Getting Real About Reform

~ jtimothyhoward

The Federal Housing Finance Agency (FHFA) received 37 responses to its request for input on single-family credit risk transfers. I have not read all of them (and likely will not), but the ones I have read appear not to have made the critical connection between FHFA’s request and the way it, in conjunction with Treasury, has been managing Fannie and Freddie in conservatorship for the past four-plus years. For both the current phase of the conservatorships—in which the companies are not allowed to retain capital—and for the future, FHFA sees credit risk transfers not as a supplement to Fannie and Freddie’s risk-taking but as a potential replacement for it. In not recognizing that fact, commentators missed an important opportunity to use their experience and knowledge to warn FHFA of the great danger of continuing to lead Fannie and Freddie towards an end-state in which credit risk transfers become the primary means of supporting their credit guarantees. That is a business model that does not and will not work.

The context for understanding FHFA’s view of risk-sharing mechanisms begins with its February 21, 2012 “Strategic Plan for Enterprise Conservatorships” (subtitled “The Next Chapter in a Story that Needs an Ending”). This plan, produced during the tenure of Acting Director Ed DeMarco, describes “the next chapter of conservatorship [as] one that focuses in earnest on building a secondary market infrastructure that will live beyond the Enterprises themselves… [and] will also see a gradual reduction in the Enterprises’ dominant position in holding mortgage credit risk as private capital is encouraged back into that role.”

Three initiatives were begun pursuant to this strategic plan to carry it out: requiring Fannie and Freddie to build a common securitization platform “capable of becoming a market utility,” increasing the companies’ guaranty fees to “move their pricing structure closer to the level one might expect to see if mortgage credit risk was borne solely by private capital,” and “establish[ing] loss sharing arrangements” to move credit risk away from the companies to capital markets investors. The goal of these initiatives—which have been underway for the past four and a half years—was to make it easier for Congress to at some point replace Fannie and Freddie with an alternative mechanism of secondary mortgage market finance.

There is no mystery as to what the mechanism envisioned by FHFA (and Treasury) as the replacement for Fannie and Freddie looks like. Two plans put out this year describe it in great detail, with only modest variations on the same idea. The first is the “More Promising Road to GSE Reform,” authored by five individuals associated with the Urban Institute and released in March (and updated several times since then); the second is “Toward a New Secondary Mortgage Market,” published this September by former FHFA Acting Director DeMarco and Michael Bright, both now at the Milken Institute.

Each proposal would replace shareholder-owned Fannie and Freddie with entities that use risk-transference mechanisms as their primary means of absorbing credit losses. The Promising Road would “merge Fannie Mae and Freddie Mac into a government corporation that is required to transfer all non-catastrophic credit risk into the private market,” while the DeMarco-Bright plan would “[r]econstitute Fannie Mae and Freddie Mac as lender-owned mutuals [after passing them through receivership], and build on the credit risk transfer (CRT) initiative to create a private market for mortgage credit risk.” The government corporation envisioned in the Promising Road would use risk-transfer mechanisms to provide capital up to 3.5 percent of its outstanding credit guarantees, and have another 2.5 percent in secondary capital in the form of noncumulative junior preferred stock. Similarly, DeMarco-Bright would use risk transfers to provide the first “300-500” basis points of capital, and as a secondary source of capital require the “owners of the mutual…to put up somewhere around 2 percent of additional enterprise capital in the companies.” Promising Road would use Fannie and Freddie’s common securitization platform to issue government-guaranteed securities, while DeMarco-Bright would use Ginnie Mae’s securitization platform to issue securities with Ginnie’s guaranty.

The underlying premise of both the Promising Road and DeMarco-Bright proposals is that “dispersing mortgage credit risk throughout the capital markets” is a less risky and equally cost-effective means of financing mortgages compared with leaving credit risk concentrated at too-big-to-fail specialized financial institutions (such as Fannie and Freddie). That sounds good in theory. But four years of FHFA-mandated experimentation with credit risk-sharing mechanisms by Fannie and Freddie leaves no doubt about the challenge confronting the Promising Road and DeMarco-Bright plans: both propose to use front- and back-end risk sharing to replace equity capital on a scale dwarfing anything attempted before, and in the face of overwhelming evidence of the limits of the market to make that capital available.

Using actual numbers helps put the risk-sharing challenge in perspective. Today, Fannie and Freddie finance $4.5 trillion in single-family residential mortgages. The Promising Road authors believe they need 3.5 percent of first-loss capital to back the single-family loans being made currently. (I think this is unjustifiably high, but it’s their proposal, so I’ll use their figure). DeMarco and Bright propose 300 to 500 basis points of first-loss capital, and to simplify I’ll use 3.5 percent for them as well.

To fully back $4.5 trillion of mortgages with 3.5 percent capital would require $158 billion. Where would that amount of risk-sharing capital come from? There are three potential sources: mortgage insurers and reinsurers, lenders keeping the credit risk on the loans they sell (through what are called recourse arrangements), and securitized credit risk transfers, or CRTs.

The combined capitalization of the U.S. private mortgage insurance industry is about $9 billion. Even were the MI industry to triple in size—which is not likely—this would result in only $18 billion in new risk-sharing capital, leaving $140 billion still to be found. Lender recourse won’t provide much of that. It has been around for decades, and seldom has been used because bank capital rules don’t favor it. (Bank capital standards are purely credit-based, so recourse arrangements have the same required capital as mortgages held in portfolio, which are much more profitable.) Almost all of the risk-sharing capital required by the Promising Road and DeMarco-Bright proposals, therefore, will have to come from securitized credit risk transfers. And that is where these proposals run into the wall of reality.

I’ve written extensively about the flaws and limitations of Fannie’s Connecticut Avenue Securities (CAS) risk-transfer program—in two previous posts titled “Risk Sharing, or Not” and “Far Less Than Meets the Eye” as well as elsewhere. Freddie’s Structured Agency Credit Risk (STACR) notes have the same flaws and limitations, which can be boiled down to the fact that neither CAS nor STACRs transfer much actual credit risk to their purchasers. This means that a dollar of CAS or STACRs is not equivalent to a dollar of equity capital, and to pretend that it is (or to ignore the fact that it isn’t), is to set the stage for a credit risk implosion down the road.

A good way to illustrate the concept of “equity equivalence” for securitized CRTs is to start with a structure that would be a very close substitute for equity capital. It would have a long final maturity—say 15 years. Its principal would not be reduced by mortgage amortization or prepayments, only if and when credit losses occur. The security would pay a floating rate of LIBOR plus a spread (determined at the time of pricing) on whatever principal is outstanding each month, and over the course of the security’s 15-year life investors would lose anywhere between none and all of their principal, depending on what happens with credit losses in the pool the security is insuring.

So why don’t we see risk-transfer securities that look like this? Because no mutual fund or pension fund investor would ever buy them. Their range of potential returns would be far too uncertain and volatile, and determined by a risk these investors do not understand (but the seller of the security does). Investors also would not be able to hedge the risk of these securities, and could diversify it only by purchasing the securities in large numbers (when they don’t want to purchase any). Investment bankers know this, so in order for them to sell the volumes of Fannie and Freddie’s CAS and STACR securities that FHFA has mandated, they have had to remove most of their credit risk by structuring them so that the majority of the principal pays off before the credit losses they are supposed to be insuring can be charged against it.

