On July 19, Judge Margaret Sweeney unsealed 33 additional documents produced in discovery for the lawsuit brought by the Fairholme Funds in the U.S. Federal Court of Claims. They were made available to the public early last week.
Not surprisingly, the documents that attracted the most attention were those that contradicted the “death spiral” explanation given to the public and in the court cases by Treasury and FHFA as the reason for the net worth sweep. Excerpts from the new documents reinforced what had been apparent from evidence unsealed earlier: that Treasury and FHFA were fully aware that Fannie and Freddie were about to experience a surge in profitability well before the sweep was announced; that the sweep was imposed precisely to prevent the companies from retaining those earnings as capital, and that stripping the companies of their capital was viewed by Treasury as essential to achieving its goal of replacing Fannie and Freddie in the U.S. secondary mortgage market with a system more to its liking.
Included among the items unsealed on July 19 were:
– A memo dated June 25, 2012—more than seven weeks before the sweep was announced—from Counselor to the Secretary of the Treasury for Housing Finance Policy Michael Stegman to Assistant Secretary for Financial Markets Mary Miller, summarizing a meeting at which FHFA acting Director Ed DeMarco told Treasury Secretary Tim Geithner that “the GSEs will be generating large revenues over the coming years, thereby enabling them to pay the 10% dividend well into the future even with the caps;”
– An August 13, 2012 memo from National Economic Council senior advisor Jim Parrott to Treasury’s Brian Deese, stating, “We are making sure that each of these entities pays the taxpayer back every dollar of profit they make, not just a 10% dividend….The taxpayer will thus ultimately collect more money with the changes” [emphases in original], and
– An August 15, 2012 email from Treasury’s Adam Chepenik to Stegman, Parrott and others that said, “By taking all of their profits going forward, we are making clear that the GSEs will not ever be allowed to return to profitable entities at the center of our housing finance system” [emphasis in original].
These and similar emails and memos show that Treasury and FHFA have not been truthful about their motives for agreeing to the net worth sweep. But beyond that, other documents among the 33 reveal a pattern of deception extending back before Fannie and Freddie were put into conservatorship and carrying forward to the current proposals for mortgage reform supported by Treasury and what I call the Financial Establishment. Three particular items stand out in this regard: the August 25, 2008 “Freddie Mac Confidential Capital Review” by BlackRock, the December 12, 2011 Draft Information Memorandum to Secretary Geithner, and an undated Treasury document titled “Housing Reform Questions and Answers.”
BlackRock’s “Freddie Mac Confidential Capital Review”
The most surprising revelation from all of the documents released last week was that on August 25, 2008—nearly two weeks before Fannie and Freddie were placed into conservatorship on September 7—the investment firm BlackRock submitted a “Confidential Capital Review” of Freddie Mac to Treasury and FHFA that concluded: “…[L]ong-term solvency does not appear endangered – we do not expect Freddie Mac to breach critical capital levels even in stress case.”
We already knew that Treasury Secretary Paulson had forced Fannie and Freddie into conservatorship without satisfying any of the twelve requisites for that action set out in the newly passed Housing and Economic Recovery Act (HERA), relying instead on what he termed “the awesome power of the government” to pressure the companies’ boards to submit to it. We also learned after the fact that both Fannie and Freddie remained profitable on an operating basis throughout the crisis. But until now we did not know that Treasury and FHFA had been told something very similar at least about Freddie’s financial condition before the fact by BlackRock, an independent and respected third party with a long familiarity with Freddie, having been a consultant to them for at least a decade. Treasury and FHFA ignored this assessment and went ahead with their pre-planned conservatorships anyway, with Paulson boasting to President Bush, “Mr. President, we’re going to move quickly and take them by surprise. The first sound they’ll hear is their heads hitting the floor.”
Following the conservatorships Fannie and Freddie booked massive amounts of non-cash losses through the end of 2011, causing them to have to draw $187 billion in non-repayable senior preferred stock from Treasury. The unsealed BlackRock document provides important insight into how the large majority of those losses—and the resulting Treasury draws—were deliberately engineered. First, the contemporaneous analysis of Freddie’s future financial condition by BlackRock makes it impossible to defend the legitimacy of FHFA’s decision to set up a reserve for Freddie and Fannie’s deferred tax assets in the third quarter of 2008 on the grounds that they would not be sufficiently profitable in the future; FHFA knew this not to be true. Second, on the penultimate page of its review BlackRock explicitly identifies and describes the method used by FHFA to create most of the other non-cash losses at the companies. It notes, “’Other Than Temporary Impairment’ accounting rule can trigger mark-to-market declines more severe than expected principal loss. Accounting treatment requires securities to be marked to market if any principal loss is deemed ‘probable.’ Given the current market environment, MTM losses will likely exceed actual principal losses. Impairments diminish capital immediately. Future recoveries in market value do not flow through capital.”
