Risk Transfer and Reform

On September 26 I participated in a conference call hosted by the Washington D.C. investment firm Compass Point, on the topic of “Mortgage Finance Reform and Credit Risk Transfers.” Below is the text of my prepared remarks for that call.

 

The topic I’d like to address this morning is credit risk transfers, and the role they might play in a reformed mortgage finance system.

Today there are two competing approaches to resolving the conservatorships of Fannie and Freddie. The first is what Treasury and those I call the “Financial Establishment”—commercial and investment banks and their supporters—have sought from the day the conservatorships began: to wind Fannie and Freddie down, and have Congress replace them with some mechanism more to the liking of large primary market lenders. Over the past few years there have been a number of proposals for doing this: Corker-Warner, Johnson-Crapo, proposals from the Urban Institute and the Milken Institute, and most recently a white paper put out in April by the Mortgage Bankers Association.

But since the election of President Trump and the appointment of Steve Mnuchin as Treasury Secretary, an alternative approach has emerged: administrative reform that would preserve and strengthen Fannie and Freddie, without legislation. This idea is backed by community lenders, affordable housing groups and plaintiffs in the lawsuits against the net worth sweep, and in June it was turned into a concrete proposal by the investment firm Moelis & Company.

The status quo of keeping Fannie and Freddie in conservatorship is very convenient for the government, but because of the net worth sweep lawsuits I don’t think it can be sustained indefinitely. And when the conservatorships do end I believe it’s more likely to be through administrative action than legislation. The deep divisions within and between the parties—as well as the House and Senate—over how an alternative to Fannie and Freddie would operate make it dauntingly difficult to come up with legislation in as complex and critical an area as our $10 trillion mortgage market. By contrast, if Treasury follows an administrative reform process it can build on two companies that have a proven record of success, use negotiation with plaintiffs to settle the lawsuits—which will be essential in any reform effort—and by keeping Fannie and Freddie at the center of the mortgage finance system extract about $100 billion in value from the warrants it holds on the companies’ common shares.

So far, though, the Mnuchin Treasury has shown no sign of moving in this direction. It hasn’t changed any of the policies put in place by the Bush and Obama Treasuries that were designed to make it easier to replace Fannie and Freddie by “winding down” their profiles in the market. One of those policies, which I’ll focus on today, is having the Federal Housing Finance Agency (FHFA) mandate the use of credit risk transfers, or CRTs, to move credit risk, and revenues, away from the companies to private mortgage insurers and investors in CRT securities.

We now know from discovery in one of the court cases that in December of 2011 Treasury proposed to “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.” A key element of this plan was “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.” There was no requirement that these risk transfers make economic sense for Fannie or Freddie.

For the past four years the large majority of the credit risk transfers done under this policy have been securitized CRTs—Fannie’s Connecticut Avenue Securities (or CAS) and Freddie’s Structured Agency Credit Risk notes (or STACRs). Private mortgage insurers and reinsurers have seen only small increases in business from Fannie and Freddie, mainly, I think, because of their capital constraints.

I’ve been a vocal critic of CAS and STACRs because they’ve been so non-economic: the companies are paying huge amounts of money to insure very high-quality books of business against levels of credit loss that have extremely low probabilities of occurring. But what I hadn’t realized until I read the Treasury policy document a couple of months ago is that Treasury and FHFA both know this, and don’t care. Their goal has been, to use their word, to “de-risk” Fannie and Freddie, and in fact it’s easier to transfer business to the private market if it’s not economic for the companies—that is, if private investors get lots of revenue and not much risk of having to absorb credit losses. And that’s exactly what’s been happening.

But Treasury can’t continue to support doing CRTs this way. When we finally agree on a proposal for secondary market mortgage reform, the credit guarantors in the new system—whether Fannie and Freddie or some other entities—will be required to prudently manage the credit risk of the loans they guarantee. For the reformed guarantors, CRTs can’t be giveaways; they’ll have to be conceived of and used in a way that strengthens, not weakens, them.

Whoever the credit guarantors are, they’ll be given an updated statutory capital requirement, and either Treasury or Congress will have to determine how credit risk transfers fit into that requirement. There really are only two alternatives, which I call the CRT model and the equity model. In the CRT model, some fixed portion of a guarantor’s capital requirement, say half, must be made up of credit risk transfers, with the rest being common or preferred equity. In the equity model, all capital must be shareholders’ equity, although a guarantor at its discretion, and with the permission of its regulator, can substitute CRTs for equity when it thinks that makes economic sense.

Over the last few years a number of prominent reform proposals, including those from the Urban Institute and the Milken Institute, have incorporated the CRT model. Wall Street firms and capital markets investors—both of which make a lot of money from the CAS and STACRs being issued today—support the CRT model as well. But making credit risk transfers mandatory for our future credit guarantors would be a disastrous mistake.

The fatal flaw of the CRT model is that while Congress or a regulator can require a credit guarantor to transfer a fixed percentage of its credit risk, they can’t require an investor or an institution to take it. Institutions or investors will take the risk in good times, but when home price growth is slowing or prices are actually falling—and mortgage delinquencies and defaults are rising—they won’t.

The housing and mortgage markets are cyclical, and in downturns credit losses are concentrated in the most recently acquired loans; older business generally performs much better, because it’s had time to build up equity. What’s been called the “Great Recession” was no exception. Loans acquired before 2005 made up 46 percent of Fannie’s book of business at December 31, 2007, but they were responsible for just 13 percent of company’s credit losses between 2008 and 2016. In contrast, loans from 2006 and 2007, which were only 38 percent of Fannie’s December 2007 book, contributed 69 percent of those losses. (Loans from 2005 were 16 percent of the book, and 18 percent of the losses.)