This is not mere theory; over the past four years we have seen investors’ credit risk aversion play out with Fannie’s CAS issuances. In the first five CAS transactions (through the end of 2014), Fannie absorbed only the initial 30 basis points of credit losses before transferring subsequent losses to the holders of the first risk-sharing tranche (called the “M-2”), which took losses up to 1.75 percent of the initial balance of the pool it was insuring, after which the next risk-sharing tranche (the “M-1”) took losses up to 3.00 percent of the pool (when Fannie began taking them again.) But just 30 basis points of first-loss protection caused losses to be transferred to the holders of both the M-2 and M-1 tranches too quickly for their liking. To induce investors to keep buying these tranches, Fannie has had to agree to take the first 100 basis points of loss. Even in a stress scenario, it takes time for that many loans to go bad, and during this time the M-1 and M-2 CAS tranches can pay off (without absorbing losses). As I noted in “Far Less Than Meets the Eye,” the loss sensitivity analyses in the prospectuses for Fannie’s last several CAS deals revealed that in none of the 64 combined prepayment and total credit loss scenarios did the M-1 CAS tranche take any credit losses, and the M-2 tranche took losses in only 9 of the 64 (four of which had zero prepayments, which is not realistic). In terms of “equity equivalents,” Fannie’s current M-1 tranches have no equity value at all—since they absorb no credit losses—and the M-2 tranches have relatively little.

So, in the real world, here is where we are. The Promising Road and DeMarco-Bright proposals require at least $158 billion in equity-equivalent credit-risk capital to meet their safety and soundness standards. Deeper front-end mortgage insurance and back-end reinsurance transactions might provide $20 billion of that. Lender recourse will not provide much at all, because any bank willing to put up capital for a recourse transaction can get ten times the return on that same capital by funding the loan on-balance sheet with low-cost insured deposits. And even after four years of CAS and STACR issuance, Fannie and Freddie have been unable to devise a risk-sharing structure that transfers any meaningful amount of credit losses to capital markets investors. The $17.6 billion in face value of CAS M-2 and M-1 tranches issued to date are worth at most $3 billion in equity equivalents, and the structures employed have become progressively less effective at transferring credit risk as more CAS tranches have been issued. Simply put, there is no credible path that gets anywhere close to the $158 billion in equity equivalents—or even half of that amount—required to make the Promising Road or DeMarco-Bright plans work as a substitute for Fannie and Freddie. They are theoretical fantasies.

In correspondence with several of the authors of the Promising Road proposal, I have spelled out in much more detail than given in this post (mercifully sparing the reader) why I believe their proposal is not workable. So far I have received no substantive refutations of any of the obstacles I’ve identified or the objections I’ve raised. The most direct responses I’ve gotten have been statements from one of the authors saying “I agree that the face value of a capital market CRT transaction isn’t necessarily equivalent to a $ of entity-based capital,” and “I agree that equity equivalency must be established. There is already work on this.” But I was given no specifics on what that work is, or what evidence exists of it being done. I was told only, “The CRT process as it currently stands is not sufficient. However, the CRT process is quickly evolving and I am confident that it will be up to the task.”

This, to me, sounds like the triumph of hope over experience. And it looks past the obvious solution. There is a mountain of evidence that capital markets investors will not take direct credit risk in anything like the amounts required to make the Promising Road or DeMarco-Bright proposals work. Yet these same investors will put private capital, and lots of it, into companies that themselves take the credit risk, then diversify and manage it—including laying off some to risk-sharing partners when it’s economic to do so, but keeping it otherwise—and pay stable and predictable dividends to the providers of that capital.

Hard equity capital invested up front, in entities responsible for preserving and earning a targeted return on it, is the only sure foundation for the secondary mortgage market of the future. That’s what I’ve proposed with my utility model of Fannie and Freddie, with updated capital standards to ensure they can survive a 25 percent nationwide drop in home prices, and regulated returns to remove any incentive to take excessive credit risk. Ironically, critics of the utility model reject it not because it doesn’t work (it has in the past, and it will work even better in the future with the changes I’m proposing) but because it’s “not enough reform.” Yet that is a hollow objection. Mortgage losses at commercial banks following the financial crisis were three times those of Fannie and Freddie, and we reformed the too-big-to-fail banks not by attempting to replace them but by having them hold more capital and regulating them more closely. That’s precisely what I’m proposing for Fannie and Freddie in my utility model—better regulation and more capital—and unlike the risk-sharing capital required by the Promising Road or DeMarco-Bright proposals, the equity capital needed by the utility model actually is obtainable.

In their current management of Fannie and Freddie in conservatorship, FHFA and Treasury have set their sights on a future risk-sharing model that has no chance of succeeding. And there is real danger in that. It will be very easy for advocates of this model to convince an uninformed public that securities like Fannie and Freddie’s CAS and STACRs really do transfer credit risk, because the experts say they do. But if that happens, the credit risk won’t disappear; it will stay hidden until a downturn arrives, then boomerang back on the issuer of the “risk-transfer” securities, who will be less able to absorb the resulting credit losses because they will have paid billions of dollars in wasted premiums to investors in securities that only pretended to take risk. The most effective way to minimize the chance of this occurring is to hold FHFA accountable for calculating, explaining and disclosing the equity capital equivalency of every CAS and STACR issue Fannie and Freddie do going forward, to prevent us from fooling ourselves that we’re transferring more credit risk than we truly are. The 37 respondents to FHFA’s request for input on credit risk transfers should have made that demand; they didn’t, because they didn’t know they needed to.

113 thoughts on “Getting Real About Reform”

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  4. Tim,

    Good morning. Thank you for taking the time to join the Investors Unite conference call. I wanted to encourage you to join Twitter and create an account. It would be a highly effective way to get your thoughts/ facts out and to remain relative with other mortgage finance professionals that do have active accounts.

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      1. Well, I do a lot of tweeting for the cause but my real enjoyment is between a select, 10 to 20, few in private groups which we have all become close friends for many years now with the same goal in mind. If us shareholders ever get our investment back we will be close friends for life. Nice thing about private groups you are not limited on words. For late comers they almost feel privileged when let in when they see the comradery and high knowledge on topic though not compared to you.

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  5. Tim
    As I understand it and hope you can clarify this, Do Private label mortgage securities have implicit guarantee from the government? They account for 30 percent plus of the 2016 secondary mortgage market. I know you have listed previously the difference between FNF and PLMS. Appreciate clarification.

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    1. First of all, your information about the private-label share of 2016 mortgage securitization is off by a factor of fifteen. According to data published by the Urban Institute’s Housing Finance Policy Center, securitization by the three federal agencies– Fannie Mae, Freddie Mac and Ginnie Mae– accounts for 98 percent of total mortgage securitizations so far this year, with private-label securities making up just 2 percent of the total. Private-label MBS issuance shares have stayed within the 1 to 4 percent range since the collapse of that market in the fall of 2007.

      Private-label securities do not have an implicit government guaranty; they rely on subordination of the lower-rated tranches to provide credit protection for the higher-rated ones. The failure of private-label issuers to provide adequate amounts of subordination in the securities they issued during the 2005-2007 period led to massive losses for investors who bought the AAA- and AA-rated tranches of those issues, and investors’ graphic memories of that experience have kept them from seriously considering any significant commitment of funds to the PLS market since then–hence its minuscule market share from 2008 through today.

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      1. Tim,
        Thank you for the clarification. My PLMS data is taken from the Economist, issue August 20-26, 2016, article on “Comradely capitalism”, chart 3, page 18, source from Inside Mortgage Finance, Urban Institute. However whatever is the right number, it just shows the importance of FNF to the mortgage and housing industry and “fixing what works” and moving forward on your “utility model” is key to strengthening them by releasing them from conservatorship and building up their capital through equity .
        There are news reports that Ackman had a previous meeting with Trump before and now that Trump is President elect, Ackman is looking forward to meeting with him to negotiate on behalf of FNF as a major shareholder. Have you looked at his proposal that includes government exercising warrants? The proposal was on his paper presented during the Sohn conference sometime in May 2015.

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        1. I did look at the presentation Ackman made at the Ira Sohn conference (it was in May 2014, not 2015), after another comment made reference to it. Ackman has the government exercising the warrants, then recapitalizes Fannie and Freddie solely through retained earnings.

