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.
HOWARD ON MORTGAGE FINANCE 
The government gave itself warrants for 79.9% of Fannie and Freddie Common stock. The government has not exercised those warrants. Does that not mean a Common shareholder still owns 100% of Fannie and Freddie Commons?
If Fannie and Freddie own CSS/CSP is that ownership interest in CSS/CSP split between Senior/Junior/Common shareholders?
I am wondering Tim… after reading your book I am aware of how long the attempts to grab Fannie and Freddie’s success have been going on, who those players are. Could you share who the newer players are in your opinion or are they the same old ones in different clothing?
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Fannie and Freddie’s common shareholders still own their respective companies, but their shares are priced assuming that Treasury’s warrants will get converted, diluting the ownership of existing shareholders. If the warrants are exercised (which if Fannie and Freddie survive as private companies I assume they will be), Treasury almost certainly will sell them to other private shareholders.
As of now, the senior preferred shareholder (Treasury) effectively owns all of Fannie and Freddie’s assets–including the CSS/CSP–because of its $187 billion liquidation preference. If the net worth sweep (and Treasury’s liquidation preference) were canceled, the companies’ common shareholders would “own” their earnings and (eventually) receive dividends from them, while in liquidation the preferred shareholders would have first claim on the companies’ assets (until they were fully paid off) then the common shareholders would split whatever is left over. I’m not a lawyer, but I would expect that if there were legislation giving the CSS/CSP to a third party it would be challenged in court by Fannie and Freddie shareholders.
Opposition to Fannie and Freddie–and attempts to limit their business or replace them altogether–have been going on in earnest since the late 1990s. It’s really an institutional opposition, with the big banks and Treasury playing the most prominent roles; the individual actors change frequently (while their postures and actions do not).
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Hi Tim, the Delaware lawsuit brought by Jacobs and Hindes was dismissed today due to lack of jurisdiction apparently. Do you know if we go to state court now?
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Hey Tim or ROLG, I don’t understand this dismissed case. Could guys provide some analysis on it? Thank you
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@billy
does a HERA conservator have the power to take over a delaware corporation and issue stock that corporation cant issue under delaware law? especially when you consider that in the o’melveney case, scotus declared that a conservator steps into the shoes of directors in the exercise of corporate powers?
judge sleet said that state law limits on what that corporation can do does not limit the conservator when he steps into the directors’ shoes.
how does judge sleet distinguish o’melveny? ignorantly. judge sleet says as opposed to the o’melveny plaintiffs in a contract/tort context, “Indeed, Plaintiffs do not have a private commercial contract with either Fannie Mae or Freddie Mac.”
excuse me? the delaware general corporation law makes it explicit that preferred shareholder plaintiffs have a contract with issuer. it’s their certificate of designation.
where has the rule of law gone?
rolg
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In this case, the company is the container, the managers and directors are its elements. how stupid.
( A minor question: .plaintiff has no preferred stocks?)
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plaintiffs hold preferred stock.
judge sleet’s opinion is essentially in two parts: 1) does NWS violate other laws?, and 2) is NWS within conservator’s power.
as to 1), he is on solid footing in pointing out that conservator cant be enjoined for doing something within its power that violates another law. there is circuit court authority for that, which is not binding upon him.
but the scotus o’melveny case is binding upon him and as to 2), he must try to distinguish it in order to rule in favor of fhfa. judge sleet acknowledges that the conservator under o/melveny has no greater contractual/tort powers than those that inhere in the conservatee, but he is blatantly incorrect when he says this is not a contract case. under delaware law the rights of existing junior preferred holders and treasury’s NWS preferred stock are all in the nature of contract rights governed by the delaware general corporation statute.
i have never seen the crux of a judge’s opinion rest on such a blatant mistake. i am trying to be charitable and understand how i am wrong and judge sleet is right on this point….and i just can’t get there.
rolg
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ROLG, hope the plaintiff files a brief to Sleet to ask him to correct obvious mistake. Perry did similar to get revised opinion.
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ROLG,
So does this Delaware decision make it unlikely that the contract claims that got remanded to Lamberth end up winning? I assume that no contract under Delaware law means no breach of contract, right?
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@ david different context and i think no read over. lamberth should find that preferred contract rights were breached by NWS, but what damages are available is the big issue. since most corporations try diligently not to breach a preferred shareholder’s rights, there is not alot of settled law on this.
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@ROLG. Sleet wrote:
Where the Agency performs functions assigned to it under HERA, equitable and injunctive relief will be denied “even where [it] acts in violation of other statutory schemes.”
