Risk Transfers in the Real World

Earlier this month Jim Parrott of the Urban Institute published a piece titled “Clarifying the Choices in Housing Finance Reform,” in which he compares three proposals for possible replacement of the current system built around Fannie Mae and Freddie Mac: the Urban Institute’s “Promising Road,” the Milken Institute’s “Toward a New Secondary Market,” and a work in progress from the Mortgage Bankers Association (MBA) called “GSE Reform Principles and Guardrails.”

In his piece, Parrott seeks to dispel the notion that the three proposals are “entirely different versions of reform,” saying instead that “they actually share a great deal and…deciding among them is not prohibitively complex, but a matter of assessing two or three key differences.” He identifies those differences as “what to do with Fannie and Freddie,” and whether the Common Securitization Platform or Ginnie Mae should be used to issue mortgage-backed securities. He also states that among the features common to each proposal is that they “distribute all [Urban Institute and Milken Institute] or most [MBA] non-catastrophic credit risk” to capital market investors “at time of origination or after pooling” [bold type in original]. That is, all three proposals—which Parrott claims represent “dominant versions” of the “strong majority view” on mortgage reform—rely exclusively or extensively on risk transfer mechanisms to absorb credit risk.

Conspicuously absent from Parrott’s review, however, is any objective assessment of the relative merits of the risk-transfer model compared with Fannie and Freddie’s equity-based model and, equally if not more importantly, any description of how the risk-transfer model would work in practice (we know how the Fannie and Freddie model works). Instead, Parrott dismisses the Fannie and Freddie model out of hand, saying, “The problem with this system was its dependence on a privately owned duopoly. Fannie and Freddie handled almost all of the securitization in this segment of the market and took almost all of the credit risk. Given our reliance on them, everyone in the market knew that we would bail them out if they ever stumbled. Their shareholders were thus incented to take excessive risk to chase greater profits, knowing that if their bets did not pay off, the taxpayer would step in to cover them. And that, of course, is precisely what happened.”

Except that’s not what happened. What happened was that our last experiment with “transferring non-catastrophic credit risk to capital markets investors”—private-label securitization—resulted in Fannie and Freddie losing their ability to set national underwriting standards. This led to the quick collapse of those standards (while regulators stood by passively), and a subsequent flood of easy credit that pushed housing activity and home prices to unsustainable levels, from which they inevitably collapsed. Fannie and Freddie were pulled into this vortex as were commercial banks, but unlike the banks—whose mortgage credit loss rates were triple those of the companies—Fannie and Freddie were not thrown lifelines; Treasury effectively nationalized them, without statutory authority and against their will.

A fictionalized version of the financial crisis is a useful device to avoid having to compare the Fannie and Freddie model with the risk-transfer model, and a written advocacy piece also affords the luxury of being able to discuss the risk-transfer model at the 36,000-foot level, where there is no visibility of what would have to happen for it to operate successfully on the ground. But when mortgage reform efforts in Washington get serious and focused, and Secretary Mnuchin becomes fully engaged with them, neither fiction nor vagueness will suffice. With the fate of a $5 trillion market at stake, the Fannie and Freddie model, the risk-transfer model and other models will be reviewed and analyzed in meticulous detail by people with real world mortgage experience. Under that scrutiny, the flaws and unworkability of the Urban Institute, Milken Institute and MBA risk-transfer models will be apparent.

I’ve written extensively about securitized credit risk transfers (CRTs), focusing primarily on Fannie’s Connecticut Avenue Securities, or CAS, but I haven’t brought that work down to the ground level either. In retrospect, I should have. My three primary criticisms of CAS (and Freddie’s similar STACRs) have been that they are too expensive, Fannie has too much first-loss exposure before they take effect, and because the risk-transfer tranches can prepay and amortize over time, they are unlikely to be outstanding long enough to absorb many of the losses that exceed the first-loss limit. My source for this last claim was the risk sensitivity tables in Fannie’s CAS prospectuses, which show virtually no losses transferred to investors in 64 different scenarios of combined credit loss and prepayment rates. But as a commenter on this site recently pointed out (and I thank him for that), Fannie’s loss sensitivity tables “assume that the Delinquency Test is satisfied” in each of the scenarios. In a severe stress scenario it would not be, which means Fannie’s sensitivity tables understate loss transfers in those scenarios, and thus are not a reliable measure of the overall effectiveness of CAS in absorbing credit risk.

It is both surprising and disappointing that Fannie would publish tables in its CAS prospectuses that omit a key variable and thus understate potential loss transfers to investors, but since it does, the only way to realistically assess the effectiveness of CAS is to simulate their performance in an actual stress environment. I now have done that. I’ve taken Fannie’s book of business at December 31, 2007, by origination year, assumed all of its $2.53 trillion in single-family mortgages were covered by CAS risk-sharing tranches upon acquisition, then analyzed that book’s credit performance through the end of 2016—specifically, which origination years took what losses, and whether CAS investors or Fannie would have picked them up.

Before I get to the results of this exercise, I should summarize how the current CAS structures work. Fannie takes the first 100 basis points of credit losses on each insured pool. (Recently it has begun sharing a portion of those first losses on a pari passu basis with investors, but the price it pays for this loss sharing—more than 12 percent per year—makes the economic effect little different from keeping all of the credit risk itself.) If cumulative credit losses on any insured pool exceed 100 basis points of its initial unpaid principal balance (UPB), those losses are transferred to the holders of the CAS M-2 tranche until either cumulative losses exceed 275 basis points of the initial UPB or the M-2 tranche is paid off. If losses exceed 275 basis points of the pool’s initial UPB, they are transferred to holders of the CAS M-1 tranche (assuming it’s still outstanding) until the loss rate reaches 400 basis points. Above 400 basis points of the initial pool UPB, Fannie takes all further losses.

