Congress established Fannie Mae and Freddie Mac as GSEs to support the supply of mortgage loans. A key function of the GSEs is to package purchased mortgages into securities, which are subsequently sold to investors. Leading up to the financial crisis, increasingly difficult conditions in the housing market challenged the soundness and profitability of the GSEs, thereby undermining the entire housing market. This led Congress to pass the HERA. This Act created the FHFA, with enhanced regulatory authority over the GSEs, and provided the Secretary of the Treasury with certain authorities intended to ensure the financial stability of the GSEs, if necessary. In September 2008, FHFA placed the GSEs under conservatorship and Treasury entered into a SPSPA with each GSE. These actions were taken to preserve the GSEs’ assets, ensure a sound and solvent financial condition, and mitigate systemic risks that contributed to current market instability. The SPSPAs were amended in August 2012 (the amended SPSPAs) and changed, among other things, the basis by which quarterly dividends are paid by the GSEs to the U.S. Government. The dividend change in the amended SPSPAs is effective commencing with the quarter ending March 31, 2013.
The actions taken by Treasury thus far are temporary, as defined by section 1117 of HERA, and are intended to provide financial stability. The purpose of Treasury’s actions is to maintain the solvency of the GSEs so they can continue to fulfill their vital roles in the home mortgage market while the Administration and Congress determine what structural changes should be made. The FHFA director may terminate the conservatorship if safe and solvent conditions can be established. Draws under the SPSPAs are designed to ensure the GSEs maintain positive net worth as a result of any net losses from operations, and also meet taxpayer dividend requirements under the SPSPAs. The SPSPAs were structured to ensure any draws result in an increased nominal investment as further discussed below. Per SFFAC No. 2, Entity and Display, these entities meet the criteria of “bailed out” entities. Accordingly, the Government has not consolidated them into the financial statements, but included disclosure of the relationship(s) with the bailed out entities and any actual or potential material costs or liabilities in the consolidated financial statements.
Under the SPSPAs, Treasury initially received from each GSE: (1) 1,000,000 shares of non-voting variable liquidation preference senior preferred stock with a liquidation preference value of $1,000 per share and (2) a non-transferable warrant for the purchase, at a nominal cost, of 79.9 percent of common stock on a fully-diluted basis. The warrants expire on September 7, 2028. Through December 31, 2012, the senior preferred stock accrues dividends at 10.0 percent per year, payable quarterly. Under the amended SPSPAs, the quarterly dividend payment will change from a 10.0 percent per annum fixed rate dividend to an amount equivalent to the GSE’s positive net worth above a capital reserve amount. The capital reserve amount is initially set at $3.0 billion for calendar year 2013, and declines by $600 million at the beginning of each calendar year thereafter until it reaches zero by calendar year 2018. The GSEs will not pay a quarterly dividend if their positive net worth is not above the required capital reserve threshold; in such cases, the Treasury may be required to provide funding pursuant to the amended SPSPAs.
Cash dividends of $18.4 billion and $15.6 billion were received during fiscal years ended September 30, 2012, and 2011, respectively. In addition, beginning in fiscal year 2011, the GSEs were scheduled to begin paying Treasury a Periodic Commitment Fee (PCF) on a quarterly basis, payable in cash or via an increase to the liquidation preference. This fee may be waived by Treasury for up to 1 year at a time, if warranted by adverse mortgage market conditions. Treasury waived the PCF payments for the calendar years 2012 and 2011 given that the imposition of the PCF at that time would not fulfill its intended purpose of generating increased compensation to the Government. Commencing January 1, 2013, the PCF will no longer be required pursuant to the amended SPSPAs.
The SPSPAs, which have no expiration date, provide that Treasury will disburse funds to the GSEs if at the end of any quarter, the FHFA determines that the liabilities of either GSE exceed its assets. The maximum amount available to each GSE under this agreement was originally $100 billion in fiscal year 2008, was raised to $200 billion in fiscal year 2009, and was replaced in fiscal year 2010 with a formulaic cap. This formulaic cap allows continued draws for a 3-year period ending December 31, 2012, at amounts that will automatically adjust upwards quarterly by the cumulative amount of any net deficits realized by either GSE and downward by the GSE's positive net worth, if any, as of December 31, 2012, but not below $200 billion, and will become fixed at the end of the 3-year period. At the conclusion of the 3-year period, the remaining commitment will then be fully available to be drawn per the terms of the agreements (referred to hereafter as the “Adjusted Caps”). Draws against the funding commitment of the SPSPAs do not result in the issuance of additional shares of senior preferred stock; instead the liquidation preference of the initial 1,000,000 shares is increased by the amount of the draw.
Actual payments to the GSEs for fiscal years ended September 30, 2012, and 2011, were $18.5 billion and $20.8 billion, respectively. Additionally, $9.0 billion and $316.2 billion were accrued as a contingent liability as of September 30, 2012, and 2011, respectively. This accrued contingent liability is based on the projected draws under the SPSPAs. It is undiscounted and does not take into account any of the offsetting dividends which may be received as a result of those draws.
OMB issued guidance to Treasury on October 7, 2009, allowing the use of fair value accounting for non-Federal securities beginning with reporting for fiscal year 2009. As a result, the GSE investments are reported at fair value as of September 30, 2012, and 2011. In accordance with SFFAS No. 7, the annual valuation is classified as usual and recurring and thus a change in value is recorded as an expense or revenue to the financial statements. Annual valuations are performed as of September 30 for the preferred stock and warrants.