I know Caine argued same in an appeal court. But I don’t remember any other judge wrote something similar. Is Sleet is right?
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@qh
this is the no injunction of conservator re violating other laws claim. there are federal court holdings to that effect. (you may sue for damages but cant enjoin). this applies to a claim that fhfa’s actions as conservator breached delaware corporation law (dgcl).
but hindes/jacobs also argued something different. that fhfa’s conservator power does not include the power to issue NWS preferred. the claim was not that NWS breached dgcl, but that you have to look to dgcl, among other things, to determine what the powers of a conservator are…since under the scotus o’melveny case, the conservator steps into the shoes of the conservatee. this implies that a conservator would have different conservator powers to issue stock with respect to conservatees chartered under differing corporate law jurisdictions (where as with fannie and freddie, fhfa chose to have the corporate law of delaware and va. apply).
this is a separate claim, the one that i thought (and still think) has much merit, and it is the claim that judge sleet totally botched up in his analysis.
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No surprise here as all the original Net Worth Sweep lawsuits didn’t contain a constitutionality argument. I believe some brand new cases have finally included it in 2017 but those will take a while to play out now… http://www.glenbradford.com/2017/11/fnma-fanniegate-644/
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Interesting that they regurgitated the same Perry arguments. No dissenting justice is disappointing. The twisting of logic and reason in these decisions is scary. The assumption that ‘may’ has a single clear definition of ‘permissive’ for instance, or that ‘conservator’ used in HERA is not the same definition as used in the past 100 years (it changed just for FHFA according the court), that ‘depositors’ under FIRREA is equal to ‘stockholders’ under HERA. They made so many errors in logic with the Perry case and that is getting incorporated by reference into all of the others. I wish other circuit courts would make their own judgments rather than just going along with what another circuit said. Sadly, it just is not human nature to stray from the pack.
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If Perry majority is right, FHFA can do anything if not explicitly prohibited in HERA, including wiring Fannie quarterly profit to Watt’s personal account.
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When I read the appellate decision on Robinson, my first thought was that before the three judges agreed on it, they must have said to each other, “Gibson Dunn, Cooper & Kirk and Boise Schiller all filed for cert on this case last month, and if the Supreme Court is now considering it there’s no way we’re going to be the first to find against the government for $100 billion; we’re affirming the lower court decision.”
To do so, however, the Sixth Circuit had to resort to tortured reasoning, as you point out. The judges argued that if Congress takes language verbatim from the 1950 Federal Deposit Insurance Act that defines what conservators and receivers can do, but (of necessity) substitutes “FHFA” for FDIC and “the Companies” for depository institutions and depositors, that somehow frees FHFA from nearly seventy years of history of what the term “conservator” means, and allows FHFA to do whatever it wishes to do with Fannie and Freddie (thus rendering all of HERA’s statutory language meaningless).
With the decision today by Judge Sleet dismissing the Jacob-Hindes case (noted above), it’s now beginning to look as if all of the chips are piled on the table in front of SCOTUS; if it doesn’t grant cert, I’m skeptical that any other court will find for the plaintiffs in any of the net worth sweep cases (including the constitutionality cases). That still would still leave breach of contract and regulatory takings, but those too would become less promising if SCOTUS doesn’t agree to hear the Perry Capital case.
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Hi Tim or ROLG,
Can this be appealed?
It appears judges left right centre are all afraid to go against the govt. The supreme courts is now the final destination. But the odds of them granting very is still low..
which means admin decision is the most plausible outcome. One has to see now that the admin is also stucked at crossroad. They can work less favourably to the shareholders but in the long run and the big picture, who will be left to sustain and uphold the rules and rights of investors. Who will ever invest (both local abd foreign) in US anymore?
RF
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Thank you for your insight Tim. My hope was/is that one other circuit court parts from the Perry decision. That would have resulted in a clear split among the circuit courts and been more support for SCOTUS to take up the matter.
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Why would any institution want to take a first loss position in this macro economic environment where home prices are again at near high record levels?
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I find it easier to answer this question about credit guarantors (if they do good credit risk analysis, they can charge a high enough guaranty fee on all of the loans in their mortgage pools to cover their likely losses on the ones that default, and have enough left over after administrative expenses to earn a competitive return on their capital) than the question, “why would anyone put new money into U.S. equities with the S&P 500 at an all time high and p/e ratios not far away?” (The answer to the latter question, of course, is: “Well, they just do.”)