Both the M-1 and the M-2 tranches are reduced by prepayments and amortization in the insured pool, unless the Delinquency Test is not met. In that case, the tranches no longer pay down with prepayments, although they do continue to be reduced by amortization. There is a complicated formula for determining when the Delinquency Test is not met, but it can be approximated by when the six-month average of the 90-day delinquency rate for any pool exceeds 1.5 percent.

With that as background, here are the key findings from the CAS stress exercise, using actual Fannie data.

Through 2016, the $2.53 trillion in single-family loans Fannie had on its books at the end of 2007 suffered a total of $85.4 billion in credit losses. Of these, $27.4 billion would have fallen below the CAS first-loss threshold of 100 basis points (and been absorbed by the company). Of the $58 billion in losses above that threshold, fewer than half, or $28 billion, would have been absorbed by holders of either the CAS M-2 or M-1 tranches; $15.9 billion in losses would have fallen within the coverage range of the CAS tranches but not been transferred to them because they would have paid off, and a further $14.1 billion would have been above the CAS coverage maximum of 400 basis points of initial UPB. Thus, even were Fannie to have insured all of its 2007 single-family loans with CAS risk-transfer securities—i.e., were it to have fully adopted the “risk-transfer model”—it still would have had to cover more than two-thirds of its $84.5 billion in losses with a combination of revenues and equity capital.

It’s also instructive to examine these credit losses, and their coverage, in groups: loans from the 2000-2004 origination years taken together, and loans from 2005, 2006 and 2007 individually. (We can safely ignore the small remaining number of pre-2000 loans).

The 2000-2004 books had an aggregate initial UPB of over $3.7 trillion (the 2003 book alone was more than $1.3 trillion); its $11.1 billion in 2008-2016 losses represented a credit loss rate (credit losses as a percent of initial UPB) of about 30 basis points. Had Fannie been required to cover all of its 2000-2004 loans with CAS, it would have issued over $110 billion in face value of M-2 and M-1 securities, with interest payments in excess of ten billion dollars, but received no benefit from them. The CAS benefit for the 2005 book, with an initial UPB of $602 billion and 2008-2016 losses of $15.7 billion (a 260 basis point loss rate), would have been only somewhat better. Fannie’s 2005 CAS M-2 tranches would have picked up $4.3 billion in losses, but another $5.4 billion that fell within the M-2 coverage range would have kicked back to the company because those tranches would have continued to amortize to zero even after prepayments to them were suspended in 2008.

Only for the very poor-performing 2006 and 2007 origination years would the CAS M-2 tranches have provided their full amounts of loss absorption ($10.3 billion and $9.3 billion, respectively). Yet because of rapid payoffs, the M-1 tranches would have provided no protection in 2006 (leaving Fannie to pick up all $6.8 billion in losses that fell within their range), and for the same reason the M-1 tranches would have absorbed just $4.1 billion of the $6.7 billion they should have taken in the terrible 2007 year. And that’s not the whole story. Credit losses in both years exceeded the 400 basis point CAS coverage cap, meaning Fannie would have picked up the $4.4 billion in 2006 losses and $9.7 billion in 2007 losses above that cap. So even in the two years when CAS were most effective, Fannie still would have had to cover far more credit losses ($34.9 billion) with its own revenues and equity than would have been transferred to CAS holders ($23.7 billion).

One obvious conclusion from this exercise is that there is no such thing as a “risk-transfer model” in the real world. Even if CRT securities are issued against every guaranteed loan, a credit guarantor still has to cover all the losses on its good books of business, and a sizable majority of the losses on its bad and very bad books of business, with earnings or equity capital. CRTs can at best be a supplemental source of credit protection.

In addition, compared with the Fannie and Freddie model of backing guaranteed loans with upfront equity, issuing CRT securities against all guaranteed loans is extremely inefficient. Interest payments on CRTs issued against high-quality loan pools—or pools that pay off rapidly—are simply wasted, whereas equity put up to back these same groups of loans can be used to cover losses elsewhere. Moreover, CRTs do not offer predictable coverage even for bad or very bad loan pools, because of their caps. The loss caps on CRTs (in the case of Fannie’s CAS, 400 basis points of initial UPB) apply to all loan pools. Just as these caps are too high, and wasteful, for most pools, they are too low, and insufficient, for the worst ones. As we saw with Fannie’s 2006 and 2007 books, once the CRT cap is breached on a bad or a very bad pool, a credit guarantor using CRTs has open-ended exposure to those pools’ credit losses, and can’t reach back to revenues from other pools to cover them.

Yet the most damning argument against the CRT-based model is the extreme and unnecessary risk it would pose to the financial system. With this model, by the time a credit guarantor realizes how much equity it really will need to cover the losses on its worst performing pools in a stress scenario, raising that equity won’t be possible.

