the GSEs was back to generating a combined annual pre-tax income of $12 billion.
In 2013, the GSEs single-family guarantee business produced $24 billion in pre-tax income.
What does the rebound mean for shareholders?
As of today, this recovery means absolutely nothing for Fannie and Freddie shareholders.
Fannie Mae and Freddie Mac were delisted from the NYSE in 2010. Since August 2012, every dollar of the two entities' profits has been going straight to the government. Unless pending shareholder lawsuits against the government are successful, the Treasury will continue to unwind the GSEs and the return to profitability for these two mortgage behemoths will be nothing more than one of the final chapters in the story of the financial crisis.
Take advantage of this little-known tax "loophole"
Recent tax increases have affected nearly every American taxpayer. But with the right planning, you can take steps to take control of your taxes and potentially even lower your tax bill. In our brand-new special report "The IRS Is Daring You to Make This Investment Now!," you'll learn about the simple strategy to take advantage of a little-known IRS rule. Don't miss out on advice that could help you cut taxes for decades to come. Click here to learn more.