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just adding a reminder that the “first loss position” is the equity of the homeowners themselves. they may suffer “tail risk” losses since they are undiversified, but a diversified finance company can absorb risk at a price that produces a profit in normal environments.
rolg
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@Sean. A liquidation preference on zero net worth would get you zero. Not sure how you are obtaining the values you mention of not recapped with new capital?
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Tim,
Happy early Thanksgiving to you and your family. We’ve heard several recent positive comments from Ackman as it pertains to Corker and Warner at the helm of new legislation. Is it possible that they are following something along the lines of the framework issued by Moelis during the drafting of this bill? I find it interesting that Ackman has praised them both and there happens to be a new bill coming. Could we be facing a holiday surprise no one sees coming?
Thanks
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I would indeed be surprised if the draft bill Senate Banking Committee members allegedly are working on tracks the Moelis plan in any significant ways. The reason the MBA and others insist on legislative rather than administrative reform is that they want things that only can be accomplished legislatively–chiefly an explicit government guaranty (along with a Mortgage Insurance Fund to partially back it) and charter changes that transfer to primary market lenders some powers and capabilities that Fannie and Freddie now have. The Moelis plan does not include an explicit government guaranty on the MBS of a recapitalized Fannie and Freddie (and the Moelis authors argue persuasively against one), and because Moelis has as one of its objectives maximizing the value of Treasury’s warrants for 79.9 percent of the companies’ common stock, it also is aimed at strengthening, not weakening, the companies post-conservatorship. I think it’s very unlikely that drafters of the Senate bill would move to embrace the basic structure and objectives of Moelis, but we may soon find out.
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From inside mortgage finance news
A roughly 40-page draft of legislation that might finally end the nine-year-old conservatorships of Fannie Mae and Freddie Mac is now circulating among various legislators serving on the Senate Banking Committee, Inside Mortgage Finance has learned.
At press time, details were sketchy, but lobbyists who claim to have knowledge of the draft caution there are several “different pieces” to the measure, though it includes language calling for an explicit government guarantee on conventional MBS.
However, there was a difference of opinion among lobbyists on whether the bill (at this point) tracks closer to a plan advocated by the Mortgage Bankers Association or ideas being promoted by the Milken Institute. One of the authors of the Milken plan is Michael Bright, who is now the acting president of Ginnie Mae.
MBA’s recommended approach to GSE reform calls for the implied government guarantee on conventional MBS to be replaced with an explicit one – but one that also puts more private capital at risk.
A spokesperson for the Senate Banking Committee declined to comment on the news
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It is no secret that the large banks and their supporters want legislation that “reforms” Fannie and Freddie in ways that benefit primary market lenders, so it also shouldn’t surprise people that members of the Senate Banking Committee would try to come up with a bill that gives these interests what they’re asking for. Senator Corker’s announced retirement from the Senate next year seems to have accelerated his colleagues’ efforts.
As I’ve said many times before, however, I think it is very unlikely that during this term both parties in both houses of Congress will be able to agree on legislation that fundamentally alters the financing of the $10 trillion in mortgages that underpin the U.S. residential housing market. If the Senate Banking Committee does come up with a draft bill before the end of the year, I will be interested to see how it handles the differences in approach that have characterized reform proposals to date. It’s possible that this new draft WILL move us closer to actual legislation, but that’s not the way I would bet. On top of all the of other obstacles, there are provisions in the House and Senate tax reform bills that are not favorable to homeownership, which should make groups like the National Association of Realtors and the National Association of Home Builders even less willing to want to incur the risks involved in moving away from a secondary market system based on Fannie and Freddie, which they know works, to something designed to favor large lenders that would have uncertainties and potentially significant transition issues.
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Some politicians took advantage of the crisis to kill housing affordability and GSEs to benefit big banks.
While most other legal arguments may appeal to conservative justices; Yours would help liberal justices to understand the issue’s political aspect. Thank you again.
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[Comment edited for length.] Perry before and now Berkowitz. Hope the case will still be pursued.
Berkowitz Liquidates Hedge Fund That Owned Sears Holdings Shares
By Charles Stein
October 16, 2017, 11:44 AM PDT
Fairholme Partnership distributed shares to investors
Berkowitz took steps before exiting retailer’s board
Investor Bruce Berkowitz is shutting his hedge fund and distributing its holdings to investors, including a stake in Sears Holdings Corp.