When a CRT security is issued “at time of origination or after pooling,” the ultimate credit performance of the insured pool is both unknown and unknowable. In most years a credit guarantor will be able to cover its losses on good pools with retained earnings (guaranty fees, less administrative expenses and CRT interest payments), but in a stress scenario it will need large amounts of equity to absorb the losses on its bad or very bad pools. The insoluble real-life problem for a CRT-based guarantor is: as a stress scenario unfolds, how does it determine the amount of capital needed to survive it, and how would the guarantor then obtain that capital?

Here again, our exercise with Fannie’s December 2007 book is instructive. With one brief exception, Fannie’s 90-day delinquency rate stayed within a range of 55 to 71 basis points from January 2003 through August 2007, while over that same period the company’s single-family credit losses averaged $0.5 billion per year. Then, in just 16 months, 90-day delinquencies shot up to 242 basis points in December 2008, on the way to a peak of 559 basis points in February 2010. At $14.0 billion per year, the average single-family credit loss for Fannie’s December 2007 book during 2008-2012 was nearly 30 times the average for 2003-2007. Had Fannie been relying solely on CRTs to protect that book, it would have had very little time to guess the magnitude of those 2008-2012 losses, and in a collapsing housing market no chance at all of raising the capital required to cover them. At the same time, the market for CRTs for its acquisition of new loans would have dried up as well.

In “Clarifying the Choices in Housing Finance Reform,” Parrot leaves out the most important commonality of the CRT-based proposals from the Urban Institute, the Milken Institute and the MBA: none of them would actually work. The Fannie and Freddie equity-based model does. It relies on equity capital put in up front, not uncertain credit loss transfers in the future, and in the equity model, capital from the best books doesn’t disappear; it’s available to cover losses from the worst books.

The Urban Institute, the Milken Institute and the MBA risk-transfer proposals may have superficial appeal to members of Congress and the media, but to mortgage market professionals they are desperate, and dangerous, attempts to argue against the only sure path to mortgage reform. Secretary Mnuchin is experienced with and understands the mortgage market. He can differentiate between a secondary market model that works and one that does not. When it comes time to make a call on how to structure the U.S. secondary market of the future—with his name attached to the outcome—there can be little doubt that he will make the right choice.

70 thoughts on “Risk Transfers in the Real World

    1. ROLG: I appreciate your posting this. I found it to be a very clear analysis of the three different legal paths that ultimately could lead to reversal of the net worth sweep (the fourth path–through Judge Sweeney’s Federal Court of Claims–won’t result in a reversal of the sweep even should plaintiffs prevail) and I would encourage everyone who follows this site to read it.

      For what it’s worth, I agree with your ranking of the relative probabilities of success for the three paths. From the time the Delaware suit was filed I thought it presented the cleanest and least complicated way to get a judgment against the sweep, provided Judge Sleet was willing to step up to the issue. A reversal of Lamberth’s DC District Court decision had been my second favorite, but February’s surprising (and perplexing) appellate court ruling pushed that back to a distant third, requiring, as you point out, one of the other District Court cases to be decided in favor of plaintiffs on appeal, followed by an appeal to, and favorable ruling by, the Supreme Court. That leaves the Collins case in Texas–with its likelihood of a successful challenge to the constitutionality of the structure of FHFA’s directorship–as the best backup to the Delaware case.

      Liked by 2 people

    2. I think we also have 2 other relevant cases that try to hit the fraud nerve while Washington Federal sits on the sidelines – A) Tim Pagliara wanting to inspect Fannie Mae’s books, court hearing on 5/1/17) and B) Edwards/Deloitte for Fannie Mae’s accounting records, last plaintiff filing on 3/8/17

      Liked by 1 person

  1. The N.D. Iowa just issued an opinion today to dismiss the Saxton complaint. Similar to the Perry ruling, Plantiff’s are barred by HERA’s anti-injunction provision.

    Liked by 1 person

    1. in short, yes. treasury has done a 180 in the past month in collins re collins argument IV.

      this was a circuitous and even rancorous way of saying that treasury disagrees with fhfa on the constitutionality of the removal for cause provision.

      it’s as if the senior DOJ official instructed the staff to change position in collins to mirror position in phh, and the lower staff wrote the reply in the most oblique manner he/she could. unlike in phh, treasury appears to intend to say nothing more about the matter in collins.

      here is fn 1 to which your link refers:

      1 Treasury also joins in FHFA’s request that the court dismiss Plaintiffs’ separation-of- powers claim (Count IV) for the reasons provided in FHFA’s Opposition to Plaintiffs’ Motion for Summary Judgment, filed on February 27, 2017.

      Liked by 2 people

      1. just one more thought re why treasury was so oblique. this is my best guess.

        phh and fhfa are distinguishable insofar as phh director as a single director was not only not removable at will, but also could draw on fed funds to pay its bills rather than seek budget appropriation from congress. fhfa director shares only in the former prong.

        so treasury was faced in collins with whether it should argue that fhfa director is unconst based solely on the removal prong. it seems treasury stopped just short of this, but went far enough to make clear that it no longer argues along with fhfa that removal for cause is affirmatively constitutional.

        Liked by 1 person

        1. If HERA/FHFA is found to be unconstitutional in a court of law then how may it affect all judgments that have been made against shareholders dating all the way back to 2008?

          Liked by 1 person

          1. Once again, I’m not a lawyer, but I suspect that if a judge does find the single director removable for cause provision of HERA to be unconstitutional, he or she also will have a stated or proposed remedy. I have no basis for speculating about what that remedy might be, however (there are many possibilities), so I’ll wait to see what happens.