          Without significantly raising guaranty fees–and I don’t think higher guaranty fees are warranted either by Ackman’s capital requirements (2.5 percent for the single-family business) or the riskiness of the business Fannie and Freddie are now doing–it takes ten years for the companies to reach his target capital level. I won’t be the one negotiating this, but ten years is a VERY long time to get to where you need to be on capital, and it would require an unprecedented degree of regulatory forbearance. I suspect the regulators will want Fannie and Freddie to reach adequate capitalization much faster than that, which will require some significant capital raised in the equity markets. Warrant conversion, which Ackman supports, will make those capital raises five times harder to accomplish (with a substantial negative effect on the share price).

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          1. What is the procedure if the Gov wanted to negotiate with shareholders? Also, do the shareholders get to vote on anything such as a recap plan or is it mandated by FHFA?

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          2. The government won’t negotiate with shareholders; it may elect to negotiate a settlement with plaintiffs in the lawsuits. That will be complicated, though, because there are so many plaintiffs, and not all of them have the same objectives in a settlement (i.e., preferred versus common shareholders, those who want to get paid on their claims but then have Fannie and Freddie liquidated versus those who want to maximize the values of the companies as going concerns post-recap and release).

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          4. If warrants get exercised, maximum government return would preclude raising capital quickly through additional excess dilution. This fits in well with limited regulation from the Trump administration and, of course, Trump’a deal making, quid pro quo M.O.

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  6. tim

    thanks for you thoughts. herewith mine.

    as to the govt’s exercise of the warrants, we all know that if there is a negotiated 4th amendment that rolls back the NWS retroactively, govt will want to retain some benefits in the bargain. how many benefits will depend upon the tenor of the appeals court opinion in perry, of course (and the prospect of boxing 11,000 documents for plaintiff review in fairholme case), but one way to bridge the gap might be to offer to the govt to keep the full warrant position but pump up the exercise price to a higher price, perhaps something like the 30 day average of the common stock price, 15 days before and after announcement of the deal. that way the govt keeps a profit, but the issuer gets a built-in financing source equal to the higher exercise price.

    all best, rolg

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    1. Given the unconstitutional structure of FHFA and then financial situation, the whole conservatorship is in serious question. Let alone a very unfair PSPA.

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    2. Unlike ROLG I’m not a lawyer, but I would think that to get a definitive settlement from the government you would need to include all of the lawsuits, and all of the plaintiffs. That would include Washington Federal, which has challenged both “the takeover and the terms” of the 2008 conservatorship.

      This conservatorship, of course, allowed Treasury (and FHFA) to balloon Fannie and Freddie’s non-cash expenses and force them to take $187 billion in senior preferred stock they didn’t need, paying an after-tax dividend of 10 percent. Because of those mammoth dividends—along with the net worth sweep—by the end of this year Fannie and Freddie will have paid Treasury $256 billion on “borrowings” of $189 billion. That leaves Treasury with $67 billion that it essentially paid itself for using the companies as an instrument of public policy during and after the crisis.

      If we were to unwind the net worth sweep by retroactively treating each of the sweep’s quarterly remittances in excess of the $4.7 billion dividend payment as a reduction in Treasury’s outstanding senior preferred stock, Fannie’s and Freddie’s senior preferreds both would be paid off (or almost paid off) by the end of this year. Fannie and Freddie would owe no further dividends to Treasury, but Treasury wouldn’t owe anything to the companies either. That is, Treasury would get to keep the $67 billion in net dividends that Fannie and Freddie have paid it to date. Why shouldn’t that be part of the settlement? The Washington Federal plaintiffs would say, “We’ll drop our suit, and you can keep the $67 billion that you granted yourself with the terms you unilaterally imposed on us, but in exchange for that you [Treasury] have to give up the warrants. Sixty seven billion dollars of the shareholders’ money is enough for us to pay you in this settlement.” That, to me, seems more than fair.

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      1. Tim,
        The best option seems to be, to review everything retroactively, make it fair to all and also be compliant with letter and spirit of law. This should set good historical precedent for all such overreach of bureaucratic authorities.

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        1. I agree with anonymous. More than fair to the government, is less than fair to the shareholders. FnF entered conservatorship whole and well capitalized. They should exit conservatorship the same way. Anything less is less than fair to the shareholders.

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          1. Excellent point — “FnF entered conservatorship whole and well capitalized.”

            Gov imposed conservatorship on FnF for public policy purposes and not to help them. Now that FnF have more than fulfilled their public policy mission, Gov should release them in a shape better than what they were before conservatorship.

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      2. i would agree that any settlement requires global participation by all plaintiffs. but while there is often a collective action problem coalescing agreement among many plaintiff parties, here i think a fair settlement would engender unanimity among GSE plaintiffs fairly easily. if you get fairholme, perry and ackman to agree to a deal, then i think most all plaintiffs would quickly follow. would there be any holdout value to be gained by a recalcitrant plaintiff? perhaps, but there would be substantial cost involved for that plaintiff to go it alone by continuing litigation after settlement. the issue that would possibly raise this issue is the warrants, and as tim points out, only wash mututal raised this issue, and they dont seem to be in it to win it, since they are using a class action firm that hasnt been paid by the hour…so wash mutual has shown little interest in putting skin in the game

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        1. As long as the settlements are based on fairness and rule of law/compliance, then there are very good chances that these things will be resolved for good. Otherwise things will linger until SCOTUS rules on all the issues.

          So long, Conservator has tried to avoid trial using every means. When the lawsuits enter trial phase, then conservator will try settlement, otherwise conservatorship will be sitting ducks for attorneys.
          The last hearing in Florida case gives some insight in to how things may work for conservatorship.

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  7. Tim,

    Good afternoon. Are you open to working with the Trump Administration if they were to reach out to you for housing finance guidance? Do you think that John Paulson would be qualified to hold a housing advisor role? Thank you in advance.

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    1. Yes, I would be willing to work with people in the Trump administration on issues related to mortgage reform.

      I do not know John Paulson, and therefore do not have an opinion about his suitability or qualifications for serving as a housing advisor (or in any other capacity).

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      1. I did long ago on this blog. I have also publicly challenged every author of the “kill Fannie and Freddie” “Private Gain Public Loss” lies and not a single one ever took up the challenge to counter Mr. Howard’s facts and figures. Not one.

        Since reading Mr. Howard’s book “The Mortgage Wars” I have held long on knowing the true and verifiable facts combined with the court documents we have seen.

        Thank you Mr. Howard, the Plaintiffs and all shareholders who have invested. Except the fraudulent government shareholders, who I sincerely hope rot in hell.

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  8. There is a contradiction in the “Promising Road” and Demarco-Bright proposals on their political ideology and the the reality of risk sharing first loss capital requirements. The Promising Road’s merging FNF into a government corporation and transferring risk into the private market are in conflict (govt owned and private market risk) while De Marco has the same conflict having Ginnie Mae as a full government owned corporation using its securitization platform to issue securities with Ginnie’s guaranty. Their proposal does not make sense because it does not fix anything. Government still has implied guaranty.

    My questions are: how do you use equity capital in your “utility” model? Utility model as I understand it will keep FNF as a privately run/publicly traded corporation. Would increasing their capitalization by offering shares to public (private in nature) allow them to raise $ 158B in equity capital? Under the utility model how would “implied government” guaranty be eliminated?

