Don’t Be Fooled by GSEs’ Record Profits

Recent news stories conclude the record profits reported by Fannie Mae and Freddie Mac not only relieve political pressure for their reform or eventual elimination but for deficit reduction as well. However, the reported profits, particularly in the case of Fannie Mae, aren't what they seem. More pointedly, direct U.S. Treasury capital infusions and the return of Fannie Mae and Freddie Mac dividends have almost nothing to do with the economic costs and benefits of these government-sponsored monopolies.

Regarding the first point, the key feature of generally accepted accounting principles is dual-entry bookkeeping. Fannie Mae recently reported a markup of over $50 billion for a "deferred tax asset." That is, now that they have returned to "profitability," taxes otherwise due to the U.S. Treasury would not be due as a consequence of this "asset" (reflecting prior tax avoidance strategies). The U.S. Treasury doesn't record the offsetting loss in tax revenue as a liability. But that's not all. Being fully backed by the government in conservatorship, Fannie Mae can borrow $50 billion against this book entry without the Treasury recording the debt because the Treasury assumed only 79.9% ownership. Fannie can then use these borrowed funds to pay a $50 billion dividend to the U.S. Treasury, which Treasury then reports as an increase in income.

Regarding the larger point, current reported profitability of a government monopoly has nothing to do with the public interest. The only constitutionally authorized monopoly charter was for the U.S Post Office, "profitable" until competition from FedEx and UPS reduced their margins. 

The next big U.S. government monopoly was the U.S. Federal Reserve System, chartered in 1913, but not granted the exclusive franchise to print global currency until the Bretton Woods agreements of 1944. In recent years, the Federal Reserve has acted as a large GSE, buying both Treasury securities and agency mortgage securities. Earnings on what Treasury pays (or guarantees) exceeding about $90 billion annually have been appropriately returned to the Treasury as dividends. Whether or not these monetary policies are appropriate is open to debate, but the short-term reported Treasury profits and deficit reduction – most likely followed by capital losses when the portfolio is liquidated – is not a legitimate policy consideration.   

Fannie and Freddie monopoly charters were granted in the 1970s. They are currently profitable not because they are more efficient than the private sector – although some analysts try to make this historically unprecedented argument– but because their monopoly advantage has increased under conservatorship as the "agency status" guarantee is now a certainty, government accounting notwithstanding. Adjusting for cost of funds and balance sheet differences between them and the Federal Reserve, they should be generating about $50 billion annually for the Treasury in federal taxes saved (on what would have been due  on their return on equity) and user fees (reflecting the benefit of cheap Treasury guaranteed debt). Until recently, this has mostly been used to offset legacy credit losses.

The U.S. and U.K. were allies militarily during World War II, but adversaries in the design of the post-war economic system, as discussed most recently in "The Battle of Bretton Woods." The British government, led by eminent economist John Maynard Keynes, tried but failed to protect the British system of "imperial preferences" that generated royalties and other "economic rents" for the crown, politicians, the elite owners and monopoly distributors at the expense of the general public. Only the U.S. dollar could serve as the international currency because large U.S. gold holdings allowed the U.S. to guarantee convertibility to gold. When U.S. gold was almost exhausted in 1971, President Richard Nixon "suspended" dollar convertibility to gold. That the Federal Reserve is still able to issue unlimited dollars internationally over four decades after this U.S. default is a reflection of temporary international financial weakness rather than a permanent source of Treasury seigniorage income.

Prior to their failure, Fannie and Freddie generally denied virtually any public cost (as do most government agencies now conducting government economic cost-benefit analyses). If there was any intellectual merit to this argument, then it could equally be applied to all services. That's already been tried elsewhere, with spectacularly unsuccessful results. If they were equally efficient as competitive firms, economic costs would equal benefits. (But when are government monopolies ever as efficient as competitive private firms?)

It is ironic that U.S. politicians, who historically favored free trade and competitive private markets and who now promote tax reform and the end of "too big to fail" purportedly to get rid of political preferences and protectionism simultaneously make the case for granting imperial preferences to  these two monopoly government-sponsored enterprises.

Kevin Villani, chief economist at Freddie Mac from 1982 to 1985, is a principal of University Financial Associates and an executive scholar at the Burnham-Moores Center for Real Estate of the University of San Diego.