This sort of skewed loss distribution wreaks havoc with a mandatory CRT program. A good way to see that is by assuming Fannie had issued CRT securities against all of the loans it owned or guaranteed before 2008. To simplify the analysis—without distorting it—we’ll look just at what Fannie calls its “M-2” security, which takes losses beginning at 1.0 percent of the initial principal balance of the pool it covers, and continues taking them up to 2.75 percent of that pool. We then can examine how these M-2 tranches would have performed with our three different loan groups: all loans prior to 2005, loans acquired in 2005, and loans acquired in 2006 and 2007.

For loans acquired before 2005, Fannie would have paid a total of about $15 billion in interest on its M-2 tranches, but because of their 1.0 percent first-loss threshold very few credit losses—well under $1 billion—would have been transferred. CRTs issued on these loans would have been almost completely ineffective. Fannie would have received a modest economic benefit from M-2 tranches issued against its 2005 book, paying $3 billion in interest and transferring $4 ½ billion in losses. The only significant benefit from CRTs would have come from Fannie’s 2006 and 2007 books: on those it would have paid just $4 billion in interest, and been able to transfer $20 billion in losses before all of the investors’ principal was wiped out.

But I’m sure you can guess what the problem here is. Fannie easily would have been able to sell CRTs against its pre-2005 loans, just as it’s been able to sell them to cover the even better books of business it’s put on over the last four years. And it probably still could have sold CRTs in 2005. But how likely is it that capital markets investors would have kept putting money into M-2 tranches throughout 2006 and 2007, and lost 80 percent of their investment? These are opportunistic investors, looking to make money on CRTs, not lose it. They can withdraw from that market whenever they want, and there are reliable indicators that signal when credit risks are about to spike. A slowing rate of increase in home prices is a classic flashing yellow light for rising delinquencies and eventual defaults, and falling home prices are a fire alarm for the same things.

U.S. home prices began to fall in the second quarter of 2006, so that means there is zero chance that investors would have continued to buy Fannie’s CRTs in the second half of 2006 and in 2007. If Fannie had relied on CRTs during the last recession for credit loss protection, it would have lost some $10 billion on the CRTs it did issue, and then been stuck with all of the credit losses from the loans it acquired after the middle of 2006. Private mortgage insurers wouldn’t have stepped in to replace the lost CRT investors, because by then the high winds were blowing, and the MIs were scrambling for capital to cover the risks they already had.

There literally is no good argument for the CRT model compared with the equity model. With the equity model, you go into a credit downturn with capital on your balance sheet; with the CRT model, you go in hoping investors will voluntarily supply that capital by buying CRT securities that let you burn up all their principal. And when they don’t, you’re out of luck. By the time you know you need the equity the capital markets won’t give it to you, and you’re very likely to fail.

The causes of the 2008 mortgage market meltdown were the lack of regulation of origination and financing practices, and a lack of capital. Dodd-Frank addressed the regulation of originations. Now we need to address the lack of capital by updating guarantor capital requirements to meet current standards of taxpayer protection, and then, to ensure that our secondary market financing system remains strong and resilient, insist that guarantors use actual shareholders equity, not contingent risk-transfer transactions, to satisfy those capital requirements.

CRTs still can play a role in a guarantor’s capital structure under the equity model. The guarantor would determine when and how to use each type of CRT, based on its assessment of their economics, while the regulator would determine the amount of capital relief to grant, based on the standard that the CRT transaction or mechanism be at least as effective in absorbing credit losses as the dollar amount of equity the guarantor is permitted to forego. This combination of an economic evaluation by the guarantor and an “equity equivalency” assessment by the regulator would ensure that CRTs used in the future do not weaken the mortgage finance system’s ability to withstand stress, as today’s CRTs so obviously do.

84 thoughts on “Risk Transfer and Reform

  1. Do you have an opinion on the analysis done by Andrew Davidson,”Why Competition Would Not Lead to Better Outcomes for Fannie Mae and Freddie Mac”
    http://knowledge.wharton.upenn.edu/article/why-competition-wont-lead-to-better-outcomes-for-fannie-mae-and-freddie-mac/
    I don’t agree with all of his assumptions, but I think he makes some interesting points with regards to cost sharing transactions and competition in the mortgage servicing market.

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    1. There are different issues being litigated in the two cases. In Perry Capital, the claim is that FHFA acted in violation of the Administrative Procedures Act by taking actions that were outside the scope permitted of a conservator by the Housing and Economic Recovery Act. The suit in Sweeney’s Federal Court of Claims argues that if FHFA’s imposition of the net worth sweep is deemed to be legal (i.e., not in violation of HERA), then it is a regulatory taking by the government, for which shareholders of Fannie and Freddie must be compensated. The legal remedy in Perry, were the plaintiffs to prevail, would be a reversal of the net worth sweep; the legal remedy if the plaintiffs prevail in the Court of Claims would be monetary damages (in an amount to be determined by Sweeney).

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        1. There is a 90-day time limit to petition the Supreme Court for a writ of certiorari on a decision made by an appellate court. Although the D.C. District Court of Appeals decided the Perry case on February 21, the opinion was “reissued” on July 17. Fairholme’s writ of certiorari was filed on October 16, just inside the window for appeal.