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    1. My utility model for Fannie and Freddie begins with their regulator, FHFA, setting specific risk-based capital standards for their single-family credit guaranty business, by “risk buckets” (combinations of loan-to-value ratios and credit scores). Based on my analysis of the companies’ credit losses in the 2008-2012 period– that is, post-housing market collapse–on the types of mortgages Fannie and Freddie are guaranteeing today (excluding interest-only adjustable-rate mortgages and low- or no-documentation loans, among others), I estimate that Fannie and Freddie could protect against a 25 percent future decline in home prices with less than 2 percent equity capital. In my “Fixing What Works” proposal (available on this website), I recommend a minimum capital requirement for the companies of 2 percent equity capital, and higher capital should their mix of business change to include greater amounts of higher-risk loans. Two percent equity capital on Fannie and Freddie’s current $4.5 trillion in single-family mortgages is “only” $90 billion, not the $158 billion the authors of the Promising Road proposal and DeMarco and Bright claim is needed for their systems.

      That $90 billion would be raised over time (pursuant to a capital plan filed with FHFA), in two ways: by offerings of common equity and preferred stock to private market investors, and through retained earnings on their current business (after the net worth sweep either is ruled illegal or canceled). The need to raise equity in the public markets is one reason I believe supporters of Fannie and Freddie should not advocate allowing Treasury to keep and exercise the warrants for 79.9 percent of the companies’ common stock as part of a negotiated settlement of the net worth sweep lawsuits. Using just Fannie Mae as an example, Treasury’s exercise and sale of the warrants would drop the company’s (post-net worth sweep) stock price from the $75- $100 range to $15- $20. Treasury’s subsequent sale of their Fannie stock (over time) would give $60 to $80 billion to the government (taking it out of the mortgage finance system), while leaving Fannie needing to issue five times as many common shares to reach its capitalization target as it would need had Treasury not been able to convert the warrants. I view warrant conversion as an insurmountable obstacle to recapitalizing Fannie (and Freddie) as a private company, which is one reason I oppose it so strongly. (The other reason is that Treasury unjustifiably and illegally granted itself the warrants after forcing Fannie and Freddie into conservatorship against their will, and I don’t think Treasury should be rewarded for that).

      I believe there DOES need to be some form of government guaranty in the future secondary mortgage market, in order to keep mortgage-backed security yields down and thus make the mortgages financed through this system more affordable. In my utility model, I propose what I call an “exchange for consideration” between the companies and the government. Fannie and Freddie’s Boards of Directors agree to accept stringent risk-based capital standards AND regulated maximum returns on their business, in exchange for a promise from the government to provide temporary assistance, through repayable loans, to them in the unlikely event that their risk-based standards prove insufficient to withstand some future unanticipated crisis. A further option would be for the government to explicitly guarantee the companies’ securities in exchange for a modest (say 5 basis point per annum) annual fee, which would be passed on to and paid by the borrowers who use Fannie and Freddie to finance their loans.

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      1. Here is my opinion. 1% capital for good bucket.

        If Congress wants to expand credit to another lower bucket, please share the risk by giving Fannie proper amount of money as compensation.

        A 100% private company, if for profit, should have no obligation to make housing affordable to risk borrowers.

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        1. The capital will, and should, be set by the regulator, who hopefully will use an objective stress standard in doing so (if it doesn’t, housing stakeholders should object). The utility model I envision is not a “100% private company;” it has either an implied or an explicit guaranty, and I think it should have housing goals. The type of company you describe could be set up by anyone, at any time. So far, no one has.

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      2. Thank you very much for your insights. Your “utility model” is a very deep analysis and doable without even involving Congress to fix what works in the mortgage industry, that has 25 % impact on our economy. As I remember this only needs an administrative order from FHFA as regulator.
        It will allow the continuity of the 30 year mortgage, it keeps the government off the hook and dispels “private gain/public loss” because in your proposal it is very clear that government and FNF can agree for the former to provide temporary assistance through repayable loans to the latter in severe market situation.
        No need to hijack and force FNF similar to what they have done in 2008 and then change the “loan” to an illegal net worth sweep (NWS).
        I hope President Trump and his future Treasury secretary (Steven Mnuchin) and his other economic advisers would listen to your “utility” concept model. Just imagine institutional investors like Goldman Sachs, fund managers can participate in the equity market to raise capital for FNF.
        If this happens your book “Mortgage Wars” can have a sequel “The Stability of the US Mortgage Industry”.
        Finally hopefully the court will see NWS as illegal and immoral.

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      3. I like this. It might verge on being a “best case,” with Shapiro Kamarck being more a base case, but it does seem plausible.

        It sounds like you would redo the “methodology” related to draws on the Treasury to be less punitive, and the “repayable loans” would be at a less punitive rate, say four percent instead of 10 percent.

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        1. I would have the repayable loans be at Treasury’s cost of funds plus some reasonable spread, say 2 percent. And remember, Fannie and Freddie’s senior preferred stock dividend is 10 percent after-tax, which is 15.4 percent pre-tax.

          The reason for the non-punitive borrowing rate is straightforward: FHFA (or the administration, or Congress) picks the stress standard Fannie and Freddie are required to protect against. They will set that standard knowing their task is to find a balance between having the standard be too severe–causing people to unnecessarily overpay for credit guarantees to guard against risks that are too remote– and being too lax and therefore exposing themselves unnecessarily to the need to intervene and support the system. Once the stress standard and its associated capital requirements are set, however, if they prove not to be sufficiently stringent Fannie and Freddie should not be punished more than they already will have been (through losing almost all of their equity and having their stock prices plunge) by forcing them to pay punitive rates on loans intended to tide them over the rough patch.

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      4. Tim,

        Ackman’s plan gives away the warrants (unfortunately), but I don’t think it requires a second dilution of shares for recap. Is his model for recap untenable in your estimation?

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        1. I’m not familiar with the Ackman proposal, but if he allows Treasury’s warrants to be exercised Fannie’s outstanding shares of common stock will rise from 1.158 billion to 5.762 billion. Treasury will get 4.604 billion shares of Fannie stock for nothing, and when it sells them (to another investor), Treasury, not Fannie Mae, will get the proceeds.

          If Fannie stock were worth $100 per share before Treasury’s exercise of the warrants, it would be worth one-fifth of that ($20 per share) after exercise of the warrants. I don’t understand your statement that you “don’t think it requires a second dilution of shares for recap.” ANY new issuance of equity dilutes existing shareholders. If Treasury is allowed to exercise its warrants, every new issuance of shares by Fannie will bring in one-fifth the amount of capital (in dollars) that would have been achievable absent the warrant exercise, That is a huge, and in my view insurmountable, barrier to put in front if the company if you want it to emerge successfully from its (unwarranted) conservatorship.

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          1. Tim,

            I get the dilution to 1/5 share value given that warrants are 4x traded shares, 80% of all shares (including warrants).

            My point is I didn’t think A’s plan pursued recap through new shares. Those new recap shares would be a second dilution given a warrant dilution. He addressed recap but only spoke of warrant dilution.

            Q. Are there viable non diluting ways to recap? I thought Ackman proposed one.

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          2. I’ll need to look for (and then at) the Ackman proposal to respond adequately to your inquiry, and I’ll try to do that tomorrow. Pending that, however, I’d say that if someone had come up with a way to recapitalize a company without diluting its existing owners the world would be beating a path to his (or her) door.

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      5. Tim,
        In your valuation of “$75- $100 range,” what kinds of assumptions put it closer to $75, and what kinds put it closer to $100? I have seen much higher valuations, for instance, Ackman’s from 2014. It would be interesting to see how the regulatory framework and valuation scenarios work together in thinking about a recapitalization plan.

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        1. The most critical assumption in anyone’s stock price estimate for Fannie is the company’s price/earnings ratio—and that unfortunately is the most conjectural and the hardest variable to project with any reliability. My $75-$100 price range for Fannie stock (using only 1.158 billion shares of outstanding common stock—i.e., no warrant conversion) assumes a P/E ratio of 10, about half the market multiple. Fannie has a long history of having a significant P/E discount to the market, and with all of the uncertainties facing the company I wouldn’t see that changing any time soon, particularly with the prospect of significant shareholder dilution from future capital raises tossed in.