            Liked by 2 people

    1. This is a narrow appeal. The institutional plaintiffs (Fairholme and Arrowood Indemnity) are seeking a hearing to reconsider the majority ruling that for technical reasons the institutional plaintiffs had forfeited their right to participate with class plaintiffs (represented by Boies Schiller) in the remand of the common law claim of breach of contract to the lower court. Neither the institutional plaintiffs nor the class plaintiffs are asking for a hearing to overturn the decision affirming the legality of the net worth sweep.

      Liked by 2 people

      1. Are they seeing something that we cannot see? Did Ginsburg make us a favor? I wonder if this breach of contract may lead to an outcome that we still cannot picture?

        Liked by 1 person

  2. Hi Tim , is there any way to save the DTA from a possible tax cut ? and if there is a tax cut , when do you think that it will be effective ? in 2017, or in 2018, or even further ?


    1. If there is a tax cut this year, in a previous interview, I believe Mnuchin hinted that it would be effective in 2018 and not retroactively for 2017. That said, Fannie and Freddie both highlighted in their last Quarterly filing that any tax change will be reflected in their financials the same quarterly period that tax reform was passed (i.e. if tax reform were to pass in August as suggested, the DTA impairment should be reflected in the Q3 earnings release.)


      1. As I noted in my previous post (“Deferred Reform, and Deferred Taxes”), if I were at Fannie or Freddie I would be looking at the accounting choices made on behalf of the companies by FHFA since the conservatorship, to see which ones might sensibly be changed to bring the book accounting treatment of the associated expenses or revenues more into line with the treatment of these items by the IRS, thus reducing the DTA related to them.

        There is no mystery about the timing of any reduction in the value of Fannie’s and Freddie’s outstanding DTAs– it will take place during the quarter in which tax reform is enacted, irrespective of the effective date of tax reform. Whatever DTAs the companies have at the end of the quarter in which tax reform is enacted (assuming that it is, and I would be remiss in not noting that the current travails of health care legislation have reduced the chance of tax reform being enacted at all), those will be written down in proportion to the decline in the corporate tax rate (e.g., by 28.5 percent if the new corporate tax rate is 25 percent, compared with today’s rate of 35 percent).

        Liked by 1 person

        1. Since you brought up the whole health-care debacle, curious what your thoughts are here and how it will effect the Administrations plans for enacting tax reform this year. Mnuchin said in an interview this morning that he is optimistic that tax reform will be accomplished by August. I have also read that its possible to bypass health-care reform for the time being if the vote fails today and move on directly to tax reform, “If it loses, we just move on to tax reform,” – Chris Collins. Might be better not to speculate as we should find out shortly.

          Separately, when Mnuchin was asked this morning how the Administration plans to fund the $1T infrastructure plan, he mentioned that there are multiple ways to accomplish this, including private-public partnerships. I can’t think of a more lucrative public-private partnership than the GSE’s today due to the warrants. The Administration has the potential to realize over $100b in value through its GSE warrants if they were to properly reform, recapitalize, and release the GSE’s back to private shareholders. Do you see the potential value in the warrants as a driver that might push the issue?


        2. Hopefully if the healthcare bill fails, Trump follows through on his threat to immediately move on to taxes & skip any follow up on healthcare for the foreseeable future. In which case, there’s a small chance it might actually accelerate tax reform…


          1. I don’t want to start making predictions about the administration’s political agenda, but I’ll make a couple of brief observations about tax reform. I thought one of the reasons for doing the health care bill first was that, if the Ryan bill went through, it would have created a tax cut for high-income taxpayers that then could have been traded away in a tax reform proposal. Not having that money makes tax reform somewhat more challenging, even before taking into account the frictions that have emerged among various factions within the Republican party over the last couple of weeks during the health care debate. And all I’ve said is that the health care impasse (they still have to vote this afternoon, but the signs aren’t hopeful) makes tax reform “less likely”– I didn’t attempt to put any probabilities on it. (As for Mnuchin’s statement this morning that he is optimistic that tax reform can be accomplished by August, that’s what one would expect him to say.)

            Liked by 2 people

  3. Tim, in your view, what is the worst case scenario wrt how the GSEs are managed by this administration, that is within the realm of realistic possibility? You’ve explained on this blog how “promising road” proposals don’t work in the real world, so I presume you’d rule this out as a realistic scenario, given that Mnuchin is in charge. Is there an alternative scenario that you see Mnuchin possibly pursuing, that is adverse to the GSEs? I know you can’t speak for the Ps, but do you have a general sense of what keeps them up at night?


    1. I’m not quite sure what you’re asking. If you’re asking about the worst-case scenario for investors in Fannie and Freddie, I would say it’s losing all the lawsuits, and all appeals on them. That would leave Fannie and Freddie with no capital, no ability to retain earnings, and Treasury with a $187 billion liquidation preference in the companies.

      Do I then think Fannie and Freddie would be liquidated? I don’t. As I said in my current post, I believe that the companies’ equity-based credit guaranty model is hands-down the best system for financing large amounts of 30-year fixed-rate mortgages at a cost that’s affordable to a broad range of borrowers. And if you’re going to use the Fannie-Freddie model, what’s the rationale for not using the two healthy companies that currently exist? (This, by the way, is why opponents of Fannie and Freddie keep coming up with ideas that don’t work. They know that if they embrace the equity-based model they have no answer to the question: “well, why not just reform, recap and release Fannie and Freddie?” That’s the last thing they want, so they reject the equity-based model that does work, and keep coming up with alternatives that don’t.)