          The Fairholme case in the Federal Court of Claims, by the way, still has a very long time to run. Because the plaintiffs in the case were granted a “quick peek” on some 1500 documents the defense had declined to produce, discovery in this case still is not complete. Once it is, Judge Sweeney has adopted a subsequent briefing schedule–agreed to by both plaintiffs’ and defense counsel–that will take at least a year to complete, and that’s just for Sweeney to decide whether her court even has jurisdiction in the case. Should she decide in the affirmative (and assuming the net worth sweep has not been ruled illegal before that point), arguments on the merits of the case then would begin, with the schedule for those to be determined at that time.

          Liked by 4 people

  2. Tim,

    Good afternoon. Paul Muolo with Inside Mortgage Finance has mentioned several times in articles that he has heard the Trump Administration might be preparing an Executive Order to give Treasury the green light for their Fannie, Freddie plans. Do you have any idea what type of Executive Order could be issued and what type of power it would grant?

    Thanks

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    1. I have not heard anything specific about an Executive Order from the administration relating to Fannie and Freddie. If there is something being discussed, however, my best guess is that it would have to do with the companies’ net worth sweep payments to Treasury–most likely changing them from quarterly to annual–rather than any sort of comprehensive administrative reform. As I’ve stated previously, I do expect Treasury to propose administrative reform of Fannie and Freddie at some point, but not until (a) the budget, tax reform/reductions and the debt ceiling have been addressed by Congress (I do not expect this Congress to put forth a legislative reform proposal), and probably (b) something happens in one or more of the net worth sweep cases that makes clear to Treasury that a negotiated resolution of these cases is essential for a permanent reform initiative to be successful.

      Liked by 3 people

      1. Hi Tim-
        Regarding Perry’s request to have SCOTUS review their case: Would it not be more prudent to wait until the final wave of documents are released after the “quick peek” to request this. Admittedly, I know very little about the legal process at this stage of the case, but if we were to lose the SCOTUS review wouldn’t that put an axe in the remaining GSE lawsuits before the fruit of the new documents could be realized? Thank you for your time.

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        1. The appeal to SCOTUS of the Perry Capital decision would not benefit from any documents that may be produced and released pursuant to the “quick peek” procedure granted by Judge Sweeney in the Federal Court of Claims case, for the simple reason that Judge Lamberth’s decision in Perry Capital–which was upheld by a majority of the judges reviewing the case at the D.C. Court of Appeals–was based purely on an interpretation of the law. Indeed, Lamberth stated directly that the facts were not relevant to his decision: his reading of HERA was that it permits FHFA to do whatever it wishes with the companies, in its sole judgment as conservator, irrespective of its motives for taking such action.

          Three things can happen as a result of the Perry appeal: (a) SCOTUS could decline to hear the case (probably the most likely); (b) it could rule for the plaintiffs, either ending the net worth sweep or, more likely, remanding the case back to Lamberth for development of an administrative record (i.e., factual determination), or (c) it could rule for the government, upholding the sweep definitively. In the event of the third outcome, all other cases challenging the sweep based on a violation of the Administrative Procedures Act–Robinson, Roberts and Saxton–would be dismissed. But several other cases– Jacobs-Hindes (which claims that the sweep is in violation of Delaware state law), Rop, Bhatti and possibly Collins (which challenge the constitutionality of FHFA, which agreed to the sweep), Fairholme in the Federal Court of Claims (which challenges the sweep as a regulatory taking, and in fact would be strengthened by a SCOTUS finding that the sweep was legal) and the contract claims in Perry (which were remanded to the Lamberth court by the D.C. Court of Appeals)– would proceed.

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          1. I hope SCOTUS does hear the case. The appeal of the Lamberth decision was argued by counsel for both the institutional plaintiffs (Ted Olson of Gibson, Dunn & Crutcher) and the class plaintiffs (Hamish Hume of Boies, Schiller & Flexner). In comments made after the decision by the D.C. Court of Appeals, Hume did not seem optimistic about the chances of the Supreme Court taking the case on petition. I may be overanalyzing this (or, given my lack of legal credentials, doing the opposite), but I viewed the absence of Boies Schiller as co-counsel in this writ as an indication that they did not feel optimistic enough about its chances of success to join in the filing.

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          2. typically scotus will grant review if there is a conflict in the circuits. perry’s filing goes to great length to illustrate the circuit split by focusing on the “conservator stamp” analysis that is prohibited in the 9th circuit. perry essentially argues that the dc circuit allowed fhfa to put the conservator stamp on nws and barred judicial review of nws. so the petition cant simply say that judge brown was right and judges millet and ginsburg were wrong. we shall see whether this presents for scotus enough of a circuit conflict.

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          3. I’ve now read the Fairholme petition, and find it to be very persuasively written, including its arguments for why the Supreme Court should address this issue. I am now more optimistic that the Court will in fact grant cert in the case. We shall see.

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  3. Tim –

    [Edited for length] I worked at Freddie Mac in their SF Counterparty Credit Risk group into early 2016. During my time there, it always seemed to be a risk that was underappreciated (internally & externally).

    You have described the CRTs (and similarly, K-Deals, etc.) in how the transaction works. One part that stood out to me is that the transactions, by definition, rely on reimbursements from the buyer of said security.

    While I was at Freddie Mac, the MBIA, Zohar Fund II, and other PMI insurers, were under extreme stress. I believe they finally went under.

    These transactions lead me to believe that, today, CRTs are working in a theoretical environment. However, in practice, when the there is stress in the market, liquidity is an issue, and firms start to fold, the GSEs will not be a priority payment for the buyers of the CRTs. I believe you have back-tested some of this (in a comment or post), but you did it only from one side of the transaction; GSEs.