I do not know whether staff at either FHFA or Treasury had previously been aware of how powerful impairment accounting could be in making a company’s capital disappear immediately, then reappear only slowly, as income. But this accounting technique was used extensively by FHFA following the conservatorship. At Fannie, impairment accounting allowed FHFA to book $17.3 billion in market value losses on private-label securities held in portfolio—very few of which became economic losses—and an astounding $62.8 billion in loss reserves on “individually impaired” loans. As I noted in my amicus curiae brief for the Perry Capital case, “Impairment accounting allowed Fannie to record as immediate expenses not only credit losses that otherwise would have been booked over time but also estimates of future losses and even the present value of foregone interest payments.” The large majority of these impairments were on loans that returned to paying status, but most of the reserves cannot be released until the loans repay. As of December 31, 2016, Fannie still had $28.6 billion locked up in reserves on individually impaired loans.
Together, the unwarranted write-down of Fannie’s deferred tax assets and the aggressive use of impairment accounting allowed FHFA to balloon Fannie’s losses by $144 billion between 2008 and 2011. (I have not calculated the comparable dollar amount for Freddie.) Treasury knew at the time it took Fannie and Freddie over that they did not need rescuing, and it also knows that virtually all of the $18.7 billion the companies were obligated to pay each year prior to the net worth sweep were the results not of the companies’ business decisions but of FHFA’s accounting decisions.
December 12, 2011 Draft Information Memorandum to Secretary Geithner
This memo, prepared by Assistant Secretary Mary Miller, presented “policy options, which taken together could serve as the basis of a comprehensive non-legislative Administration reform proposal.” As we now know, Treasury ended up choosing “Policy Option 1– Restructure the calculation of Treasury’s dividend payments from a fixed 10 percent annual rate to a variable payment based on available net worth (i.e., establish an income sweep).” But what drew my attention was “Policy Option 2- Develop a plan with FHFA to transition the GSEs from their current business model of direct guarantor to a model more aligned with our longer term vision of housing finance.” The idea behind this option was to “Amend the PSPAs to add additional contractual obligations for the GSEs and FHFA associated with transition.” Policy Option 2 had four elements:
– “Guarantee fee price increases – pricing for direct GSE guarantees could be increased by a minimum of five to ten basis points per annum (or at a pace determined annually by FHFA and Treasury) until pricing reaches levels that are consistent with those charged by private financial institutions with Basel III capital standards and a specified return on capital.”
- “Risk syndication – consistent with the phase-in period of guaranty fee increases, the GSEs could be required to sell a first-loss position (or the majority of the credit risk) to the private market on all of their new guarantee book business within a five- or seven-year time period. It is important to note that risk syndication would likely reduce the earnings capacity of the GSEs (similar to how the winding down of the retained portfolios also limits income generation).”
–“Single TBA delivery – require the GSEs to align payment standards and issuance process to establish a fungible TBA market for common delivery of Fannie Mae and Freddie Mac securities,” and
– “Additional transition requirements – additional requirements could also be considered, such as down payment levels, faster retained portfolio wind down…etc.”
With the exception of the faster run-off of Fannie and Freddie’s portfolios, none of these activities were codified in the Third Amendment to the PSPAs. Instead, FHFA did all of them (clearly at the direction of Treasury) in its capacities as conservator and regulator. Yet they remained Treasury’s initiatives, intended to further the goal of “winding down and replacing” Fannie and Fannie with a bank-centric alternative. And the initiatives were exceptionally cynical.
Begin with the guaranty fee increases. Why were they being proposed? Not because of credit risk, but to reach “levels that are consistent with those charged by private financial institutions with Basel III capital standards,” i.e., banks. Homebuyers, of course, would pay those unnecessarily high guaranty fees. Prior to the financial crisis, Treasury (and the Federal Reserve) had aggressively promoted unregulated private-label securities (PLS) as the preferred alternative to Fannie and Freddie financing. When the PLS market imploded to trigger the crisis, Treasury and the Fed quickly intervened to ensure that the commercial and investment banks would suffer no lasting negative effects, but left homeowners to fend for themselves, with eight million of them ultimately losing their homes. Here, in another attempt to replace Fannie and Freddie, Treasury proposes to have homeowners pay higher guaranty fees solely to make it easier for banks to compete with those companies.
The Miller memo also introduces the idea of mandatory credit risk sharing. Note, though, the statement that “risk syndication would likely reduce the earnings capacity of the GSEs (similar to how the winding down of the retained portfolios also limits income generation).” Earnings are income less expense, and if the envisioned risk-sharing transactions reduce earnings it only can be because the interest expense on them exceeds the income from transfers of credit losses they supposedly will produce. In fact, forcing Fannie and Freddie to buy insurance for up to 400 basis points of credit losses on pools of loans with better risk characteristics than books from the early 2000s—which only experienced about 50 basis points of credit losses even through the financial crisis—is burning up their earnings just to make them look less profitable, and easier to replace. I’ve suggested that publicly; in this memo Treasury actually says it privately.