As part of the fair valuation exercise, Treasury prepared a series of long-range forecasts through 2025 to determine what the implied amount of the total contingent liability to the GSEs under the SPSPAs would be as of September 30. Since future payments under the SPSPAs are deemed to be probable, Treasury estimated a contingent liability of $9.0 billion as of September 30, 2012. This estimate reflects the projected equity deficits of the GSEs stemming from credit losses and contractual dividend requirements until December 31, 2012. The estimated contingent liability as of September 30, 2012, included several case scenarios which resulted in total SPSPA estimates ranging from $3.5 billion (based on an “optimistic” case scenario) to $22.4 billion (based on an “extreme” case scenario).
The $9.0 billion contingent liability reported as of September 30, 2012, reflects Treasury’s best estimate. This compares to the $316.2 billion contingent liability reported as of September 30, 2011, which was based on a range of $309.6 billion to $376.1 billion. At September 30, 2012, the maximum remaining potential commitment to the GSEs for the remaining life of the SPSPAs under the Adjusted Caps was estimated at $282.3 billion, which was based upon case scenario estimates ranging from $274.0 billion to $291.5 billion. The recorded contingent liability of $316.2 billion at September 30, 2011, constituted the maximum commitment payable under the Adjusted Caps, minus actual payments made through the end of that fiscal year. Such accruals are adjusted as new information develops or circumstances change. Based on the annual valuation of Treasury’s estimated future contingent liability, Treasury reduced its estimated liability by $288.7 billion and $22.9 billion at the end of fiscal years 2012 and 2011, respectively, via a reduction in expense. The significant reduction in this estimated liability at September 30, 2012, compared to 2011 is primarily due to a forecasted reduction in the amount of future draws needed by the GSEs as a result of the amended provisions of the SPSPAs. With the revision, dividend payments would be limited to the amount of the positive net worth in excess of a capital reserve amount. Prior to the revision, dividends were forecasted to be paid on an amount that was projected to increase as draws continued to be made to fund the dividends. The anticipated dividend payments after the revision are lower than previously forecasted.
In determining the fair value of the senior preferred stock and warrants for common stock, Treasury relied on the GSEs’ public filings and press releases concerning its financial statements, projection forecasts, monthly summaries, quarterly credit supplements, independent research regarding high-yield bond and preferred stock trading, independent research regarding the GSEs’ common stock trading, discussions with the GSE’s management, and other information pertinent to the fair valuations. Because of the nature of the instruments, which are not publicly traded and for which there is no comparable trading information available, the fair valuations rely on significant unobservable inputs that reflect assumptions about the expectations that market participants would use in pricing.
The fair value of the senior preferred stock considers the amount of forecasted dividend payments. The fair valuations assume that a hypothetical buyer would acquire the discounted dividend stream as of the transaction date. The significant decline in the fair value of the senior preferred stock at September 30, 2012, compared to 2011 is primarily due to a decrease in expected dividend payments and an increase in the discount rate used in the current year’s valuation to reflect more of the variable nature of the future cash flows anticipated as a result of the amended SPSPAs compared to the prior fiscal year.
The fair value of the warrants are impacted by the nominal exercise price and the large number of potential exercise shares, the market trading of the common stock that underlies the warrants as of September 30, the principal market, and the market participants. Other discounting factors are the holding period risk related directly to the amount of time that it will take to sell the exercised shares without depressing the market and the other activity under the SPSPA.
Pursuant to a provision within the Dodd Frank Act, the Secretary of the Treasury conducted a study and developed recommendations regarding the options for ending the conservatorship. In February 2011, the President delivered to Congress a report from the Secretary of the Treasury that provided recommendations regarding the options for ending the conservatorship and plans to wind down the GSEs. To date, Congress has not approved a plan to address the future of the GSEs, and thus the GSEs continue to operate under the direction of their conservator, the FHFA, whose stated planned objectives are to build a revitalized infrastructure for the secondary mortgage market and a continued gradual contraction of the GSEs presence in the secondary mortgage market.
In December 2011, Congress passed the Temporary Payroll Tax Cut Continuation Act of 2011 (TPTCCA), which included an increase in the GSEs’ guarantee fees that would expire on October 1, 2021. Under TPTCCA, the amount of the fee increase shall not be less than an average increase of 10-basis points above the average fees imposed in 2011 for such guarantees. The increased fees are to be remitted to Treasury and not retained by the GSEs.
On September 28, 2012, the GSEs remitted to the Department an amount of $35 million as the first payment of these increased fees covering the period of April 1, 2012, through June 30, 2012. This increase in guarantee fees did not affect the profitability of the GSEs during that time period.
As of September 30, 2012, and 2011, GSE investments consisted of the following:
|(In billions of dollars)||
Gross Investments as of 9/30/12
Cumulative Valuation (Loss)
9/30/12 Fair Value
|Fannie Mae Senior Preferred Stock||117.0||(51.3)||65.7|
|Freddie Mac Senior Preferred Stock||72.1||(30.2)||41.9|
|Fannie Mae Warrants Common Stock||3.1||(2.0)||1.1|
|Freddie Mac Warrants Common Stock||2.3||(1.7)||0.6|
|Total GSE Investment||194.5||(85.2)||109.3|
|(In billions of dollars)||
Gross Investments as of 9/30/11
Cumulative Valuation (Loss)
9/30/11 Fair Value
|Fannie Mae Senior Preferred Stock||104.5||(26.7)||77.8|
|Freddie Mac Senior Preferred Stock||66.0||(12.4)||53.6|
|Fannie Mae Warrants Common Stock||3.1||(2.1)||1.0|
|Freddie Mac Warrants Common Stock||2.3||(1.7)||0.6|
|Total GSE Investment||175.9||(42.9)||133.0|