    If the buyers of CRTs are likely large institutional investors, what would happen when the GSEs demand payment, rightfully owed under the contracts, and the investors withhold payment as they believe their is a counterparty risk, from their side?

    Interested in your thoughts on the counterparty risk that seems to go unadressed in most discussions. “In theory there is no difference between theory and practice. In practice there is.” – Yogi Berra

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    1. It’s important to distinguish between credit risk transfers done with investors (such as Fannie’s CAS and Freddie’s STACRs) and CRTs done with institutions. The latter do have counterparty risk that needs to be measured, monitored and managed, but there is no meaningful counterparty risk with CAS and STACRs, for the simple reason that when investors buy a securitized CRT they give Fannie and Freddie the full amount of principal up front; if either company has losses that meet the criteria for allocation to these investors, it deducts the losses from what it returns to them upon the contractual maturity of their securities.

      That’s not the case with institutional CRTs. As you know, counterparty risk arises when a company has a contract with an insurer, reinsurer or a lender (including a multifamily loss-sharing arrangement) to reimburse it for credit losses, but does not hold high-quality collateral equal to the dollar amount of those potential losses. (Fannie and Freddie also have counterparty risk on the borrower-paid MI they’re required to have on all loans with down payments of less than 20 percent; if they price their credit guarantees assuming that all this primary MI is “money good” and the MIs can’t cover some of it, those losses will be borne by the companies.)

      I do not know how Fannie, Freddie or FHFA currently are assessing the companies’ institutional counterparty exposure. They discuss the issue in general terms in their 10Ks and 10Qs, but there does not appear to be any defined stress standard they use to determine where to limit their exposure or how much collateral to require for their various types of risk sharing. That is an oversight that needs to be remedied—and it could be, were FHFA to implement a true stress-based capital standard for Fannie and Freddie, as it was instructed to do in the 2008 HERA legislation. With such a standard, the companies would set counterparty exposure limits and collateral requirements so that in the FHFA-defined stress environment all of their risk-sharing transactions were fully covered either by collateral or capital.

      Neither of the key requirements for Fannie and Freddie’s risk sharing involves rocket science. Securitized CRTs have to make economic sense for the issuers across the economic and housing cycle, and institutional CRTs have to be backed by enough counterparty capital and high-quality collateral so that they are money good. But those who advocate mandatory risk sharing for Fannie and Freddie blatantly ignore both requirements: just move as much of the risk (and revenue) away from the companies as possible, they say, and we’ll call that success. As I note in the current post, however, in a reformed credit guaranty system the risk-sharing transactions that are done—whether with investors or institutions—have to be structured and implemented in a way that strengthens the guarantors, not weakens them. Few seem to have focused on that nagging little detail yet.

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      1. Mr Howard

        Will CAS and STACRs present and future result in less debt issued by the GSE’s due to additional risk transfer?

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    2. As Mr Howard has stated in the past nothing substitutes for equity financing.Which would anyone want adequate equity financing or whatever earnings on…

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  4. Tim,

    Your prepared remarks (above) at Compass Point were to run about 15 minutes, then you were going to have a “questions and answers” session.

    I am wondering how the question and answer session went?
    Any impressions you could share with us?

    Thank you endlessly for your unselfish efforts to educate and your irrefutable expertise.

    Liked by 3 people

    1. The Q&A for the Compass Point call covered topics that would be familiar to readers of this blog: the differences in, status of and prospects for the various court cases; the strengths and weakness of the competing alternatives for mortgage reform–legislation altering or eliminating Fannie and Freddie, and administrative action preserving and strengthening them; and speculation on the reasons for FHFA’s continued deferral to Treasury on the management of the companies in conservatorship, among others. The callers seemed interested in learning my views on these topics, with no one challenging any of them. Finally, there wasn’t anything really new or different in either the questions or my responses that merits a more detailed elaboration here.

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  5. In a positive development, Judge Sweeney grants in favor of Fairholme on Motion to Compel. Govt has to turn over 1,500 additional documents that Fairholme asked for

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    1. I saw that. It’s good news for a couple of reasons. First, I have little doubt that there will many new documents produced among these 1500 that will make clear that the story Treasury has been telling since 2008 about the “rescue and bailout” of Fannie and Freddie is knowingly false, and that Treasury has been attempting to conceal that fact from the public through its aggressive (and unwarranted) claims of deliberative process and examination privilege. The more it becomes clear to the general public that the legislative “reforms” the banks are pushing for with respect to Fannie and Freddie are their self-serving answer to a made-up and lied-about problem, the better the chances become for administrative reform that preserves and strengthens the companies. Second, it also seems apparent that Judge Sweeney understands that defense counsel in the Fairholme case has been deceiving the court extensively and willfully about the content and relevance of documents it has been withholding; she can’t be happy about that, which should work to the advantage of the plaintiffs as the case proceeds.

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      1. Tim, Out of the previous approximately 3500 docs released only a hand full have been made public. Maybe you can help educate me on why not more of these docs have not been made public. Much regards and thanks for all your great input.

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        1. It’s at the discretion of Judge Sweeney, who has to agree to release them from their protective orders. I believe she does that for documents that she thinks provide meaningful and relevant information for all of the other cases, since hers is the only case for which discovery has been authorized and is ongoing.

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  6. That hearing was one of the worst I ever saw. No substance or logic quite the opposite just a lot of misinformation from committee members. Capuano is the only one that knows.