      But if the government is going to keep the existing companies as the basis of the secondary market system going forward, it’s in the government’s own best interest to treat existing shareholders fairly. Otherwise, what new investors would provide the capital necessary to get the reformed version of the companies going?

      Still, there ARE reform alternatives that involve liquidating Fannie and Freddie, and replacing them with financing mechanisms that do work, but would provide access to a limited number of borrowers at higher cost. I’m not inclined to outline what these might look like—I’ll wait for others to do that, then critique them—although one that falls into that category is Mark Calabria’s “originate to hold” model, which would go back to having depository institutions be the source of the majority of single-family mortgages. We tried that once before and got two savings and loan crises (one in the late 70s, and a second in the late 80s), so I’d be surprised if we tried it again. But you certainly can’t rule it out.

      Liked by 1 person

      1. no one wants calabria’s originate to hold program other than calabria. not even the banks. days of pay 3% to depositors, lend mortgages at 6%, and play 9 holes in the afternoon are gone along with ozzie and harriet.


      2. “Still, there ARE reform alternatives that involve liquidating Fannie and Freddie, and replacing them with financing mechanisms that do work…”


        As you say, such “would provide access to a limited number of borrowers at higher cost.”

        They “work” but just not effectively? Regarding Calabria’s genius, it too will work yet in tbe past such a model ran undue risk of our savings and loan crisises? I’m waiting for Clarence to step in to save George Bailey from himself and Mr. Potter. 🙂


        1. I make a distinction between reform plans that literally will not work– that is, if implemented would ultimately result in either a failure of the system or significant nonrecoverable costs to taxpayers–and plans that provide less available or affordable secondary market financing than could be achieved from some different alternative.

          The Urban Institute, Milken Institute, and MBA risk-transfer programs, as proposed, will not work; if we actually tried one of them, during a period of extreme stress whatever entity was exposed to the credit losses uncovered by the risk-sharing securities the system was relying on would find itself unable to absorb them, and the system would collapse. This is a black and white issue. No “tweaks” can fix these proposals; those of us who understand how the mortgage finance system actually works have to convince those who do not that these systems are lunacy. (I personally believe that the people at the Urban Institute DO understand their system won’t work; I suspect their strategy is to pretend it will long enough for Congress to pass legislation replacing Fannie and Freddie with such a system, then suddenly “discover” the flaws in the risk-sharing model, and replace it with a bank-centric alternative that WILL work, just much better for the banks than for homeowners.)

          Another unworkable system that I fear is still lurking out there is putting government guarantees on private-label securities (PLS). Opponents of Fannie and Freddie almost universally pretend that our disastrous experiment with private-label securitization never happened. The only thing that would have made our 2004-2007 episode with unregulated, toxic PLS worse would have been if those PLS had carried government guarantees. In that case, not only would six million families still have lost their homes, the government would have had to write hundreds of billions of dollars of nonrecoverable checks to investors in those securities to make good on the government guaranty. There still are many, many people talking about how the solution to mortgage reform is an explicit government guaranty on mortgage-backed securities (to lower rates for homebuyers), combined with the “benefits” of bringing “more private capital” into the system. More private capital plus a government guaranty equals government guarantees on PLS. That’s another unworkable system, but don’t be surprised if the idea pops up again.

          Beyond these unworkable ideas– which as I say are black and white issues and must be defeated–there is a whole spectrum of efficiency along which a final, workable, secondary market reform proposal can settle. For simplicity’s sake, let’s divide reform stakeholders into four groups: homebuyers, the government, investors and financial institutions. For me, the most successful reform outcome would be for the government to set a defined standard of taxpayer protection for the operation of secondary market credit guarantors (a combination of stress-based capital requirements, return limits, and regulation) and for the government then to agree to provide emergency support to credit guarantors who abide by these standards. The resulting strong implicit government guaranty would protect investors who provide capital for funding fixed-rate mortgages, and the efficiencies of this system would be passed along to homebuyers in the form of lower mortgage rates and widely available mortgage credit.

          This would be a stronger version of the system we had before the financial crisis (the old Fannie and Freddie system, with updated and higher capital requirements, regulated returns, and more effective and less adversarial regulation). You’ll note, though, that “other financial institutions”–i.e., principally banks, don’t really benefit from this. The credit guarantors control fixed-rate mortgage underwriting standards (because they are taking the bulk of the credit risk), and with implied government backing mortgage rates remain low. Most of the fighting over what is called “mortgage reform” today comes from banks who want more control over both how mortgages are underwritten and where mortgage rates end up. (That’s why they’re so intensely focused on getting rid of Fannie and Freddie). The banks have enormous political clout. Under various banners of public benefit– whether it be “protecting the taxpayer,” “bringing more competition to the market” or something else–they will continue to aggressively advocate for systems or features that benefit themselves at homebuyers’ expense.

          It is much better economic and public policy to have mortgage reform that benefits homebuyers rather than banks. Prospects for economic growth will be hurt by a reform outcome that takes money out of the pockets of low and moderate income homebuyers (also known as consumers) and transfers it to banks. Although a bank-centric reform system would still be “workable,” it’s not what we should be trying to achieve.

          Liked by 4 people

          1. Thank you for the nuance and that most thorough elaboration. If you’re right about the Urban Istitute, and I have no reason to believe you aren’t right, their strategy of later discovering flaws in their own system so to hand the industry over to the banks would be sinister indeed. Unfortunately, such evil is now par for the course. Thanks, again.


