Fannie Mae (NASDAQOTH:FNMA) and Freddie Mac (NASDAQOTH:FMCC) were recently stress-tested, and the results were discomforting to say the least. It was found that in another major recession, the lack of capitalization at the agencies could create the need for another bailout of up to $157.3 billion from U.S. taxpayers.
While this is definitely troubling, it may be the wake-up call lawmakers need to finally figure out what to do with Fannie and Freddie. Here's why the agencies could be headed for trouble, and what the government could do about it.
Fannie and Freddie are profitable, but their capital is being drained
After several years of losses following the financial crisis and ensuing $188 billion bailout, Fannie Mae and Freddie Mac back both returned to profitability in 2012 and have remained that way ever since.
However, as a condition of the bailout, 100% of the agencies' profits are diverted to the Treasury as "dividends." To make matters worse, the agencies are being forced to drain their capital reserves as well, limiting their ability to absorb potential losses if things go bad again. Under the terms of the agreement, the agencies are required to reduce their capital reserves by $600 million per year. As of the latest data, both agencies have $1.8 billion in reserves, which is already inadequate to prevent losses.
According to the stress test, in an "extremely adverse scenario," Fannie and Freddie would need to draw an additional amount between $68.6 billion and $157.3 billion. Now, under the terms of the bailout agreement, the agencies have the ability to draw an additional $258 billion in funding if they need it, so they would have access to more than enough money to cover losses.
However, that's money that comes straight from the Treasury (i.e., U.S. taxpayers), so nobody wants to see that happen.
Releasing the agencies from government control could be the best option
According to Fannie and Freddie's shareholders, as well as many government officials, returning Fannie and Freddie to the shareholders is the best scenario that could produce a win-win situation for both shareholders and the government. And taxpayers could rest easier knowing that the companies are sufficiently capitalized to handle another crisis -- hence, no more possibility of bailouts.
Here's how each party could potentially benefit from a recapitalized Fannie Mae and Freddie Mac:
- Shareholders: If Fannie and Freddie were returned to the shareholders and released from conservatorship, current shareholders would own 20% of the outstanding shares and as a result would be entitled to some of the agencies' profits. According to a thorough analysis performed by hedge-fund manager Bill Ackman, the agencies' share prices could be worth between $23 and $47 per share. Even at the low end of the spectrum, that's nearly 10 times the current value.
- Government: The government holds warrants for 80% of Fannie and Freddie's stock, so if the agencies were to return to the shareholders, the government could potentially make even more money than it already is. According to the same analysis I referenced earlier, the government could realize up to $600 billion in revenue from a fully capitalized Fannie and Freddie.
- Taxpayers: If Fannie and Freddie were allowed to rebuild their capital levels, it would minimize the risk of any further bailouts. Of course, in an extreme scenario, there is always the possibility that they'll need help, but the better capitalized the agencies are, the lower the ongoing risk to taxpayers will be.
Whatever happens, they need to act soon
Lawmakers have three basic options when it comes to Fannie and Freddie. They could end the government conservatorship, as I mentioned. They could do nothing and wait for Fannie and Freddie's capital reserves to drain to zero, which will happen in 2018. Or they could dismantle the agencies entirely.
The latter option is popular among many in Congress, but nobody can agree what would take their place. Most proposals so far call for some type of new government-guaranteed mortgage agency, which Republicans are strongly opposed to. They want to get rid of the explicit government guarantee of mortgages -- not add to it or make it permanent.
By doing nothing, the risk of further bailouts remains and continues to climb. Once Fannie and Freddie's capital levels dwindle to zero, they won't be able to absorb even the mildest losses, and there's no reason to believe the newly recovered real estate market will remain strong forever.
Just as with the thought of dismantling the agencies, the problem with privatization is that nobody can seem to agree how to do it. Many Republicans favor allowing the agencies to recapitalize but don't want to do anything that would be a "bailout" to shareholders.
My hope is that the prospect of further bailouts helps to expedite the efforts to find a solution to the problem. If something isn't done soon -- within the next few years -- another bailout of Fannie and Freddie could become a reality.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.