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    1. Agree. The lack of substance and the inability to understand the precarious state of the GSE is frightening. I am concerned that almost none of these members really have the fortitude or intelligence to tackle this problem. The need for Recap and Release must happen now.

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  7. Tim,

    In today’s testimony to the House, Watt says he thinks bank capital standards would be to high to apply to the GSEs and they would only need 2% – 3%. Finally someone is listening!

    Sean

    Liked by 6 people

    1. I did not see the live stream of the Watt hearing–and now know that it was almost 4 hours long, so I don’t think I’ll watch it on YouTube–but I did see the string of comments (now deleted) noting that Watt seemed to have endorsed a 2 to 3 percent capital requirement for the companies in one of his responses and a 3 to 5 per cent capital requirement in another. In reviewing the Twitter excerpts of the hearing, it seems that he cited the 3 to 5 percent requirement as being appropriate for banks, but then said that the 2 to 3 percent figure is more appropriate for Fannie and Freddie because of their credit risk transfer programs.

      Based on that, I would not agree that Watt is “listening.” The reason the 3 to 5 percent “bank-like” capital requirement is not correct for Fannie and Freddie is that they are not banks: they are limited to dealing in only one product type, residential mortgages, and now essentially take only one type of risk (and a relatively safe one–credit risk on prudently underwritten loans), compared with the multiple product and risk exposures of commercial banks. And as I discuss in this post, Fannie and Freddie’s current CRT programs do NOT substitute for equity capital on anything close to a dollar-for-dollar basis, and in fact if used programmatically as a substitute for hard equity actually would weaken the companies’ ability to withstand economic and financial stress.

      It is more than a little disappointing that the director of Fannie and Freddie’s regulator–which has been given the duty in its enabling statute, HERA, to update the companies’ capital requirements using a true risk-based capital stress test–continues to discuss Fannie and Freddie’s capital using a framework put forth by opponents of the companies who want to replace them with a bank-centric alternative. Fannie and Freddie DO need “private capital,” but that capital should be shareholders equity, not fair-weather CRTs, and it should be supplied in an amount set not by what supporters of banks would like them to have (so they have to price their business uneconomically), but by what their regulator, FHFA, determines is necessary to survive a defined level of stress, given the risk profile of the loans the companies are guaranteeing. I understand that this was a political hearing, but Watt’s responses to the questions he was being asked do not give any evidence of the leadership he should be showing in helping Congress get to the right answer on how to restructure the secondary mortgage market so that it can continue to perform the valuable public function it has done the past, at negligible risk to taxpayers. He needs to step up and do that.

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      1. Yes, risk transfer was his sole reason for distinguishing lower capital requirements for the twins. I didn’t like that justification. He had the correct answer but for the wrong reason.

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          1. To paraphrase Michael Oakeshott’s take on Jeremy Bentham, Watt’s ‘general credulity’ makes him a *philosphe* par excellance. Watt, like Bentham before him, ‘begins with an entire miscellany of presuppositions he has neither the time, the inclination, nor the ability to consider.’

            Mr. Howard is absolutely correct: it’s not Watt’s conclusions that matter, but the reasons he gives for them. These *rationes decidendi* are not only more interesting in themselves, but are also more germane to predicting how he’ll *act* beyond his commentary in a political – and politicised – forum.

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      2. I like, agree with and applaud what you have written here. However, is it not true that Fannie Mae has interest rate risk as well as credit risk? Sorry for splitting hairs, but I still believe your case for lower capital requirements for Fannie is strong.

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        1. Yes, both companies have interest rate risk on their portfolios as well as credit risk on their MBS guarantees. But there isn’t much controversy over how capitalize for that (there is little disagreement with what was done previously for the companies: whatever the capital requirement is for credit risk, plus an additional 200 basis points of interest rate risk capital for loans retained in portfolio). That should be more than adequate, provided the companies continue to use active rebalancing to keep the asset-liability match on those portfolios close to equal as interest rates move. And as you know the portfolios now make up barely ten percent of Fannie and Freddie’s combined books of business (MBS plus portfolio), so the effect of the extra 200 basis points of interest rate risk capital on the companies’ overall capital requirements will be relatively small.

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  8. Tim,

    I forget, if Mnuchin/Trump grow frustrated w Congress & their inability to reform the GSEs and they then decide to act administratively – can Munchin enact the Moelis plan or similar reform on his own or does he need Mel Watt to sign off in order to actually do it? I know that Corker’s bill for the gov’t to sell GSE shares expires at the end of 2017 but again, if Mnuchin/Trump decide to finalize reform, recap, & release do they explicitly need Watt’s (FHFA) stamp of approval?

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    1. Yes. Just as Treasury needed FHFA to be the one to put Fannie and Freddie into conservatorship (under HERA, only FHFA was given that authority), it also will need FHFA be the one that releases the companies from conservatorship, if that’s what Treasury elects to do. FHFA also would have to sign off on any negotiated settlement between the government and the plaintiffs ending the net worth sweep and other lawsuits or, alternatively, agree to a Fourth Amendment to the PSPA that does that.

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        1. I’d flip the question, and ask, “what would be Watt’s incentive to resist what Treasury believed was the right outcome for Fannie and Freddie?” Even though FHFA by charter is supposed to be an independent agency, it has followed what Treasury has told it to do since before the conservatorships were imposed on the companies. (You may recall that Secretary Paulson was surprised and peeved that then-FHFA Director James Lockhart had sent Fannie Freddie letters on August 22, 2008 saying they were safe and sound and exceeded their capital requirements; in less than two weeks Paulson got Lockhart and his entire agency to reverse themselves and send each company an extremely harsh mid-year letter as a prelude to the conservatorships Treasury wanted). FHFA has continued to follow Treasury’s directives or wishes throughout the conservatorships–most recently last Friday, when Watt overruled himself on allowing Fannie and Freddie to retain their second quarter earnings as a means of beginning to build a capital cushion, because Mnuchin said he opposed it–and I can’t imagine why FHFA suddenly would become rebellious if and when Treasury gives it a way to move from its role of interminable conservator back to the more traditional and comfortable role of financial regulator.

