Then, and Now

In an interview on November 30, 2016, Treasury Secretary-designate Steven Mnuchin said, “It makes no sense that [Fannie Mae and Freddie Mac] are owned by the government and have been controlled by the government for as long as they have,” adding, “we gotta get them out of government control….and in our administration it’s right up there in the list of the top ten things we’re going to get done, and we’ll get it done reasonably fast.” More than four years later, on January 14, 2021, Mnuchin and FHFA Director Mark Calabria signed a letter agreement allowing Fannie and Freddie to continue to retain earnings in an amount up to 4 percent of their adjusted total assets (with a dollar-for-dollar increase in Treasury’s liquidation preference), but stopping far short of getting them “out of government control.” To the contrary, the letter agreement mandated that each must remain in conservatorship until all material litigation relating to the conservatorship is resolved or settled, and their common equity tier 1 capital equals at least 3 percent of their assets for two or more consecutive calendar quarters.  

What went wrong? Readers of this blog might have had a sense that something like this would happen. In a post published last January, titled “How We Got to Where We Are,” I wrote, “It is difficult to evaluate the wide range of opinion about how best to end Fannie Mae and Freddie Mac’s conservatorships, or the alternatives Treasury and FHFA now have for doing so, without an understanding of the political battles that have engulfed the companies over the past two decades, which I call ‘the mortgage wars’.” After a brief summary of that history—highlighting the deceptions and false claims from critics and opponents of the companies seeking legislation to replace them with a secondary market mechanism more advantageous to primary market lenders—I then said:    

“Today, [Mnuchin] and FHFA director Mark Calabria both understand that the only way to make good on Mnuchin’s pledge is through administrative reform. But neither, I believe, has fully come to grips with the crucial fact that in switching between these two tracks, the fictions about Fannie and Freddie that were essential elements of the attempt to replace the companies in a legislative process become impediments when the goal is to successfully recapitalize and release them in an administrative process.

If the best economic result were the overriding objective, getting Fannie and Freddie out of conservatorship would be no more difficult than it was to get them in: Treasury would settle the lawsuits by unwinding the net worth sweep and canceling its liquidation preference; FHFA would specify a true risk-based capital standard without excessive conservatism—making the companies attractive to new equity investors—and based on their updated capital requirements Fannie and Freddie each would prepare capital restoration plans for FHFA’s approval….But that’s not how process will work, because of two carryovers from the failed legislative efforts of the past. The first is that the Financial Establishment and its supporters remain committed to their twenty-plus year goal of hamstringing Fannie and Freddie’s competitive position, and are hoping to accomplish this in administrative reform by convincing FHFA to subject the companies to excessive and unnecessary required capital and burdensome regulation by using the arguments of promoting safety and soundness and a ‘level playing field’ for new competitors. The second is that Treasury as of yet has shown no signs of moving away from the false claims it’s been making about Fannie and Freddie since before the conservatorships, which it must do if it wishes them to be able to raise new capital.”

As is now evident, neither Calabria nor Mnuchin were willing or able to break free of their prior non-economic policy objectives for Fannie and Freddie, or their fictionalized versions of the companies’ business, performance during the financial crisis, and current levels of credit risk. Ultimately, this doomed the chance of Fannie and Freddie being released from conservatorship before the end of the Trump administration last Wednesday.

Director Calabria bears the brunt of the blame for this failure, in my view. The Housing and Economic Recovery Act (HERA) states that “the Director shall, by regulation, establish risk-based capital requirements for the enterprises to ensure that the enterprises operate in a safe and sound manner, maintaining sufficient capital and reserves to support the risks that arise in the operations and management of the enterprises.” Calabria dismissed this clear directive to base Fannie and Freddie’s capital on the risks of the loans they guarantee, and instead imposed on Fannie and Freddie a 4 percent minimum capital requirement taken from the Basel bank standards—in spite of the fact that the companies are not banks, have no business or activity in common with banks, and for the last three decades have had credit loss rates one-sixth those of the commercial bank credit loss rates published by the FDIC. Then, to purportedly be in compliance with HERA, Calabria produced a risk-based standard with enough cushions, elements of conservatism and buffers to push its required capital first near (in the May 20, 2020 rule) and then above (in the final standard, the December 17, 2020 “Enterprise Regulatory Capital Framework”) his bank-like minimum.  