          2. Excellent piece as usual… Please speak directly w Mnuchin & Trump (even though I know you said you can’t tell us if you do). Thanks again.


          3. Tim

            So Secretary Mnuchin representing one of the stakeholders, the Government, was a banker. What side of the ledger do you suppose he falls on? The side which provides a system with lower mortgage rates and credit availability or the side that he came from which wants more control over how mortgages are underwritten and priced?


          4. Here we go again, https://www.bloomberg.com/news/articles/2017-03-28/fannie-freddie-fix-is-focus-of-senators-push-across-party-lines.

            Reported that Corker and Warner will be leading the charge in congress for a bipartisan effort. They previously tried and failed to replace the GSE’s. As great it would be, it doesn’t seem like this is a government will arrive at any sort of bipartisan reform, eventually leaving the door for UST and FHFA to act unilaterally. I just hope they choose to do so sooner rather than later, before putting tax payers at risk once there is no capital buffer remaining in 2018.

            Liked by 1 person

    1. It IS the same Washington Federal case, but having the lead counsel add one affiliated lawyer isn’t a significant development, and in my view doesn’t change in any meaningful way the status of this litigation.


  4. Hey Tim,

    Thanks again for all your time & expertise Tim, It’s not often the public has access to a multi year AMA with a former Fortune 50 CFO.

    Quick question. Given the Congressional meetings on GSE recap taking place (imo:re-laying foundation Ginsburg razed with his bull….dozer) any chance of a partial payment to UST end of March? Even if 10-20% of the 10B impending was kept to collateralize FnF, I’d assume that to be a positive indicative of coming intentions, or would that be a non starter iyEo?

    Thanks again for your time Tim,


    Liked by 1 person

    1. My personal opinion is that a partial payment of Fannie and Freddie’s scheduled combined $10 billion net worth sweep payment next Friday is highly unlikely; either the full payment will be made as scheduled or Treasury and FHFA will allow the companies to retain it. As I’ve mentioned in earlier comments, I think it’s most likely that the payment will be made. I believe that Secretary Mnuchin wants to “work the process” on mortgage reform with all parties, including Congress, and many if not most of those parties would object strenuously to Treasury allowing Fannie and Freddie to retain the sweep payments prior to a consensus having been reached– or a firm decision by Treasury– on what to do with the companies going forward. I suspect that Mnuchin would reason that the blowback from cancelling the sweep payments would significantly complicate getting to the right outcome on reform, so he’ll not act to interfere with what’s already been scheduled to occur.

      Liked by 2 people

      1. Remind me not to play chess against you for money Tim, always steps ahead. You’re absolutely correct that a half measure would surely do all you have suggested and more. Thanks again for your insight. What you can bet on though would be a 25 yr single malt beginning with Bradford’s first name, of your choice, if commons aren’t diluted an inch away from death. 🙂

        Would be naive to think your steadfast and irrefutable input didn’t affect a potentially positive outcome. Proof of that is nary a Congressman nor “Think” Tank even mentions you or our work as erroneous. Very definition of Guerrilla Lobbying. Hit n’ Split

        Have a good one,

        Good luck folks,

        Liked by 3 people

      2. So what you are saying is that Mnuchin will let capital deplete as scheduled until action with congress proves successful/unsuccessful? What do you think of putting the payment “on hold”? Making FnF put the payment aside, not using it in anyway, potentially being required to use it to pay the Treasury, until reform attempts go through. This way, he can still make all the same arguments to Congress, while showing that he doesn’t want to act without them.

        Liked by 1 person

        1. Not quite. What I am predicting–and I could be wrong–is that Mnuchin will not initiate any action with respect to the net worth sweep until he believes he has a plan for mortgage reform that he can implement successfully. I believe he can accomplish mortgage reform administratively. I think he would LIKE to have the support of Congress for what he does, but if Congress can’t, or won’t, back what he thinks is a sensible and the correct way to go forward, I believe he will be prepared to move on his own. And until he gets to that point, I don’t see him doing anything to change the status quo on the sweep, including putting it “on hold.” But we’ll know soon enough–March 31 is nine days away.

          Liked by 1 person

          1. Nine days is a long time nowadays. It takes only a click to transfer the money, so it can be cancelled at the last minute.
            A media campaign to discourage shareholders seems to have been launched this week. They are using the noun “Congressional Staffers” as the source of statements declaring that no action will be taken this year by Congress. It is obvious that the fight is heating up.
            But … ALWAYS something unexpected happens. God is in the details.

            Liked by 1 person

      3. i have no clue whether the dividend distribution scheduled for 3/31 will be made, but i note one thing that i know to be true:

        money made and retained is far easier capital to gather than money to be raised in the capital markets.

        if the objective is to recapitalize and restructure GSEs, then a great “jumpstart” would be to prime the capital raising effort with an initial capital retention effort. every dollar of capital retained makes that dollar of capital to be raised that much easier.


        1. I still am operating under the assumption that “reform, recap and release” of Fannie and Freddie would be accompanied by a reversal of the net worth sweep (hopefully mandated or at least made likely by a court decision, but voluntarily if necessary). If that’s the case, whether the March 31 sweep payment is made or not shouldn’t make a difference to the recapitalization effort (although it will to the potential for a draw caused by a DTA write-down due to tax reform).

