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Republican tax plan will trigger another Fannie, Freddie bailout

Reduction in corporate tax rate would impact GSEs’ deferred tax assets

On Thursday, the Republicans finally released their highly anticipated tax reform plan, and as it turns out, the Tax Cuts and Jobs Act may impact the housing economy much more than first thought.

In fact, the Tax Cuts and Jobs Act could bring on a flashback to the housing crisis that many thought they’d never see again – another bailout of Fannie Mae and Freddie Mac.

The plan, which Republicans claim will simplify individual tax rates and cuts the mortgage interest deduction in half from $1 million to $500,000, also calls for a reduction of the country’s corporate tax rate from 35% to 20%.

And if the corporate tax rate is reduced to 20%, Fannie and Freddie would both likely need another draw from the Department of the Treasury in the quarter that the tax plan goes into effect.

The issue is complex, but it boils down to two things: the fact that the government-sponsored enterprises will soon have zero capital and the GSEs' deferred tax assets.

Under the terms of the Preferred Stock Purchase Agreements that went into effect when the government took the GSEs into conservatorship, Fannie and Freddie send dividends to the Treasury each quarter that they are profitable.

In the third quarter, Freddie posted earnings of $4.7 billion, while Fannie made $3 billion, but under the PSPAs, the GSEs are prohibited from rebuilding capital, meaning that that $7.7 billion is headed to the Treasury.

Additionally, the PSPAs stipulate that each of the GSEs’ capital base is required to be reduced over time, with their capital reserves scheduled to be drawn down to $0 on Jan. 1, 2018.

And with zero capital on hand and a reduced corporate tax rate potentially taking effect, another bailout is highly likely, if only for that quarter, an investigation by HousingWire can reveal. 

Why would this happen? Fannie and Freddie's deferred tax assets.

Here is how Fannie Mae explains it in its 3rd quarter 10-Q filling with the Securities and Exchange Commission (emphasis added by HousingWire):

The current Administration proposes reducing the U.S. corporate income tax rate. Under applicable accounting standards, a significant reduction in the U.S. corporate income tax rate would require that we record a substantial reduction in the value of our deferred tax assets in the quarter in which the legislation is enacted. Thus, if legislation significantly lowering the U.S. corporate income tax rate is enacted, we expect to incur a significant net loss and net worth deficit for the quarter in which the legislation is enacted and we could potentially incur a net loss for that year. As noted above, if we experience a net worth deficit in a future quarter, we will be required to draw additional funds from Treasury under the senior preferred stock purchase agreement in order to avoid being placed into receivership.

Basically, that means that if the corporate tax cut is passed, Fannie and Freddie likely won’t have enough profits in that given quarter to cover the reduction in the value of their deferred tax assets, nor will they have any capital on hand to cover the losses.

That means Fannie and Freddie will need another draw from the Treasury, in order to make up the difference.

Here’s how Freddie describes it in their SEC filing: “A reduction in corporate tax rates would require us to measure our net deferred tax asset using the new rate in the period in which the rate change is enacted, resulting in a one-time charge through the tax provision. This increase in tax expense could significantly increase the risk of a draw.”

As Fitch Ratings noted earlier this year when broaching this very topic, the GSEs’ deferred tax assets consist primarily of “deferred fees, basis differences related to derivative instruments, mortgage related assets and allowance for loan losses.”

When Fitch calculated the estimated impact of a reduced tax rate in February, it based its calculations on Fannie’s DTA of $35.1 billion and Freddie’s DTA of $18.7 billion.

Under that scenario, if the corporate tax rate is cut from 35% to 20%, Fannie would write down its DTA by $15 billion, while Freddie would write down its DTA by $8 billion.

However, each of the GSEs current DTA is less than it was in February. A review of each of the GSEs’ 3rd quarter earnings materials shows that Fannie’s DTA is currently $30.45 billion, while Freddie’s DTA is $14.58 billion.

So the write down would be less than Fitch originally projected, but the likelihood of Fannie and Freddie needing another bailout would significantly increase under the Republican tax proposal because each of the GSEs’ profit in the given quarter is likely to be less than the write down amount.

And taxpayers would be left covering that difference.

Now, as Fitch also noted, Fannie and Freddie each have additional funding available to them under the PSPAs that would likely cover the needed draw.

As Jim Vogel, fixed income strategist at FTN Financial told HousingWire, the one-time tax hit and subsequent draw would likely be counteracted by future profitable quarters for the GSEs, which would also benefit from the lower future tax rate.

And as Fannie noted Thursday, it “expects to remain profitable” for the foreseeable future.

“It will lead to a draw as deferred tax assets are reduced in value, if for no other reason the entire change is recognized in one quarter and any quarter’s results can trigger the Treasury backstop,” Vogel told HousingWire. “Then, dividend flows will gradually ‘pay back’ the draw to Treasury as net income rises based on the lower rate. In economic terms, taxpayers will see little net difference due to their backstop of the GSEs in conservatorship.”

So, with another bailout now looming, will Congress or the Federal Housing Finance Agency act to either allow the GSEs to retain some capital or truly pursue housing finance reform? The clock just started ticking.

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