Miller’s reference to the income effects of winding down the portfolio business is telling. Elsewhere in the unsealed documents we find the statement: “Many commentators tend to point incorrectly to the retained portfolios as the cause of Fannie Mae and Freddie Mac’s collapse; while the losses were significant and were indicative of the risks Fannie and Freddie took, the Investment/Capital Markets (Retained Portfolio) segment has only accounted for 9% of cumulative losses.” That is an accurate assessment. With relatively low credit losses, the spread income from the mortgages Fannie and Freddie held in portfolio was helping them absorb losses from their mortgage-backed securities business. That was of no import to Treasury, however. It always had opposed the companies’ portfolio business, and when it imposed the PSPAs on them in 2008 it required them to shrink their portfolios by 10 percent per year (increased to 15 percent in the Third Amendment). One neither rescues nor conserves a company by reducing its income, but Treasury’s mandates to Fannie and Freddie to shrink their portfolios and to issue risk-transfer securities without regard to their economics had that deliberate intention and effect.
Housing Reform Questions and Answers
One of the questions in this undated document is, “What caused the crisis in the housing market?” After saying “No single cause can fully explain the crisis,” the paper identifies five “structural flaws” that contributed to it, including “A complex securitization chain [that] lacked transparency, standardization, and accountability and allowed lenders to pass toxic product through the system without regard for its risk” and “Inadequate capital in the system.” In this piece marked “Not Intended for External Distribution” there is no mention of a “flawed business model” at Fannie and Freddie being one of the causes, let alone the most important cause, of the crisis. To the contrary, in response to the question, “Did Fannie/Freddie cause the financial crisis by lowering their underwriting standards, allowing consumers to get loans they couldn’t afford?” the answer is, “No. Rather than leading the market into subprime and other risky mortgages, Fannie and Freddie followed the private sector.” Internally, Treasury well understands why and how the crisis occurred.
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There can be little doubt about why the government has been fighting so hard to hold on to the documents Fairholme requested in discovery for its regulatory takings suit: the ones produced so far reveal that what Treasury knows to be true about Fannie and Freddie privately—and tells itself in memos, emails and other materials—is starkly at odds with what it has been claiming about the companies publicly.
For whatever reason, and perhaps it is nothing more complicated than wanting to support the institutions it is responsible for regulating, Treasury has for decades sought to “rein in” or replace Fannie and Freddie, whose activities in the secondary market reduce the market power and the potential profits of banks in the primary market. Treasury and the Federal Reserve saw the financial crisis as a serendipitous opportunity to seize control of the companies, burden them with a mammoth and non-repayable amount of indebtedness, reduce their earnings, and in 2012 take all of their capital in the hope this would prod Congress to replace them. To execute its plan, however, Treasury has had to be untruthful about virtually everything having to do with Fannie and Freddie—their health going into the crisis, the reason for taking them over, the source of their losses in conservatorship, and why the net worth sweep was imposed, among others. Documents released in discovery to date lay bare this pattern of deception.
When the truth about Fannie and Freddie is substituted for the fictions about them, the rationale for the legislative mortgage reforms being proposed by the Financial Establishment—whether Corker-Warner, Johnson-Crapo or the latest version from the Mortgage Bankers Association—crumbles. If, as Treasury admits in an internal document, Fannie and Freddie “followed the private sector…into subprime and other risky mortgages,” why is the right public policy response to dismantle the more responsible entities, Fannie and Freddie, and turn the secondary market over to the “private sector” companies who were more culpable in the crisis? And if the real problem in the crisis was “inadequate capital in the system,” why not allow FHFA to follow HERA and implement a true risk-based capital standard for Fannie and Freddie, updated to meet current standards of taxpayer protection? Fannie and Freddie are not the “failed business model” their critics claim; loans they financed leading up to the crisis performed far better than loans from any other source.
The banks see great profit opportunities from substituting themselves for Fannie and Freddie as the centerpieces of the secondary mortgage market, and historically Treasury has supported those ambitions. But Treasury now has new leadership, and is taking a fresh look at Fannie and Freddie in conjunction with its commitment to “get them out of government control.” The documents released by Judge Sweeney make clear that in order to advance the banks’ agenda, past leadership of Treasury has had not only to make claims about Fannie and Freddie it knows to be untrue, but also to require millions of homebuyers to pay higher guaranty fees not because of the risk of their loans but to put banks in a better competitive position to get their business. I believe that current Treasury leadership will recognize the folly of the course its predecessors have been on, and that they will change this course to one that builds on Fannie and Freddie, and benefits homebuyers rather than banks.