How Fannie and Freddie’s $7.7 Trillion in Debt Became Our Burden to Share

President Donald Trump said in a May social post he is considering releasing Fannie Mae and Freddic Mac from government ownership. (Andrew Harnik/Getty Images)

About the authors: Edward J. Pinto is a senior fellow at the American Enterprise Institute’s Housing Center. He and Stuart McFarland were both executive vice presidents at Fannie Mae.

In May, President Donald Trump announced he wants to take Fannie Mae and Freddie Mac public after nearly 20 years under government conservatorship. The government would maintain its implicit guarantees for their solvency and still provide strong presidential oversight, he said. The government is still working out the details, but for taxpayers, one thing is clear: Fannie and Freddie would still be part of our shared national obligations.

For decades, Fannie and Freddie have been considered government-sponsored enterprises, a hybrid entity that isn’t part of the government nor a traditional private company, but provides a government service—home loans, in their cases. As GSEs, Fannie and Freddie’s $7.7 trillion in debt hasn’t been included on the federal government’s balance sheet.

This labeling and accounting practice might have worked for the mortgage giants in the past—but no longer.

The Federal National Mortgage Association, as Fannie was originally known, was chartered in 1937 as an entity owned and managed by the federal government. It was rechartered in 1954 as a mixed-ownership government corporation; the federal government held its preferred stock and the private sector held its common stock. Its debt obligations were required to state on their face that they weren’t guaranteed by the U.S. government. In 1965, Fannie was transferred to the newly formed Department of Housing and Urban Development. But its split ownership structure continued, with the federal government as both the principal owner and the manager.

Roughly a decade later, the president’s commission on budget concepts for the first time defined a GSE and laid out parameters for how a GSE’s debt would be accounted for. It said a GSE’s debt isn’t included as part of the federal debt when the entity is private and for profit, with all its stock privately held.

Under this definition, Fannie didn’t qualify as a GSE, and its debt would need to begin being counted toward the federal debt in the 1969 fiscal year.

But President Lyndon B. Johnson had other plans. After racking up $45 billion in deficits since 1965, he was determined to have a balanced budget by the end of his term. Adding Fannie’s debt to the federal deficit would prevent that. HUD also had plans for a massive increase in federal support for housing, and boosting Fannie’s funding capacity was a necessary ingredient. In order for Fannie to balloon its debt without it affecting the government’s balance sheet, it had to be converted into a GSE.

So Fannie was provided a new charter in 1968. As a GSE, it would keep performing an important government function—lending to home buyers—but would now become a privately owned company, ending all federal ownership and moving its debt off the federal balance sheet for good. Fannie would now be run by a board of directors, the preponderance of whom were elected by private shareholders. Its debt would be its own—in theory. Freddie was changed from a GSE tied to the Federal Home Loan Bank system to a publicly traded, for-profit corporation in 1989, making it similar to Fannie.

By qualifying as a GSE, Fannie’s off-balance sheet debt was accorded an implicit guarantee that the government would bail them out if need be, notwithstanding language to the contrary in Fannie’s 1954 charter. Given Fannie’s low capital levels, having an implicit guarantee was necessary if it were to implement Johnson’s plan to balance the budget, which necessitated selling mountains of debt at a generous rate, just above what the U.S. Treasury Department paid.

In fact, in a 1982 letter to the rating agency Standard & Poor’s, the U.S. Treasury advised that Fannie’s securities benefited from “significant attributes” accorded “agency securities’ by federal statutes and regulations.” S&P responded that, based on Fannie and Freddie’s relationship with the U.S. government, it would start considering the obligation of those “government agencies and instrumentalities” as “eligible investments for ‘AAA’ rated structured financings.” This conclusion was reached notwithstanding that Fannie was effectively insolvent at the time.

This setup held until September 2008, when Fannie and Freddie were put into conservatorship by their regulator, the Federal Housing Finance Agency, after the subprime mortgage crisis. However, they were still considered privately owned and managed, performing an important governmental function—and since they were both insolvent, were still reliant on the federal government’s implicit guarantee, along with a new limited backstop provided by the U.S. Treasury.

Some 17 years later, it is clear now that Fannie and Freddie are no longer GSEs. Having remained in an unending conservatorship, they are being operated not as a hybrid entity, but as part of the U.S. government.

In March, FHFA Director and Fannie/Freddie Conservator William Pulte, leaving no doubt about who is in charge, ousted 14 board members, installed replacements, and named himself chair of both boards of directors. The U.S. Treasury holds senior preferred shares in Fannie Mae and Freddie Mac, with a combined liquidation preference of approximately $341 billion—more than twice their combined total book equity. This leaves them deeply insolvent, as they have been since 2008.

Treasury also owns warrants giving it the right to acquire new stock so that it can own up to 79.9% of Fannie and Freddie’s common stock, for a minuscule exercise price of one-thousandth of one cent per share.

Since they are clearly no longer a GSE nor privately owned, Fannie and Freddie’s $7.7 trillion in debt must be added to the national debt. If the government wants to unload this debt, it either needs to follow rules laid out by the Commission on Budget Concepts or release Fannie and Freddie from conservatorship. But before doing so, they need to be well-capitalized and reduced in size. Otherwise they are simply too big to fail.

And to the extent Fannie and Freddie still have an implicit guarantee from the government, they should pay a fair rate for it.

Guest commentaries like this one are written by authors outside the Barron’s newsroom. They reflect the perspective and opinions of the authors. Submit feedback and commentary pitches to ideas@barrons.com.