Fannie, Freddie won't last forever, here's why

While not everyone agrees on the future of Fannie Mae and Freddie Mac, one thing is certain – it’s current state is unsustainable.

While not everyone agrees on the future of Fannie Mae and Freddie Mac, one thing is certain – it’s current state is unsustainable. However, that doesn't mean the two mortgage giants are on the verge of collapse, but rather the government-sponsored enterprises (GSEs) aren’t being allowed to rebuild and will eventually need a bailout, according to a Federal Housing Finance Agency (FHFA) regulator.

In a white paper released Wednesday titled "The Continued Profitability of Fannie Mae and Freddie Mac is Not Assured," the Office of Inspector General (OIG) of the FHFA warned that the profitability of the two GSEs may not continue due to their having to rely on core earnings for profits in the future.

Fannie’s fourth quarter earnings fell by 66% from $6.5 billion in Q4 2013 to $1.3 billion in Q4 2014. Freddie reported a profit of $227 million in the fourth quarter compared to $8.6 billion a year ago and said it would send the government $900 million. The combined profits of the two GSEs totaled $135 billion in 2013.

The declining profits don’t reflect trouble in the GSEs’ mortgage business, which has continued to report consistent earnings. Fannie Mae’s net interest income was $5.1 billion in the fourth quarter compared to $4.9 billion during the same period of 2013.

That upswing is mostly due to to rising home prices and settlements, but those won’t last forever.

Fannie and Freddie were put into government conservancy in 2008 after teetering on the brink of insolvency. A $197.5 billion cash infusion from the U.S. Treasury saved the mortgage finance giants. Under the terms of the bailout, the GSEs have to send their profits to the government and cannot build their capital buffer, which the white paper suggested is putting the profitability of the GSEs in jeopardy.

The GSEs cannot legally accumulate a financial cushion to absorb future losses – they must pay a dividend to Treasury each quarter equal to the excess of their net worth over an applicable capital reserve amount. That capital buffer is currently $1.8 billion and is required to be reduced by $600 million per year until it reaches zero by 2018. Should the GSEs' losses exceed their capital buffer, they would require another draw on Treasury, according to the white paper.

"Fannie Mae reports that it expects to remain profitable for the foreseeable future; however, it acknowledges that a decrease in home prices or changes in interest rates, combined with provisions of their agreements with Treasury that require the reduction of their retained asset portfolios, could lead to losses," wrote Acting Deputy Inspector General for Evaluations Kyle Roberts in the white paper. "Thus, if these losses result in an Enterprise reporting a negative net worth, that Enterprise would be obligated to draw on Treasury’s funding commitment."

The FHFA OIG's white paper was the second report released this week discussing the declining profitability of Fannie Mae and Freddie Mac. On Monday, the Urban Institute published a research brief entitled "What to Make of the Dramatic Fall in GSE Profits" and examined the likelihood of Freddie Mac having to take another draw on Treasury, which it has not done since 2012.