          By my calculation, paying down the senior preferred stock by unwinding the net worth sweep would leave Fannie with $8 billion, and Freddie with $5.5 billion, in senior preferred outstanding at the end of 2016. Were the companies allowed to retain their $5.5 and $4.5 billion respective March 31 sweep payments, they still would have to retire the remaining outstanding senior preferred at some point during the process of their recapitalization and return to private status.


          1. tim

            thanks for those updated calculations. my hp12c is in a landfill somewhere.

            but that logic cannot be expressed by treasury on 3/31 even if this is behind its thinking, because it speaks of a game plan (amend spsp agt to get treasury paid in accordance with original deal but no more) that i dont think treasury will want to announce then, in terms of timing and consultations. but we shall see.



          2. I agree that logic can’t be expressed publicly; it’s why I think the least potentially damaging path, and thus the most likely, is to stick to the schedule and let the payments come in. We’ll know soon enough.


      4. I read the comment above, “work the process” is what Mnuchin wants, but if F&F have already been massively reformed/changed and the consensus is that there is no better way to finance mortgages in the US, what is there for Congress to do? What is there to wait on? The utility model? That seems unlikely as Congress would never decide on on how to do it. The only other suggestions are simply non-starters, correct? So if “none of the above” are the answers to the other ideas, then why not start the recap and release process this quarter? There is no other choice – or realistic choice – unless the choice is to wait for an event. (Of course I can agree that is usually the way Congress works instead of thinking ahead, but still is that what we have to wait for, the last moment before it is to late? Really?)


      1. @mark

        read the brief linked. collins counsel points out that fhfa itself does not dispute that decisions made by an official appointed in violation of the Appointments clause of US const are voidable (for example, whether a potus recess appnt occurred during an actual congressional recess). fhfa argues that the official improperly appointed was never acting in a lawful capacity, but that until fhfa structure is determined to be unconst, fhfa director has been acting in lawful capacity.

        collins counsel goes next step and argues that fhfa director cant be found to be acting in a lawful capacity if the structure of the office itself is unconst. indeed, the graver const issue is for a director to act not subject to separation of powers oversight, such as fhfa, as opposed to some official whose appointment was subject to what is often a technical oversight.

        this is the core collins argument, and they do a good job. whether a federal district judge in houston buys it is another matter.

        Liked by 1 person

        1. PS no judge wants to void potentially innumerable director decisions with a finding that the office is unconst. structured. which is the attraction to a judge of choosing as a remedy, if the removal provision is found unconst, of excising the unconst removal provision from statute on a prospective basis.

          collins proposes a more palatable remedy for judge atlas in event she decides fhfa director removal provision is unscont: void the prior fhfa decision to enter into NWS and afford the fhfa director, now subject to removal, the opportunity to ratify it.

          one may think this will be too little of a remedy from the Ps perspective, but it is also a more palatable remedy for a judge to order. from a political point of view, it does have the effect of putting the trump admin imprimateur on the NWS if a fhfa director subject to removal ratifies the NWS (which is what the separation of powers doctrine is really intended to do, make executive agency actions subject to potus oversight).

          Liked by 2 people

  5. Thank you for the very informative post as usual. The information you provide always cuts straight to the meat without any BS.

    Curious as to what your thoughts are on private-label mortgage securitizations today? Will they ever regain some competitive ground against the GSE’s? Seems like they are starting to make a comeback (although still only accounts for ~1% of total market).

    See link: http://www.cnbc.com/2017/03/20/private-label-mortgage-bonds-are-rising-from-the-grave.html

    Liked by 1 person

    1. The future of the market for private-label securities (PLS) will depend in large part on what happens with Fannie and Freddie. If the companies are “wound down and replaced” (which I don’t expect), PLS will very likely become more popular again, although I wouldn’t expect them to get anywhere near to the market share they enjoyed in the 2004-2007 period, when they effectively were a production line for aggregating, pooling and “slicing and dicing” low-quality loans whose risk was grossly underestimated by the credit rating agencies. Investors have figured that game out, and aren’t inclined to try to play it again.

      In a world without Fannie and Freddie, the future of PLS would depend on what the dominant form of mortgage financing turned out to be. There are several “reform” proposals that envision some type of government corporation that would determine what sort of mortgage credit enhancement could qualify for an explicit government guaranty. I suspect many people pushing for this would like to see government guarantees be made available to PLS issuers. If that were ever to happen it would be shameful, but it would give PLS production a tremendous boost, at the expense of the government having to write large, non-recoverable checks on many of these PLS in the future. I don’t think government guarantees for PLS are likely, though. And absent such a guaranty, and with Fannie and Freddie remaining as the primary issuers of MBS, I would expect PLS issuance to stay under 5 percent (and perhaps well under that figure) for the foreseeable future.

      Liked by 2 people

    1. No, I really don’t have any insight into that. I hope he does. Many of the post-conservatorship accounting entries made to book non-cash expenses involved dubious assumptions or judgments; it certainly would be interesting to see what the auditors work papers say about them.

      Liked by 2 people

      1. most dgcl books and records stockholder requests are made by stockholders seeking to launch proxy contests and seeking the shareholder list in order to send out their proxy materials. what dgcl section 220’s books and records inspection means in the GSE context (how detailed, how far back in past etc) will be subject to much to and fro, no doubt

        Liked by 1 person

  6. You have taught us again to use and understand Gaussian distribution, Einstein’s relativity, godel’s incompleteness and most relevant what is common sense.
    Thank you Professor Howard.