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          1. i would only add that the expiration of the “jumpstart” no-action period on 1/1/18 removes the deference that treasury/fhfa may feel obliged to accord congress. i never found the actual jumpstart language to prevent administrative action if carefully considered and executed, but jumpstart certainly expressed the notion that, pre-1/1/18, congress expected it would drive GSE reform. by negative implication, failure of congress to act before end of 2017 leaves treasury/fhfa with a much freer hand.

            rolg

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          2. My prefered outcome from all of this would be for all stakeholders to be part of any solution. Haven’t stakeholders so far assumed the risk along with the taxpayers?

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  9. Mr. Watt’s recent comments only serve to corroborate that the Treasury has been calling all the shots all along for that “independent” agency, the FHFA. But I guess we already knew that. What a sham it was for Mr. Watt to have implied he’d dance alone! He has always needed a dance partner, not just to dance but to lead.

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    1. The mystery for me is, why would Watt have gone out of his way to tee up the possibility of having FHFA temporarily suspend Fannie and Freddie’s net worth sweep payments– with public statements about the need for a capital buffer, and approved changes in the language used about the payments in the companies’ quarterly earnings releases and financial filings–and then, with no visible impediments to suspending them this quarter, not do it? Something had to occur between the time Watt began his “softening up” campaign and now to change his mind. One possibility is that he and Mnuchin have agreed to (partially) deal with the capital buffer problem by changing the net worth sweep from a quarterly to an annual payment. That way, Treasury still would get its money from Fannie and Freddie for as long as the sweep remained in effect, while Fannie and Freddie would get somewhat more protection from accounting-related earnings volatility than they have now. (With an annual sweep they would have no capital buffer only in the first quarter of a year; in each subsequent quarter their buffers would grow with each quarter’s earnings until the end of the year, when all retained earnings would be swept and the cycle would begin again.) That’s the most plausible–and least sinister–explanation for this odd sequence of events that I can come up with, but who knows?

      Liked by 4 people

      1. Tim,

        Are both GSEs on a calendar fiscal year? If so, is there some financial or accounting impediment that would have precluded annual sweeps to have begun four quarters from now, enabling them to have begun building a buffer between now and then? I’d think not but I surely don’t know.

        My take, which also my hope, is Treasury is planning a favorable administrative solution and when they uncork it (no pun intended) wants to be able to say that they 100% complied with Congress, even allowing GSEs to become a taxpayer risk per Congress’s fiscally reckless strictures. Here’s to hoping.

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      2. Tim,

        Aside from the Watt mystery, can you figure out how Mr. Mnuchin can extricate the current administration from the very thing he accused the previous administration of, using the sweep to fund x, y or z?

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  10. Tim,

    Good morning. What type of maneuvering would the Trump Admin need to take if tax reform legislation does pass in a timely manner as it relates to the DTA at Fannie, Freddie? Is there anything specific they can do to prevent cutting a check to Treasury but keep the companies in conservatorship?

    Thanks

    Liked by 3 people

    1. I don’t think the Trump administration will do any “maneuvering” in response to the impact a cut in the corporate tax rate will have on the value of Fannie and Freddie’s deferred tax assets (DTAs). It’s up to the companies to manage this, and I certainly hope they are focused on the issue. The dollar amount of those DTAs is to a significant extent under the control of the companies, since it is largely the result of accounting decisions they (or FHFA, as their conservator) have made that affect the timing of when they recognize income and expense for book purposes compared with when the IRS recognizes them for tax purposes. As I noted in a post earlier this year (“Deferred Reform, and Deferred Taxes”), if I were at either company–but particularly Fannie, which has a considerably higher dollar amount of DTAs–I would be looking at what I could do to work that DTA number down before tax reform is passed. If either company has a DTA write-off that is larger than the GAAP earnings they report during the quarter in which a cut in the corporate tax rate is passed, they will have to take a draw of senior preferred stock from Treasury, and suffer whatever political or other consequences ensue.

      Liked by 1 person

    1. I’ve skimmed but not yet read FHFA’s draft 2018-2022 strategic plan, so have not decided whether to make a public comment on it. But a couple of points as they pertain to risk sharing. First, a number of senior FHFA officials do read the blog, so my views on this issue are known to them. Second, I draw a distinction between what FHFA is doing with Fannie and Freddie on risk sharing now and what it should be doing whenever, post-reform, it again is regulating credit guarantors that have updated and binding capital requirements and are allowed to raise equity and retain earnings. My current post is aimed at this second set of circumstances. With the companies in conservatorship and subject to the net worth sweep–which FHFA assumes will continue during the time covered by its strategic plan– one can make the argument that even though Fannie’s CAS and Freddie’s STACRs are uneconomic, (a) they at least give SOME credit protection in adverse circumstances that the companies wouldn’t have otherwise because of their lack of capital, and (b) as long as the net worth sweep is in effect it’s the government’s money, and it’s their decision whether or not to issue these securities.

      Liked by 1 person

      1. So because the government is taking these monies through the sweep they in turn make the uneconomic inefficient decision to give it away because the sweep leads them with no capital, correct?

