Why Fannie and Freddie Are Paying Back Uncle Sam

A few years ago, the conventional wisdom in Washington said that Fannie MaeFNMA -1.71% and Freddie Mac wouldn’t ever be able make taxpayers whole for the 2008 bailouts of the mortgage-finance giants.

Those who haven’t followed the companies closely will be surprised to learn that Fannie and Freddie are now on the brink of doing just that.

When the companies report their third-quarter earnings, which could take place as soon as this week, they could show that by the end of this year, they’ll have sent more money to the Treasury in dividends than what they received over the past five years. (And if that doesn’t happen this quarter, it very likely will occur when the companies report their fourth-quarter earnings next February.)

Of course, Fannie and Freddie aren’t allowed to “repay” the money they’ve received from the U.S. Treasury. Here’s how their agreement works: The government in 2008 agreed to inject massive sums of aid so that Fannie and Freddie would stay solvent, allowing mortgage markets to operate smoothly. In exchange, the Treasury took a new class of “senior preferred” shares in the companies that originally paid a 10% dividend; they also received warrants to acquire up to 80% of the firms’ common shares.

The agreement doesn’t provide any mechanism for Fannie and Freddie to buy back the government’s senior preferred shares, which now total $188 billion. If it sounds like Fannie and Freddie are making interest payments on a loan that can’t ever be repaid, that’s because they are. So any discussion of “repayment” needs this disclaimer: Even once Fannie and Freddie have paid $188 billion in dividends, they’ll still owe $188 billion.

This makes any “repayment” of taxpayers a mostly symbolic event—one that doesn’t change whether the companies can be freed from government control. And the political ramifications are altogether unclear. At a housing forum last month, Sen. Mark Warner (D., Va.) brushed away the idea that Fannie and Freddie should be returned to their former ownership simply after paying as much in dividends as they had borrowed. “I was a venture capitalist for a lot longer than I’ve been a politician. If I had put $180 billion into Fannie and Freddie back in 2009, I’d expect more than a one-to-one return on that,” he said. “So once I got a 30-to-one return…talk to me about Fannie and Freddie making money.”

Still, the event is significant given that few expected it would happen this soon. What changed? Here are nine reasons the companies are paying the Treasury more money:

1. The government altered the terms of its support of the companies last year. It scrapped the 10% dividend, which in some quarters had forced the companies to borrow money to pay the dividend, and instead required all profits to be sent to the Treasury as dividends. In quarters where the companies run a loss, they don’t owe anything. While this hasn’t changed the firms’ profitability, it has sharply increased the amount of money the companies send to the government. It also prevents Fannie and Freddie from rebuilding capital. (Shareholders have filed lawsuits challenging the arrangement; Treasury and FHFA say they’ve acted appropriately.)

The companies have sent $146 billion to the Treasury in dividends, with $91 billion in payments being made this year. If the old terms had been in place, the companies would have sent around $14 billion to the Treasury this year. The Treasury, meanwhile, has invested $188 billion in the companies.

2. Fewer homeowners are defaulting. Fewer than 2.6% of loans backed by the companies were 90 days or more past due at the end of September. While this is still very high historically, it is down sharply from peaks of 5.5% and 4.1% for Fannie and Freddie, respectively, in early 2010. Fewer delinquencies mean fewer foreclosures, reducing the amount of money the companies have to set aside to cover loan losses.

3. Home prices are up sharply over the past year. The companies estimates around loan losses are heavily sensitive to home prices because that determines how much the companies lose when they sell homes through foreclosure. Losses on foreclosures are down sharply as prices have risen. During the second quarter, Fannie lost around 25 cents for every $1 in debt that went through foreclosure, down from 35 cents one year earlier. The upshot is that the companies are foreclosing on fewer properties than a year ago, and they are losing less money when they do.

4. Exposure to loans from the worst years of the housing bust is declining. Loans made in 2006 and 2007, which have been by far the worst performers, are either moving through foreclosure or refinancing, thanks to a program the companies launched two years ago that made it easier for underwater borrowers to refinance their mortgages. The dollar volume of loans from these two years has fallen by 46% through June from two years earlier, according to an analysis by Jim Vogel at FTN Financial. Home-price gains have also reduced the number of borrowers who are underwater and at risk of foreclosure.

5. The companies are guaranteeing much better quality mortgages, and they’re charging significantly more for those guarantees. Fannie and Freddie don’t make loans but instead buy them from banks and other lenders, packaging them together and selling them off as securities to investors. They charge “guarantee fees” to lenders when they buy those loans, and those fees have more than doubled over the past three years. Meanwhile, the companies have tightened up lending standards, and banks have been even more cautious to guard against the risk they’ll have to buy back loans that have underwriting mistakes.

6. Fannie and Freddie have won some big legal settlements. The firms’ regulator, the Federal Housing Finance Agency, has settled five of 18 lawsuits filed on the firms’ behalf in 2011. Two of those settlements—with J.P. Morgan ChaseJPM +0.29% & Co for $4 billion and UBS AGUBSN.VX +1.39% for $885 million—have been made public. Others could follow. Also, the companies have recouped billions of dollars by forcing banks to buy back defaulted mortgages that ran afoul of underwriting guidelines.

7. Some of the eye-popping profits have been driven by the same accounting rules that required the companies to take eye-popping write-downs five years ago. Fannie, for example, reported a $58.7 billion profit in the first quarter, due mostly to a one-time gain of $50.6 billion from reclaiming certain tax benefits that had been written down during the bust. Freddie has around $28 billion in so-called deferred tax assets that it hasn’t yet claimed, but the company has said it could recapture some of those benefits as soon as the third quarter. “Much of the current ‘profit’ is the reversal of earlier” loss reserves, meaning “the original losses that caused great outrage weren’t necessarily that big to begin with,” wrote Mr. Vogel earlier this year.

8. The firms have very little competition right now. Outside of other federal agencies such as the Federal Housing Administration, there are few investors willing to invest in mortgages or mortgage-backed securities right now.

9. The companies have as close to an explicit government guarantee as they can get. Because the Treasury has made clear that it will ensure the companies have enough resources to pay bondholders, Fannie and Freddie have been able to borrow cheaply in the capital markets to fund portfolios of mortgages that, while shrinking, are still large.