  7. Tim – I am a former mortgage and asset-backed specialist with a large institutional asset management firm and was an early pioneer of identifying credit problems within mortgage-related securitizations. The lesson learned time and again is that he who has the deal structure (and collateral) correctly modeled, and who knows how to stress the collateral accurately, will gain the necessary knowledge to avoid investment mistakes. Or in FnF’s case, from an Issuer’s viewpoint, to avoid issuance mistakes.

    Your analysis is excellent and a valuable service to the future of the housing industry. I am quite confident Mnuchin and his staff will be focused on this analysis. He’s seen this type of industry sleight of hand a thousand times and I trust will have the integrity to take a stand against it.

    Thanks for all you are doing.

    Liked by 8 people

  8. I feel like the end of this post should have contained *drops the Mic*. Very detailed and well thought-out response to another overly biased piece by one of the usual suspects.


  9. tim

    great work as usual. many thanks.

    i wonder if you have considered uploading your worksheets to a dropbox file, accessible from this site? i have no idea if they are in a form that would be useful for others (they certainly would be beyond my ken), but that might be a way in which you could further distinguish the usefulness of your “real world” analysis from the Parrott “institute make-believe world” analysis.



    1. I am an “old school” analyst; I do analytical work such as was required for this piece in hand-written columns on 8 1/2 x 11 inch lined paper, which I check and double-check with an HP-12C calculator. I don’t even use Excel. I got comfortable doing that in my early days at Fannie, and as I rose higher in the company I always had staff who were much better at computer-based econometric analysis than I was, and also were whizzes at Excel and PowerPoint. (I never learned to use them, although I probably should have, and I certainly could do so now, but always find an excuse not to).

      So unfortunately, uploading my worksheets to Dropbox would not be of use to anyone. But I did make every effort to ensure the analysis was accurate, and am confident that if I made any errors they were relatively minor, and wouldn’t affect the overall outcomes and conclusions of the post. (All the numbers have to tie out, and there are consistency checks that can be made.)

      Finally, I’d add that the main distinction of my analyses from those of people supporting bank-centric alternatives is that I give details, and they almost never do. They stay at the 36,000 foot level, with generalities, where the operational gaps and contradictions in their proposed systems aren’t apparent.

      Liked by 4 people

  10. “with his name attached to the outcome”
    I love that sentence. It is time that those participating in the housing reform debate assume that the life of people depends on the outcome of the reform, and stop acting to please the “establishment” that hires them to lobby.
    Coincidentally, all those non-experience-backed approaches come from “institutes” that have large overheads and that pay huge salaries to the so-called “thinkers” . One wonders where all the money comes from to pay such expense.


  11. “A fictionalized version of the financial crisis is a useful device to avoid having to compare the Fannie and Freddie model with the risk-transfer model…”

    Most people still believe that fiction.

    Liked by 1 person

  12. Another incredible contribution to the truth. I’m looking forward to the day when my pre-cship shares are worth something again and I can make a contribution to a worthy charity in your name. Endless thanks, shadow

    Liked by 1 person

      1. Tim, Thank for the insightful article once again. I have to admit I did not understand all of it. In reading about Mr. Calibria’s comments today, I was hoping you could respond to an article he puplished on April 16, 2016 that clearly spells out his views on Freddie and Fannie and how this squares with comments made by Mr. Mnuchin

        Liked by 1 person

        1. Mark Calabria, formerly of the Cato Institute and now chief economist to Vice President Pence, is a staunch opponent of Fannie and Freddie.

          I believe the article you are referring to is the one he submitted for the Urban Institute’s “Housing Finance Reform Incubator” series (for which I also submitted an essay), titled “Coming Full Circle on Mortgage Finance.” The “full circle” he advocates in that article is turning Fannie and Freddie into bank holding companies, and returning to what he calls the “originate to hold” model– that is, having all, or almost all, single-family mortgages made and held by commercial banks. His recommendation is premised on his contention that, “Securitization is a false god that failed us.” To make this conclusion, however, he has to conflate private-label securitization (which really was, and is, a “failed business model”) and securitization as it has been and is done by Fannie and Freddie. The two are totally different, and the fact that Calabria incorrectly treats them as being the same in my view invalidates his analysis.

          Which brings me to your question about how Calabria’s views may differ with Mnuchin’s. Mnuchin hasn’t said that much about Fannie and Freddie, although at his confirmation hearing he did say, “I think Fannie and Freddie have been well run without creating risk to the government and they played an important role. I believe these are very important entities for liquidity…” That statement certainly doesn’t square with Calabria’s opinion. More to the point, though, there is a tremendous difference between Calabria and Mnuchin in market knowledge and experience. In his paper, Calabria gets the history of the financial crisis wrong, and his prescription for the future is more based on hope (and ideology) than experience. Mnuchin is a pragmatist, and he knows how the mortgage market works. I don’t see Calabria’s wishful thinking having much effect on what Mnuchin wants to or will do in guiding the Trump administration’s actions on mortgage reform.

          Liked by 3 people

          1. Calabria is VP’s advisor, not Trump’s, not Mnuchin’s, not Cohn’s. He may know roughly what is going on thru Pence. Pence is not an expert in the area and has no strong interest. Calabria has little influence if not at all


          2. Thank you so much for responding. You have no idea how helpful it is to have someone who truly understands the issues explain them for average folks to understand.


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