        Additionally their strategic plan assumes this absurdity to continue even though they have the unilateral power to stop it?

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      2. It concerns me that you have continued to signal the demise of the GSEs multiple times by pointing to credit guarantors, whomever that is after reform. Does this mean you see the GSEs going away entirely? A shift to the MBA’s goal of getting a gov’t backstop on ALL securitized investments that the banks push…

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        1. You’re misinterpreting my use of the formulation “Fannie and Freddie, or other credit guarantors” post-reform. The reason I use it is to make the point that the issue of the role of CRTs in a credit guarantor’s capital structure must be dealt with (thoroughly and properly) irrespective of who the guarantors end up being. I continue to believe that preserving Fannie and Freddie in this role not only is the right choice, but also the most likely one.

          Liked by 1 person

      3. “With the companies in conservatorship and subject to the net worth sweep–which FHFA assumes will continue during the time covered by its strategic plan…” Are you saying that FHFA is planning on continuing the NWS post 9/30. Has your viewpoint on the continuation of the NWS post 9/30 changed? Thank you very much for all that you do, Tim.

        Liked by 1 person

        1. No; I’m simply saying that in the absence of any firm plans that the conservatorships will end– and remember, Mel Watt contends that Congress, not FHFA, must be the entity to trigger that action–FHFA is assuming that they will continue throughout their strategic planning horizon. I strongly believe they will not, and I also believe they will end either through administrative or judicial action, not legislation.

          Liked by 2 people

          1. Tim,

            Given that Mel Watt seems to be unwilling to do anything without Congressional approval (as evidenced by the wording of his letter today and at other times), why are you still so certain that administrative action will precede legislative action? Or do you think that judicial action will have to happen first and that is what it would take to spur the administration?

            Liked by 1 person

          2. I was very disappointed to see that FHFA went ahead and made Fannie and Freddie’s net worth sweep payments to Treasury today. Mel Watt has on a number of occasions expressed his strong concern that the declining capital buffer at the companies (scheduled to hit zero at the end of this year) poses a dangerous and unnecessary threat of resulting in a draw of senior preferred stock from Treasury because of the effect of accounting volatility on their quarterly GAAP earnings. FHFA has the authority to create a capital buffer against such earnings volatility by temporarily withholding the net worth sweep payments, and has approved language in both Fannie’s and Freddie’s quarterly earnings releases indicating that such an action might be imminent. With a showdown over the debt ceiling pushed from the end of this month to sometime in the first quarter of next year, this appeared to be a perfect time for Watt to exert FHFA’s independence and take a step he has said he supports (and is empowered to take unilaterally). Yet he didn’t, and in a letter he sent today to Ranking Member Sherrod Brown of the Senate Banking Committee he told us why. Watt is going to wait to get the green light from Treasury Secretary Mnuchin. In his letter Watt told Brown, “FHFA is exploring with the Department of the Treasury a number of options. We remain committed to working with Secretary Mnuchin to resolve this issue.”

            Of course, by the statute that created FHFA, the Housing and Economic Recovery Act, FHFA is an independent agency, not subject to the control of any other agency, including Treasury. But FHFA has done exactly what Treasury has directed it to since even before the conservatorships were imposed on Fannie and Freddie, and obviously it continues to do so.

            Watt’s deferral to Mnuchin on the capital buffer issue, however, does not change my view that mortgage reform is more likely to be accomplished by administrative action than legislation, simply because I do not believe this Congress will be able to agree on WHAT to legislate, and that after the budget, tax reform and the debt ceiling have been dealt with Treasury will make administrative mortgage reform a priority. The danger for Mnuchin is that if he waits too long there may be some adverse ruling in one of the legal cases that limits the options Treasury has for what it can do with Fannie and Freddie; he would be wise to move while he still can exert some degree of control over those options.

            Liked by 3 people

      4. Mr Howard,

        Assuming the conservatorship ends and the GSE’s are recapitalized, what should the investment portfolio be invested in to bring the safest and highest return, or can the GSE’s operate safely without an investment portfolio?

        Liked by 2 people

        1. This is one of the few issues on which almost everyone seems to agree: post-conservatorship, Fannie and Freddie’s on-balance sheet portfolios should be limited to residential mortgages, with the size of those portfolios being only as large as necessary to facilitate (a) the management of non-performing loans (which typically are bought out of mortgage-backed security pools and held on the companies’ balance sheets, where they hopefully can be brought back to paying status), (b) the management of a “cash window” for smaller lenders (who are not easily able to accumulate enough mortgages to pool into their own MBS issuances, and instead prefer to sell loan-by-loan to Fannie and Freddie, who pool them with loans from other lenders and issue the MBS themselves), and possibly (c) to serve as an “incubator” for new or innovative loan products, to see if they can achieve a size and scale where an MBS market for them can be sustained.

          Liked by 1 person

          1. Mr Howard

            I have never looked at a MBS and suppose few people have but have the terms and conditions changed post 2008?If no,would you like to add anything that would be benifical?

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  11. Tim one item I feel should be added.

    In a housing downturn, not only will CRT counterparties refuse to accept new CRT’s because it won’t make economic sense. They may not even be able to if they wanted to.

    Many CRT buyers are also GSE MBS buyers. In a housing downturn, CRT counterparties may be so adversely affected that their risk management will block any CRT purchases.

    And that’s assuming a crisis isn’t so bad that CRT counterparties don’t end collapsing.