          After you make your P/E assumption, you’re down to the earnings themselves. I make my earnings projections by business segment—single-family, multifamily, portfolio and other. I assume constant volumes for Fannie’s single-family business (which hasn’t grown since the end of the recession), the portfolio falling to its mandated cap of $250 billion, and the multifamily business growing modestly. I use projected net margins (guaranty fees less administrative expenses and normalized loss provisions) of 40 basis points for the single-family guaranty business and 70 basis points for multifamily, and 100 basis points (including a guess on amortization of the cost of swaps and swaptions) for the portfolio. That gets me to $15.3 billion (pre-tax) for those three segments, to which I add a billion dollars for normalized “fee and other income,” leaving me at $16.3 billion for the company. That’s $10.6 billion after-tax, or $9.15 per share (using the 1.158 non-diluted share amount). A P/E of ten then gets you to a share price of $91.50. Adding ten percent for favorable surprises gets you to about $100, and taking about 20 percent off (because typically there are more bad things you don’t anticipate than good ones) gets you to $75.

          That’s the “open kimono” on my price estimate for Fannie stock. I don’t know how Ackman gets to his estimate.

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          2. Hi Tim,

            2 questions about your earnings estimates assumptions.

            1. Does one need to subtract interest/dividend on preferred shares to arrive at pre-tax EPS for common shareholders? Is there also a need to subtract any kind of interest expense on debt or is 40bps net gfee on single fam business assumes that no debt is needed for this business?

            2. 40bps fee (after admin expenses and loss provisions) is probably around 60bps before fees. How likely that this level of gfees will continue and not revert down closer to historic levels (what was it before – 30-40bps before fees)?

            thanks a lot

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          3. On your first question, no, pre-tax EPS does not include deductions for dividends (if and when paid) on (junior) preferred stock. And while there is some debt in the credit guaranty business (to fund non-performing loans purchased out of mortgage-backed securities pools), I’ve ignored it in my rough earnings approximation (just as I’ve ignored interest on capital and remittance float on MBS, which, at current levels of short-term interest rates, are de mimimis).

            On your second question, the 40 basis point net fee in my calculation is closer to 55 basis points gross. And that’s assuming a somewhat higher percentage of lower-credit score loans than Fannie has been doing in the last couple of quarters. As long as FHFA is subjecting Fannie to arbitrary capital requirements, I wouldn’t see the gross fee going much below 45 basis points, although if and when FHFA follows HERA and updates Fannie’s REAL risk-based capital requirement, the gross fee could go to 40 basis points or even a bit lower (i.e., a net fee of somewhat under 30 basis points).

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    1. I have no reason to think that any sort of “political decision” is in the works (although I’ve read speculation about that), so by default I would say a court decision is most likely to come first– either the (long awaited) decision from the appellate judges in the Perry Capital case, or a ruling by Judge Sweeney on the government’s petition for a writ of mandamus overturning her decision to compel production of the 56 documents plaintiffs’ counsel has requested.

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      1. Hi Tim
        How could judge Sweeney rule on the government’s petition for a writ of mandamus? can she rule? or she has to wait the Circuit Court rule?

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        1. My mistake– I wrote my response too quickly. It will be the U.S. Court of Appeals for the Federal Circuit that will rule on the writ of mandamus, and Judge Sweeney (and the government) will act in accordance with that ruling.

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  10. Tim,
    Would you be open to going back to Fannie Mae if invited by the new administration? If you haven’t thought about that, under what conditions would you consider such a proposal? Your expertise in guiding the companies forward would be a big boon to the stability of the mortgage market.

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    1. If asked I certainly would consider it, although I would want it to be in a transitional role–leading to longer-term leadership by another management team–rather than an open-ended assignment. (I’ve grown quite accustomed to not having to go to an office every day.) In addition, somebody’s lawyers would need to deal with the consent decree Fannie Mae signed with the SEC and OFHEO (FHFA’s predecessor agency) in 2006–and I agreed in 2008 not to challenge–in which the company said it would not employ me in the future.

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  11. Hi Tim
    May I use your blog to express a personal opinion?
    I think that FannieGate is Obama’s own to be scandal. Donald will not pick up the tab. If there is no settlement in the next few weeks, the first thing Donald will do is expose all the 11,000 documents to not get himself stuck in the affair. This old fox will choose to not inherit problems.

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    1. And ,also PriceWaterhouse is not off the hook with the recent settlement, because WF has been stayed and hence the statute of limitations do not apply to them and they will come behind PWC

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    2. Not to appear contentious but the new president will have the most powerful nation in the world to run. I wouldn’t expect GSEs to make his top 5. It’s nowhere listed or inferable in his contract with America.

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    3. Let me answer Eric’s question by making a general statement about the purpose of this blog, then giving some thoughts on how I’d like to manage it.

      My intention in starting the blog this past February was to create a source of information and analysis on mortgage finance issues, where people could both learn things they didn’t know and present and defend views that might be counter to the ones I had. I deliberately did NOT want the site to become a “message board,” where literally anyone could give their opinion (often, as occurs in other blogs, at great length and with no evident factual basis) without providing any valuable or useful insight to the reader. It’s a judgment call on my part when an opinion is useful or interesting as opposed to being just a personal airing of views, but I’m comfortable making that call. Several readers I’m sure have noticed that comments they’ve made have been deleted, and that’s typically the reason.

      Let me be clear, therefore, on my ground rules for personal opinions. If a commenter is just giving their opinion on an issue, without adding any insight, perspective or other information that might be of interest to the rest of the readership, I’m likely to delete that comment. I do want to encourage different or dissenting views, but there also is a “quality hurdle” those views need to clear before I will leave them on the site.

      And there is one other informal rule I should inform people about: if any commentator gets to a point where they have too high a percentage of recent questions or comments on the site (another subjective call on my part), I’ll use a tougher grading standard in deciding which of their additional questions or comments to leave up and respond to.

      I hope these rules make “Howard on Mortgage Finance” a better site, and one readers can come to for reliable information and analysis, with a minimum of chaff.

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      2. Assuming the NWS is reversed and this money is applied to retiring the original sr. preferred, how large of a capital raise would be needed? I guess you would also have to take into consideration retained earnings over a certain period of time.

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        1. If the net worth sweep were to be reversed as you describe, Fannie would have essentially no capital but also would be able to keep all of its retained earnings going forward. (Interestingly, if reversal of the net worth sweep is delayed beyond the end of this year, Treasury will end up owing Fannie money, an amount that will grow each quarter and thus help the company recapitalize.)

          With a 2 percent capital requirement on Fannie’s single-family credit guaranty business, an additional 2 percent for the interest risk in its mortgage portfolio, and a (guesstimated) 3 percent capital requirement for its multifamily guaranty business, Fannie would need $70 billion in capital (roughly $60 billion for single-family, $5 billion for the portfolio’s interest rate risk, and $5 billion for multifamily).

          You wouldn’t need all of that as raised equity capital, however. If I were at Fannie, I would get together a group of investment bankers and senior FHFA officials and devise a capital plan that reaches the target capitalization amount as quickly and efficiently as possible. I would ask the investment bankers to opine on the optimum sizes and pacing of a series of common equity issues—with some issues of preferred stock mixed in—and their advice on timing would determine how much reliance could be placed on the accumulation of retaining earnings in meeting the ultimate target (the more time we have, the more we could rely on retained earnings to get where we need to go). I also would ask FHFA to give us “check points” for the capital plan—how much capital must be raised by when–reflecting the fact that Fannie’s current book of business is, as the Urban Institute recently said, “squeaky clean” and therefore won’t require 2 percent capital right away to meet FHFA’s stress standard.