Calabria’s arbitrary and unjustified capital rule had three negative effects on the process for releasing Fannie and Freddie from conservatorship. Most obviously, it resulted in an excessively large amount of capital (nearly $300 billion) they had to retain or raise before they could be deemed adequately capitalized. Second, having to hold far more capital than needed to cover their worst-case credit losses will force the companies to significantly increase their guaranty fees, making them less competitive and reducing their growth and value. Finally, a capital standard so evidently, egregiously and deliberately misaligned with the risks of Fannie and Freddie’s credit guaranty business signaled a degree of regulatory hostility certain to deter potential new investors from putting equity into the companies.

Treasury holds the key to the release of Fannie and Freddie from conservatorship: it must approve that release, and of course no new capital will be invested in the companies as long as the net worth sweep is in effect and Treasury retains its liquidation preference. Since the first lawsuit against the sweep in the spring of 2013, Treasury has consistently maintained that the sweep was legal, and a reasonable business judgment by it and FHFA. This posture put Mnuchin in the position of needing an extremely good reason for canceling the sweep and relinquishing the liquidation preference voluntarily, as these would be, and be seen as, significant concessions. Delivering on his promise to release Fannie and Freddie from conservatorship might have been such a reason, but the FHFA capital requirement put this out of reach. With Calabria requiring the companies to have close to $300 billion in capital to be considered “safe and sound,” Mnuchin could not credibly allow FHFA to release them from conservatorship, even under a consent decree, with only the $35 billion in capital they have currently, nor could he assure anyone that the additional capital could be acquired over any specified period of time. Thus deprived of the “win” of being able to authorize a definitive release from conservatorship, Mnuchin had no reason to give up the net worth sweep and liquidation preference, making his, and Director Calabria’s, best alternative the January 14 letter agreement, kicking the problem to the Biden administration.           

But that was then; what will happen now? Barring a dramatic shrinkage in the size of their business (which may be an objective of the Calabria capital rule), it would take Fannie or Freddie longer than the end of the new administration that just began last week to achieve 3 percent capitalization through retained earnings alone. But this should not be their fates, because neither of the factors that impeded their release from conservatorship during the Trump administration—the non-economic policy agenda imposed upon them, or the stubborn adherence to a fictionalized version of their past and present roles in the market and risks posed to taxpayers—are likely to persist in a Biden administration.

Fannie has been political since it was spun out of the government in 1968, and Freddie since its creation in 1970. Through the late 1990s, both enjoyed strong bipartisan support in Congress. Yet even during this period, Republican and Democratic administrations had different policy objectives for them. In general, Republican administrations sought to limit or roll back the benefits conveyed to the companies by their federal charters, which they believed gave Fannie and Freddie unfair advantages over their private sector competitors. (Banks were considered “fully private,” even though they benefit greatly from government guarantees on their consumer deposits.) Democrats, in contrast, supported those charter benefits, but wanted the companies to use them to do more affordable housing business, at lower returns, than company management and shareholders would have done themselves.

These same philosophical differences exist today. Mark Calabria is an extreme example of the school of “neutralizing Fannie and Freddie’s benefits through overcapitalization and overregulation,” while the majority of the members of the Biden economic team should view the companies as vehicles for helping to make housing finance affordable to as broad and diverse a group of potential homebuyers as possible. This opposite orientation is likely to result in a more favorable dynamic for a successful release from conservatorship than was in evidence during the Trump administration—particularly if, as I and many others expect, the Supreme Court rules for the plaintiffs in the Collins case this spring.   

Plaintiffs are asking the Supreme Court to uphold the decision by the Fifth Circuit en banc that the net worth sweep was a violation of the Administrative Procedures Act (APA), and also to uphold the Fifth Circuit decision that the director of FHFA is unconstitutional while reversing the remedy of prospective relief and granting relief retroactively in the form of a voiding of the net worth sweep. I am skeptical that plaintiffs will prevail in their request for retroactive relief on the constitutional claim, but I believe the Court is very likely to uphold the Fifth Circuit’s ruling on the unconstitutionality of the FHFA director, and extremely likely to uphold the Fifth Circuit’s finding that the net worth sweep is a violation of the APA. If these predictions prove correct, the APA issue would be remanded to the District Court for the Southern District of Texas for trial on the facts, while the Fifth Circuit’s decision on the FHFA director would stand, allowing President Biden to remove Director Calabria at will (although Calabria may challenge that action, adding some time to the process).

