Urban Institute Report Discusses Plunge in GSE Profits

GSE’s had an impressive year in 2013, however Fannie Mae and Freddie Mac saw a huge drop in profits in 2014, forcing many to question the future of these enterprises. The Urban Institute has released a report discussing the impact of these changes and the likelihood Freddie Mac will need to take another draw from the Treasury.

Accord to the report, Fannie Mae and Freddie Mac made a combined profit of over $120 million in 2013. But by 2014 the net profit from both institutions fell by 80 percent, with Fannie Mae profit totaling to $14 billion and Freddie totaling $8 billion. More alarming were Freddie’s fourth quarter profits, which were down 90 percent from just the previous quarter.

Fannie and Freddie get about half of their profits from reclaiming tax assets that were written down during the crisis. Almost a third of their profits came from earnings in their portfolio and they also get a significant sum from legal settlements. All of these sources are disappearing rapidly, leaving these institutions with only one source of revenue that is not being wound down. The only major revenue source not being wound down is what the GSEs generate from their core guarantee business, in which they collect a fee in exchange for guaranteeing the default risk of loans for investors.

As these more large sources of income decrease, GSEs will have to rely more on their guarantee business for their profits. Having the GSE’s rely heavily on this single resource will create a significant shift in profitability for the institutions, and thus explains the big drop in revenue from 2013 to 2014. Stripping away all non–guarantee fee earnings from the 2013 numbers, for instance, Fannie would have made about $8 billion in profits ($12 billion taxed at 33.8 percent) and Freddie $3 billion ($5 billion taxed at 32.6 percent). Of the profits made in 2014, Fannie made about $9 billion from guarantee fees ($14 billion taxed at 32.8 percent) and Freddie made $4 billion ($5 billion taxed at 30.1 percent); the rest came from investments on their portfolio and other net income. Freddie’s investment profits were notably down over prior years, in part because its portfolio is being wound down, but also because Freddie took a large loss on a derivative position used to hedge some of its portfolio risk.

Freddie’s dramatic drop in profits in the fourth quarter has raised some concern that it may be headed for another draw on the Treasury, something both enterprises have avoided since 2012. The GSEs require a draw when their losses exceed their capital buffer. Each enterprise has a buffer of $1.8 billion in 2015, declining by $600 million each year until it is extinguished altogether in 2018.

According to the report, several key factors lessen the probability that Freddie would need the draw in the coming quarters. Freddie will likely see a reversal of the accounting losses on its derivative position as interest rates rise. Freddie will also have a still-significant portfolio for next couple of years and Freddie’s older loans, which have lower guarantee fees, will gradually be replaced by newer ones with higher fees. As long as Freddie retains a dominant market share, this shift toward more high-fee loans will mean an increase in revenues. However, Freddie’s risk of a draw will continue to rise in the next several years.