          There’s one final wrinkle I’ll just touch on here. As of September 30, 2016, Fannie had $22.5 billion in its loan loss allowance. That’s capital. But $21.3 billion of that is tied up in “life on loan” reserves on loans that were modified pursuant to Treasury’s mandatory Home Affordable Mortgage Program (HAMP). The vast majority of these HAMP reserves are against loans that are now performing, but the accounting rules require that the loss reserves be maintained until the loans either amortize or are paid off. If I were at Fannie—and searching for a way to reach full capitalization as quickly as we could—I would look very hard at ways to free up as much of that “regulatorily immobilized” capital as I could. Any amounts of loss reserves moved from the “individually impaired” to the “collectively reserved” category would reduce the amount of the equity capital the company would need to raise.

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          1. Thanks. The companies currently have $billions of non-cumulative jr. preferred stocks, some of them owned by noted activist investors. How would you deal with these obligations in a recapitalization plan? As non-cumulative, can they simply be ignored indefinitely?

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          2. It won’t be up to the companies (or me) to deal with the existing junior preferreds; their fate will depend on the outcome of the court cases, or a negotiated settlement. I know the goal of the preferred investors in the suits is to have their securities redeemed at par. Fannie and Freddie together have about $20 billion in face value of outstanding junior preferred shares today; redeeming them all at par would raise the companies’ recap requirements by that same amount– $20 billion.

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  12. Hi Tim,

    Now that the election is coming to a close, what’s your take on whoever who won will affect the fate of fnf. I know that many are saying its in the courts hands but I just like to hear your opinion. Baring in mind it’s the republican motive to do away with fnf ( and trump is winning as of now). Democrats on the other hand are just too greedy for fnf money.

    Cheers,
    Rick

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    1. Well, the election now HAS come to a close, and Donald Trump is the winner. He said nothing about Fannie and Freddie during the campaign (or, as far as I know, elsewhere) so I have no basis for speculating about what his position on the companies will be. Absent informed analysis or reporting from other sources, my position will be to wait to see who he appoints as his key economic and policy advisers and to his cabinet, then assess their views and past histories before coming up with a point of view or strategy for the best way to proceed with the Trump administration to maximize the chance of constructive mortgage reform.

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  13. Tim, How much below comment is valid?

    http://thehill.com/blogs/congress-blog/economy-budget/304804-what-the-administration-can-do-now-on-housing-reform

    Allowing the GSEs to retain capital, gives them the means and independence to strike a prudent balance of risk with the availability of credit, particularly to less affluent, and underserved, borrowers. Weak or non-existent capital causes institutions to constrict their credit standards and make credit available only to more affluent borrowers in order to avoid risk.

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    1. I largely agree with the first sentence, although I believe it is the responsibility of regulators, the administration or Congress–and not the credit guarantors themselves–to set levels of required capital that strike an appropriate balance between the price and availability of mortgage credit to a wide range of borrowers and protection against systemic risk. I don’t know what to make of the second sentence, at least as a general statement. If by “weak” capital the author means low capital requirements, I don’t agree that would lead to less risk-taking or a bias in favor of more affluent borrowers, although if weak means ill-designed or ineffective, it could. Finally, non-existent capital seems to be a specific reference to Fannie and Freddie’s current situation with the net worth sweep, and here I don’t believe the inability to retain their earnings is the reason the companies’ business has skewed away from affordable housing borrowers towards “squeaky-clean” credits; I think that has more to do with the arbitrary (notional) capital requirements FHFA has imposed on the companies as a basis for their setting of guaranty fees.

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    1. I’m not surprised that a hedge fund would want to have a rating agency again say “the whole is greater than the sum of its parts” and give an investment grade rating to a new security made up of sub-investment investment grade components—that enables the hedge fund to finance the new security with cheaper borrowings—but I AM a little surprised that Fitch is willing to go back down that road after what happened with CDOs during the housing bubble. The article is vague on why the Fitch analyst (identified as Grant Bailey) thought it was appropriate to do that; it simply quotes him as saying that he used a “different way to assess them,” without which “the grades for the top-rated notes might have been four or five steps lower.” I’ll see if I can find something from Fitch that is a little more specific about the rationale for the rating before saying anything other than that I’m surprised they’re going near that hot stove again.

      Still, I do think there is a huge difference between this new security (however it works) and the pre-2008 CDOs. CDOs took very risky and low-rated tranches of subprime and other private-label securities, put them all together in a new pool and tranched it, then convinced the rating agencies that the risks on the component pieces were independent and not correlated, so they graded 80 percent of the new security AAA or AA. That, as you know, did not work out well. In the case of Fannie and Freddie’s CRT tranches, however, these are securities that are NOT very risky, because they pay extremely generous yields and are highly unlikely to take credit losses. I think Fannie’s CAS and STACR tranches are rated too low for what they are. And that may in fact be what the Fitch analyst is doing: he may be looking at how the reference pools for older Fannie and Freddie CAS and STACR tranches are performing (which is exceptionally well), seeing how quickly the tranches are amortizing or paying down because of pool prepayments, and concluding that there is even less of a chance of credit losses being charged to these tranches then there was when they were issued—hence the higher rating.

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  15. Tim, does it bother you that an imposter is using “Timhoward717” on Twitter? His real name is Patrick Malloy from Connecticut. His scotch induced rants about Trump are really hurting the cause. #Fanniegate

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    1. No, it doesn’t. “Timhoward717” and I have very different audiences and purposes, and I don’t know anyone whose views or knowledge I respect that confuses the two of us. I’m not on Twitter and therefore don’t see what he writes there, but I suspect that if he were to change his pseudonym to “macaroni” he would write the same things.

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    2. Both gentlemen you mentioned were invited to speak on a GSE panel, later this month in the Big Apple, to discuss/debate the various “new US mortgage model schemes.”

      One immediately said “yes” and the other said he couldn’t make it.

      I’ll let you figure out who was whom?

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  17. Hi Tim
    some couple of years ago, an author in seeking alpha said that the g-fees to be collected in the future by FnF could be converted in securities at the present time and sold for a quick capitalization. Is it possible ?

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    1. It’s possible, yes, but the companies would be foolish to do it; the “capital” that would result from this sale would be swept to Treasury in the following quarter, leaving them with no capital AND no future guaranty fees (of those that were securitized and sold).

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    2. Given current low share price, current holders would not like a public offering. With Net Sweep, not even a fool would be interested. .

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  19. Tim,

    This looks to be based on fully diluted:

    “• Freddie Mac (OTCQB:FMCC): Q3 EPS of $0.01 may not be comparable to consensus of $0.28.”

    Grabbed from seeking alpha.

    I think I understand .28: 1.12 annualized x 5 (to get to undiluted) x 10 p/e = 56 & 11.2 fully diluted. That seems somewhat reasonable.

    What’s the .01 EPS? And .04 for Fnma?

    Thx.

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    1. I don’t know what the Seeking Alpha authors were referring to with their “consensus of $0.28” for Freddie Mac. I doubt it was any measure of earnings per share. (And in your attempted reconciliation a P/E ratio is not relevant, because it’s not an element of an earnings per share calculation).

      Both Fannie and Freddie explain their third quarter EPS numbers in their earnings press releases. I’ll give Fannie’s (Freddie’s can be found at the bottom of page 14 of their release): Its “Net income attributable to Fannie Mae” for the third quarter was $3.196 billion. After “Dividends…available for distribution to senior preferred shareholder” (through the net worth sweep) of $2.977 billion, Fannie is left with $219 million in “Net income attributable to common stockholders.” At both June 30, 2016 and September 30, 2016, Fannie had 1,158.1 million shares of common stock outstanding (EPS is calculated based on average shares outstanding during the quarter). In calculating both basic and diluted earnings per share for the quarter, Fannie assumes Treasury’s warrants for 79.9 percent of the company convert, so the 1,158 million shares owned by shareholders become 5,762 million for basic weighted-average common shares outstanding, and 5,893 million for diluted shares outstanding. Dividing the $219 million in net income attributable to common shareholders by either 5,762 million or 5,893 million shares outstanding gives you earnings per share (EPS) of $0.04 for the third quarter.