    Liked by 1 person

  12. Tim

    Would you be able to provide an estimate to date as to how much of the economics have been lost and transferred away from Fannie for instance as a result of the current CRT structure?

    Liked by 1 person

    1. It’s not a huge amount yet—probably not much over $1 billion since Fannie began its CAS program at the end of 2013—but the company disclosed in its second quarter 2017 10Q that based on the outstanding balance of CAS it had then its interest payments on them were running at rate of about $730 million per year. That annual interest cost will continue to rise as Fannie issues more of these securities. Fannie has not said that any losses have yet been transferred to the holders of a CAS tranche, and almost certainly none have been.

      Liked by 1 person

      1. Still waiting for sanity, leadership and clairvoyance to take hold. Cannot believe this is happening in our great country! Sad. The next generation is paying attention. Thanks for helping us all stay on it!

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      2. i take it that the $730MM annual interest payment should have netted out fnma’s cost of capital in order to determine the pure cost to fnma of transferring the credit risk, no? if so, any view as what this net annual payment amount is? tia

        rolg

        Liked by 1 person

        1. This gets at the critical issue, which I hope mortgage reformers will begin to focus on: how much capital credit should a guarantor get for issuing securitized CRTs like CAS and STACRs, in terms of what I call “equity equivalents”? If a regulator gives an equity credit of 100 percent for CAS- or STACR-like securities–that is, $1.0 billion reduction in required capital for every $1.0 billion of face value of CRT– that would greatly reduce the economic cost to the guarantor of issuing these. But it also would badly compromise the safety and soundness of the guarantor who was given that credit, which is what I’m trying to warn about.

          If a guarantor has to put up $1.0 billion in equity against a good book of business, that billion will be available to cover losses on the guarantor’s bad books of business. If a guarantor is allowed to substitute $1.0 billion in CRT for $1.0 billion in equity, (a) the interest payments on the CRT are lost to the guarantor, and (b) the $1.0 billion of equity credit can only be used against the good book the CRT was issued against– it can’t be transferred to a bad book or a very bad book.

          This is what I was trying to show in my example using Fannie’s December 31, 2007 book. If Fannie had gotten full capital credit for the CRTs it issued against its pre-2005 books of business, it would have paid about $15 billion in interest, AND have been allowed to forego about $25 billion in equity capital (not discussed in my post, but that’s the average amount of M-2 CRTs that would have been outstanding against those books) that wouldn’t have been available to cover the outsized losses on Fannie’s 2006 and 2007 books. Add to this the fact that the market for CRTs would have dried up in mid-2006, leaving Fannie no capital for losses on its post-June 2006 books either, and you have the recipe for a total meltdown of the company in the midst of a crisis.

          The problem a regulator is going to have to wrestle with is that a dollar of a contingent, far-out-of-the-money CRT is not remotely close to equivalent to a dollar of hard equity put in up front. If a regulator either doesn’t know that or pretends that it is, it’s setting us up for another disaster. If it were me, I would allow only a very small equity capital credit– less than ten cents per dollar of CRT face value– for a newly issued CRT, then allow that capital credit to rise over time, based on the credit performance of the underlying book. If you did that, then the capital credit initially would be only a small offset to the interest cost of the CRT, not improving the economics of the transaction very much.

          Liked by 4 people

          1. If I understand what your saying, it would take a long period of time, through at least several market cycles, to gather enough historical data to properly value CRTs against equity. But of course, what happens when one of those once in a lifetime earthshaking events (the Great Depression of 1929 or the Great Recession of 2007 for example) occurs, where there’s a wide deviation from the norm?

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          2. The problem isn’t a lack of data–Fannie and Freddie have data on millions of loans, of all risk types and in all economic and financial environments–it’s agreeing on the right analytical framework for using and valuing CRTs.

            If Congress, or Treasury, really does want to have some form of mandatory CRT for credit guarantors, it will have to increase their capital requirements, relative to what they would be if CRTs are discretionary. HERA instructs FHFA to come up with an updated true risk-based capital requirement for Fannie and Freddie. If the capital is all equity, FHFA can pick a stress environment–I’ve proposed a 25 percent nationwide drop in home prices over a five-year period–and then, using Fannie and Freddie’s historical data, project how much equity capital the companies would need, given the guaranty fees they’re charging, to survive that stress. If, however, some of the companies’ “capital” is made up of CRTs, this becomes a much more difficult exercise, because unlike equity (which is permanent and can be used to cover any amount of loss on any book), securitized CRTs have limited lives, can prepay, are limited to the loans against which they were issued, and have both loss thresholds that must be breached before they become effective and lifetime caps after which losses are again absorbed by the issuer. Whatever the “all-equity” capital requirement is to meet the stress test, a “half equity- half CRT” capital requirement, therefore, would be higher. And you’d STILL have the problem that once home price growth starts to slow you have to question whether securitized CRTs would be available at all. A regulator would have to make a judgment about that availability, and if it drew on the experience from the last crisis, it is likely that the “half equity- half CRT” capital requirement actually would be more than double the “all equity” requirement, because of the phenomenon I addressed in my post: CRTs cost money when issued against good books of business then aren’t available to cover losses on bad books, therefore they weaken a guarantor who is required to issue them, adding to the amount of equity capital it needs to withstand a given degree of stress.

            Liked by 2 people

  13. Great post as usual, very informative and eye-opening re: CRT’s. Thanks Tim.

    “This idea is backed by community lenders, affordable housing groups and plaintiffs in the lawsuits against the net worth sweep,”

    I would add most recently RNC to that group as well.

    Liked by 1 person

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