A win by plaintiffs on the APA claim would give Secretary Yellen a rationale for initiating settlement talks, together with the political cover Mnuchin wished for but never felt he had. Treasury will not want a trial on the facts in Collins, and it may not even want to get to the motion to dismiss stage. As I documented in my amicus curiae brief for the Supreme Court, the facts overwhelmingly contradict Treasury’s claims that the conservatorships were legitimate rescues of the companies, and that the net worth sweep was a reasonable judgment about the best way to help them continue to pay their dividends. Moreover, documents produced in discovery in the Court of Federal Claims show Treasury officials knew Fannie and Freddie were about to experience a surge in earnings from the reversal of estimated or artificial losses booked by FHFA, and discussed among themselves and others that the purpose of the sweep was to prevent the companies from retaining those earnings. These “bad facts” give plaintiffs a very strong hand in settlement negotiations, and should produce a result for them nearly as favorable as the granting of a motion to dismiss.

A second favorable decision from the Supreme Court, upholding the Fifth Circuit’s ruling on the unconstitutionality of the FHFA director, should lead President Biden to quickly ask for Mark Calabria’s resignation, for two reasons. First, a win by plaintiffs on the APA claim will make it clear that Fannie and Freddie cannot be kept in conservatorship indefinitely, and the Calabria capital rule is the main impediment to attracting the private capital necessary to permit their timely release. Second, as I noted earlier, I believe most of Biden’s economic team will not be nearly as ideologically hostile to the companies as Calabria is, and will understand the benefits of a Fannie-Freddie capital rule that meets a stringent standard of safety and soundness but does not go so far beyond that as to impede (or, in the case of the Calabria rule, cripple) the companies’ abilities to carry out their chartered missions.

The fact that Calabria so evidently ignored the readily available data on bank, Fannie and Freddie credit losses when he imposed the 4 percent Basel bank minimum capital standard on the companies’ credit guaranty businesses will make it easier, and less controversial, for a Biden-appointed FHFA director to set a new, more effective, and much lower risk-based capital requirement for them, in turn justifying a much lower minimum. My “Comment on FHFA Capital Re-proposal” identifies the relevant historical data the Biden team can draw on and cite as a basis for coming up with a true, data-driven risk-based standard, while the final section of the comment (“FHFA must re-do, and greatly simplify and clarify, its risk-based capital standard”) offers suggestions for structuring the standard in a way that will make it transparent, understandable, and defensible to advocates of taxpayer protection and affordable housing alike.

Director Calabria may have thought he was “hard-wiring” his final capital proposal when he got Secretary Mnuchin to agree in the January 14 letter that Fannie and Freddie could only be released from conservatorship, even under a consent decree, when their common equity tier 1 capital reached 3 percent of their adjusted total assets for two consecutive quarters. Changing that now requires Secretary Yellen’s concurrence. But that will be good, because it will ensure that she and her senior staff engage in the development of the new capital rule. Yellen not only is Treasury Secretary, she also is chair of the Financial Stability Oversight Council (FSOC), which had this to say about the Calabria rule: “Risk-based capital requirements and leverage ratio requirements that are materially less than those contemplated by the proposed rule would likely not adequately mitigate the potential stability risk posed by the Enterprises.” Yellen’s involvement in the development of a data- and fact-based version of the capital rule, to which she is committed, should be sufficient to gain the FSOC’s support for the new rule. That will be important when it comes to setting the periodic commitment fee for the continuation of the Treasury backstop. If the financial regulatory community is in agreement that the revised capital standard is indeed rigorous, this fee will be much lower.

The cancellation or unwinding of the net worth sweep—whether through a ruling by the Supreme Court granting retroactive relief on the constitutional issue, settlement of the lawsuits, or a successful motion to dismiss by plaintiffs in the Southern District of Texas—a new risk-based capital standard based on historical fact rather than ideological fiction, and a reasonably priced periodic commitment fee would make the path to recapitalizing and releasing Fannie and Freddie from conservatorship far easier for the Biden economic team than it turned out to be for the Trump team. In particular, a sensible capital requirement would enable FHFA (with Treasury approval) to greatly shorten the time at which Fannie or Freddie could be released from conservatorship under a consent decree, perhaps by tying that release to the closing of an equity issue that hits some threshold percentage of “adequately capitalized,” and it also would allow the companies to raise capital more easily, and on better terms, by making them more attractive as investments.

Nothing in Washington ever happens ideally or smoothly, but the elements now appear to be in place to finally produce an end to the twelve-year conservatorships of Fannie Mae and Freddie Mac. The keys, in my opinion, will be whether the Biden team is willing to abandon the fictions about Fannie and Freddie in favor of the facts and data, and to replace the Calabria capital rule with one that works for the companies and homebuyers rather than banks. I believe it is in the best policy interests of the Biden administration to do both, and that it will.