      Freddie’s calculation leading to a $0.01 third quarter 2016 EPS is done exactly the same way.

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      1. “And in your attempted reconciliation a P/E ratio is not relevant, because it’s not an element of an earnings per share calculation.”

        Obviously it’s not a component of p/e. Rather, I was trying to rationalize the twenty some cents to what we might expect to be a reasonable share price (apart from c-ship).

        Thx.

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  20. Since no one asked, I felt compelled to ask.

    On September 23rd, Fairholme delivered a letter (Doc. 1637216) under seal to Perry Appeals Court advising them of additional authorities. Fairholme’s letter presumably discusses Judge Sweeney’s discovery-related Opinion and Order dated Sept. 20, which is also under seal at this time.

    Do you think the judges in the Perry Appeals case would be willing to review the additional discovery evidence from Federal Claims before moving forward with an Opinion? Therefore, we might not get any opinion from Appeals Court until later.

    Your thoughts would be greatly appreciated.

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    1. I do not have any non-public information on this, but I do not believe the appellate judges are waiting on resolution of Judge Sweeney’s order to compel production of the 56 documents (which now has become a motion by the defense for a writ of mandamus, adding more time the the process) before issuing their ruling on the Perry Capital appeal.

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    2. I’m not a lawyer. But I guess that any significant decision by any court, if favorable to us, will arrive likely after Obama leaves. The current DOJ will do everything to delay an embarrassment or loss.

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  21. Hi Tim
    I have a question (maybe for the lawyers here): the petition of mandamus and the appeal are before the same judges? . I assume that both are in the same Court of Appeals known as “Federal Circuit”. Am I right?

    Second question: How long can it take a decision in the mandamus? and in the appeal?

    Third question: Would a new President pick up the tab? I mean why would a new President cover the wrongdoing of the former President and be left holding the bag? In the shoes of the new President the first thing I would do is order the total disclosure of the documents, otherwise I will find myself paying the bill without even smelling the dinner.

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    1. On your first question, the appeal of the Perry Capital decision is before the U.S. Court of Appeals for the D.C. Circuit; the petition for a writ of mandamus to the U.S. Federal Court of Claims is before the U.S. Court of Appeals for the Federal Circuit. They are different bodies, so the appeals will be heard by different judges. Most informed observers expect a decision in the Perry Capital appeal to come at any time (decisions are issued on Tuesdays and Fridays); I don’t know what the expectation is for a decision time on a writ of mandamus.

      I think your third question greatly overstates the independent role of both President Obama and the incoming president as it concerns the fates of Fannie and Freddie. The government’s current position on Fannie and Freddie, both in the courts and in mortgage reform, is driven by Treasury, and supported by the large banks and Wall Street firms. Treasury as an institution has opposed Fannie and Freddie for over two decades, through both Democratic and Republican administrations. Whichever party wins the White House next week, it’s going to take a concerted effort to get the new president’s financial advisors–who almost certainly will come from the same commercial or investment banking environment that has been so solidly arrayed against the companies in the past–to focus on the issues we all know so well, understand them, and then have the will and the commitment to take on Treasury and what I call the Financial Establishment and fight for what’s best for ordinary people and the country on mortgage reform. It will be an uphill battle.

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        1. Both institutions were critics or opponents of Fannie (and to a lesser extent Freddie) when I joined the company in 1982, so there’s considerable history here. Here is what I said about the reasons for their opposition in my book: “The Federal Reserve and Treasury were mistrustful of a profit-making entity with the implied backing of the government but not controlled by it, and they felt Fannie Mae’s government sponsorship gave it the ability to expand its business at will (to the disadvantage of the competitive position of the banks they regulated) as well as the incentive to take excessive risk.”

          For close to 20 years we tried to satisfy both the Fed and Treasury that we were doing more to control our interest rate and credit risks than any other institution that financed mortgages, and we were the subject of numerous government agency studies that confirmed this (or at least made no substantive suggestions as to where and how we should improve). The Fed and Treasury’s opposition really ramped up in the late 1990s, after Fannie got very large and its market power increased. When a Treasury undersecretary (Gary Gensler) testified in Congress in favor of removing some of Fannie’s agency attributes in March 2000, we (I was Fannie’s CFO at the time) held a series of meetings with Secretary Summers’ top staff to explain in detail to them what our risks were and how we were managing them, and we offered to voluntarily undertake a series of risk management or disclosure initiatives if Treasury would publicly vouch for the efficacy of our risk management. Summers would not do that (and we ended up adopting the six “voluntary initiatives” anyway). I summarized this episode in my book: “Treasury was not going to sign on to a deal that could make Fannie Mae stronger, even if it involved a reduction in taxpayer risk. Treasury’s opposition was absolute. They, along with the Federal Reserve, were committed to constraining us and over time to replacing us as the foundation of the U.S. mortgage finance system with the free market alternatives they favored.”

          Sixteen years later, little has changed.

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      2. Thanks for your answer. In my second question I was not clear enough. Sorry.I was asking about the appeal of Mrs Sweeney order to produce the 56 documents not about Perry’s . Do you have any idea of how long can this appeal take? The question is because I assume that if the mandamus is denied , we still have to wait for a decision in the Court of Appeals for the documents to be produced . Am I right?

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        1. No, I don’t think you are. I’m not a lawyer, but I believe that if the writ of mandamus is denied, defense counsel must turn over the 56 documents to plaintiffs’ counsel to avoid being held in contempt of court.

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  22. Tim,

    Good afternoon. Were you surprised when Berkowitz publicly endorsed Donald Trump for President? I think this speaks volumes for the transparency and honesty issues that have plagued investors by way of the Obama Administration. It seems that having John Paulson involved with the future decision making process would be a fantastic development for investors currently being deceived. Gene Sperling also seems to be a major threat to investors. We were curious as to your thought process as it pertains to the current political landscape.

    Thanks,
    #FannieGate

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    1. Well, in just over a week the political landscape for the next two years (Congress) and four years (administration) will be clarified. Nothing I’ve seen during the campaigns has made me think there will be much likelihood of Congress being able to agree on legislative mortgage reform in the coming session, whether the Republicans retain the Senate or not. That means, for me, that changes to the status quo for Fannie and Freddie will come down to (a) what the courts do, and (b) how the next administration reacts to that. As the winner sets up their cabinet and chooses their key advisors, we’ll all get a better idea of who we’ll need to try to influence to get the Fannie and Freddie situation resolved in the best way possible.

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    1. No. I don’t have any information about it, and opinions without information aren’t worth much.

      But to be candid, I likely will try to get some information about it soon– to confirm (or refute) my suspicion that settlement of the PWC case allows more time, money and energy to be put into the more potentially important and consequential Deloitte case– but I will do so under a promise of confidentiality, and so will not be able to share what I learn.

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  24. Good Morning Mr. Howard .
    fannie and freddie’s portfolio has decreased $ 883.621 millions so far. this decrease has adversely affected companies. severe blow.
    my question is what relation is there between quantitative easing and companies’s portfolios?
    Thanks in advance

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    1. Actually, Fannie and Freddie’s combined on-balance sheet mortgage portfolios have shrunk by over a trillion dollars in the last seven and a quarter years: they reached their (combined) high point of $1.65 trillion at the end of March 2009, and in June 2016 totaled $637 billion (about $320 billion each). That shrinkage certainly has cost them considerable net income, but that was by design. When it created the Preferred Stock Purchase Agreements for the companies, Treasury mandated annual shrinkage in their on-balance sheet portfolios until they each reached $250 billion each. We’re now almost there.

      There certainly IS a relationship between Fannie and Freddie’s portfolio shrinkage and the Fed’s quantitative easing activities; the question is how much of that relationship is coincidental and how much is deliberate or causative.

      I’ll start with an irony. Fed Chairman Alan Greenspan– who was a fierce opponent of Fannie and Freddie’s portfolio business– consistently maintained that the portfolios only served to make money for the companies, and provided no benefits to either the cost or availability of mortgages. (I thought that was nonsense, and said so in my book.) But as soon as Fannie and Freddie’s portfolio shrinkage began, the Fed started buying Fannie, Freddie and Ginnie mortgage-backed securities, “to support the mortgage market.” The Fed owned zero agency (Fannie, Freddie and Ginnie) MBS at the end of 2008; a year and a half later it owned over a trillion of them ($1.12 trillion as of June 30, 2010). I have no doubt that a large part of those purchases were intended to offset the otherwise negative impact of Fannie and Freddie slowly exiting the portfolio business, at a time when the housing market was struggling to recover from its meltdown.

      And then something interesting happened to the Fed’s agency MBS holdings. Between mid-2010 and the fall of 2012 they fell by almost $300 billion, to $835 billion on October 10, before they suddenly shot up again, rising to $1.75 trillion at the end of 2014 and staying at about that level since that time. It may just be coincidence, but this second round of increase in Fannie, Freddie and Ginnie holdings by the Fed came right after Treasury and FHFA agreed to the net worth sweep. I’m speculating here, but I wonder if the Fed’s renewed interested in buying agencies post-sweep had anything to do with a view that with the companies effectively nationalized (at least as Treasury and FHFA saw it), it would henceforth be buying not the MBS of two companies that could be potentially returned to private ownership, but rather the securities of companies Treasury intended to keep control of indefinitely.

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  25. Tim – I totally agree with you that the 3.5% figure for upfront capital is way out of line. If that were real equity capital that needed to earn equity risk returns, the cost of GSE mortgages would no longer be affordable. The proposals you address only work if the risk transfers have artificially low costs because the amount of risk transferred is limited and the capital backing the risk is really debt capital (versus equity capital) coming from the repo market. While lower cost initially, and seemingly affordable, significant reliance on such risk sharing approaches would have a cost down the road in terms of taxpayer exposure and systemic stability.

    I also note that the gfees borrowers pay must be looked at as a source of capital. Consider that a 40bps gfee will produce 160-200 bps of future loss absorbing capacity. The first principal of insurance is the mutualization of risk, where the premiums of those who do not experience a hazard cover the losses of those that do. To ignore this is to make borrowers overpay for the cost of credit. This makes little sense.

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    1. Adolfo: I agree with you on both points. The 3.5 percent capital figure is an artificial number, based on the average capital required of Fannie and Freddie by FHFA currently, which in turn was set as part of its initiative to “move their pricing structure closer to the level one might expect to see if mortgage credit risk was borne solely by private capital,” as noted in the post. It has nothing to do with risk (or making mortgages affordable to homebuyers). To the contrary, the Housing and Economic Recovery Act of 2008 mandated FHFA to set true risk-based capital requirements for Fannie and Freddie, and FHFA has yet to do that. If it did, the fact that charged guaranty fees absorb losses WOULD reduce equity capital requirements, as you point out, making them far lower than 3.5 percent given anything close to the mix of mortgage business being originated today.

      Advocates for the Promising Road and DeMarco-Bright proposals are fond of saying that their plans “wouldn’t push guaranty fees any higher than they are today.” But that claim is both misleading and false. It’s misleading because guaranty fees today are higher than they should be–precisely to make it easier for plans like these to seem successful. More importantly, though, securitized risk-sharing structures will be much less available, if available at all, during more difficult housing markets. Then–if we’re relying primarily or solely on risk-sharing to attract capital–mortgage rates will soar. We shouldn’t need to wait until that happens to realize it will.

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    2. The 3.5% capital, I believe, came from the some study on loss of GSE MBS in the past crisis.

      The number does not consider that the current and likely future underwriting standard is far stricter than then.

      My opinion: 1% would be fine.

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  26. Hi Tim, did you have a chance to see the what happened in Sweeney’s court today?

    Fairholme asking for documents, then Sweeney giving gov deadline and then Gov appealing motion to compel.

    I have never witnessed such a huge attempt to try and hide hide hide in my life. It really is disgusting what this administration is doing.

    Do you have any thoughts?

    How long could this appeal take?

    Thank you
    Billy

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    1. I did see these developments, and wasn’t surprised by them at all. Judge Sweeney issued her order to compel production of the 56 documents over three weeks ago. The government has the documents, obviously, and the fact that it didn’t give them to plaintiffs’ counsel immediately was a strong indication that it intended to file a writ of mandamus asking the federal court of appeals to override Sweeney’s order. That’s been the government’s legal strategy from the start: use any legal means to drag the case out as long as it possibly can, in the hope that something serendipitous happens in the meantime. Sweeney, I believe, feels she has to play along, to make it more difficult for the government to find procedural grounds for (successfully) appealing her ultimate ruling.

      As for how long this appeal could take, I don’t have the answer to that. Perhaps one of the lawyers following this blog does.

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  28. I hope the judges in our court cases read this article and the rest of this blog’s undeniable observations. There is no way a reasonable person with a decent understanding of the history of this conservatorship could say the government’s intentions are just or in the best interests of those Fannie and Freddie have served.

    “Hard equity capital invested up front, in entities responsible for preserving and earning a targeted return on it, is the only sure foundation for the secondary mortgage market of the future.”

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  29. The main problem seems to be, Conservator is gambling in trillions with shareholder’s and taxpayer’s money. The worst part is, no one including courts can question conservator. In which part of world do they allow one person to manage trillions of dollars without any questions?

    It is doubtful that they even have one mortgage finance expert in Conservator’s team.
    Working for FHFA must be lawyer’s dream. Probably by now the legal budget of FHFA must be matching that of DOJ.

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  32. It doesn’t get said often enough, but I think you are doing a great thing by putting forth your time and effort to make sure that the government does this job correctly. Making sure that people can have a place that they can call home is the American dream and I am glad you are doing your best to preserve that part of our nation’s identity. Thanks again Tim.

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  33. Some further thoughts along the same lines about risk sharing bonds.

    “The tax section of the bond documents suggest there isn’t much risk of bondholders not getting paid. The companies both expect that payments under the bonds will be favorably treated as “qualified stated interest” payments, because the likelihood of reductions in amounts owed to investors is so “remote” that they can be considered unconditional payment promises.”

    http://www.wsj.com/articles/freddie-and-fannie-bonds-dont-share-and-share-alike-1403558448

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    1. This coming from the same USG personnel that swore to defend the constitution against all enemies, foreign and domestic. They now Taos the middle finger to the 3rd amendment. Low trust is increased risk to no payments whenever they want.

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  35. Excellent analysis and counter proposal, Tim.

    If only a few more “mortgage finance experts” come off the sidelines, look at what you’ve written, independently verify it, and–if they agree–repeat it, maybe others in DC (think Congress and new WH) will begin to get the message that UI and “the two who should remain nameless for past GSE transgressions” are peddling horse manure.

    For these new proponents, it doesn’t seem to be about identifying the most effective way to finance mortgages for low, moderate, and middle income Americans–employing past workability– but how far they can go to avoid the GSE success, since the failure of their new systemic proposals, if implemented, only will be realized years after they depart the scene.

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    1. Bill you are too kind to them because horse manure is still a good thing for fertilizing plants. I used to peddle when I was a kid

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  37. 1. FHFA sees credit risk transfers not as a supplement to Fannie and Freddie’s risk-taking but as a potential replacement for it.

    2. … hold FHFA accountable for calculating, explaining and disclosing the equity capital equivalency of every CAS and STACR issue Fannie and Freddie do going forward, to prevent us from fooling ourselves that we’re transferring more credit risk than we truly are.

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