Berkowitz’s Fairholme Capital Management reported the fund’s unwinding, without naming it, in a U.S. Securities and Exchange Commission filing on Oct. 13. The fund is Fairholme Partnership, which Berkowitz created roughly five years ago, according to a person familiar with the situation.
Berkowitz, a contrarian and the second-largest Sears investor, is known mostly for his mutual funds and has struggled this year as some of his biggest investments have declined. He made the move in his private fund before stepping down from the ailing retailer’s board Monday.
The investor’s $2.1 billion Fairholme Fund, a registered mutual fund, has lost 6.6 percent year-to-date. It has lagged 99 percent of rivals over five years, according to data compiled by Bloomberg.
Berkowitz’s Fairholme Fund holds stakes in mortgage-finance giants Fannie Mae and Freddie Mac.
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As the article states, Berkowitz’s Fairholme Fund (which is a mutual fund, not a hedge fund) holds his stakes in Fannie and Freddie. The hedge fund holding the Sears investments that he is liquidating–Fairholme Partnership–is a separate entity. Berkowitz’s decision on the latter has no implications for his investments in, or attitude about, the former.
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Thank you Tim, for all your insight this year. It’s been awfully quiet in FNMA/FMCC land lately. Clearly the stocks don’t like a vacuum either. I would hope we see some information about quick peek documents shortly. Are you hearing anything from the Hill that you can share?
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No, nothing that I deem to be reliable.
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Tim, what would be the net effect of an explicit guarantee that MBA is pushing for? Do you support it?
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The net effect of the explicit government guarantee the MBA advocates can’t be reliably estimated, because it depends on other variables that are as yet unknown or unspecified, such as the amount of capital credit guarantors (whether Fannie and Freddie or some other entities) would be required to hold in order to qualify for it.
And, no, I do not support an explicit government guarantee on mortgages, because I don’t believe one is necessary. If FHFA follows the directive in the 2008 Housing and Economic Recovery Act and updates Fannie and Freddie’s capital standards so that they are sufficient to withstand a defined amount of stress (I’ve recommended a 25 percent nationwide decline in home prices over a 5-year period)—and Treasury explicitly endorses those new standards—I believe investors would price Fannie and Freddie’s MBS at levels very close to where they are today, with the companies in conservatorship. And if for some reason that does not happen, Fannie and Freddie should be able to get catastrophic loss protection from private reinsurance companies on very reasonable terms (given the remoteness of the insured losses, and the fact that these companies aren’t significantly exposed to other types of single-family mortgage risk). Alternatively, Treasury could agree, for a modest annual fee, to agree to extend repayable short-term loans to the companies in the highly unlikely event that their credit losses exceed the stress amounts they are being required to capitalize against (which Treasury would have approved), in order to allow them to recapitalize by issuing new equity after the stress period has passed.
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tim
as politics is so enmeshed in the GSE saga, i still expect some form of compromise (the stock in trade of politicians) will result. can you see something like the following:
all securitized pools going forward will be tranches with a senior, say 25%, mbs tranche explicitly guaranteed by treasury, and the subordinated 75% mbs tranche guaranteed by GSEs. banks could buy the senior tranche and get regulatory capital relief, and slightly less risk adverse investors would buy the GSE guaranteed support tranche.
that way, MBA gets thrown a bone by folks like corker who are bank puppets.
happy thanksgiving
rolg
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In the arrangement you propose, of course, any investor (not just banks) could buy the government-guaranteed tranche, which for all practical purposes would be without risk to the government, since for the guaranty to be triggered Fannie or Freddie would have to suffer a loss in excess of 75 percent on an insured pool of loans (or 100 percent defaults with 75 percent severity). And your proposal doesn’t change the capitalization problem for Fannie and Freddie: someone still will have to determine how much capital the companies will need to hold for their guarantees on the first 75 percent of the losses on their pools to be viewed by investors as AAA/Aaa (or better). Viewed this way, the 25 percent senior guaranty almost becomes a negative; since the government’s explicit guaranty won’t affect either the pricing of guaranteed loans to consumers or the probability of investors in a Fannie/Freddie pool bearing a loss, why have the government involved in the process at all?
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tim
why have government involved in the process? because it might get the “reform” process out of stuck and achieve most parties priorities in a reasonably effective manner.
i agree that it is not necessary in order to promote an efficient secondary housing finance market, and it might even tend to increase costs on an overall basis, compared to a system reliant solely on well capitalized GSEs (depends on comparative pricing of the two guarantees, and the two mbs tranches). but it achieves compromise (gives banks an opportunity to convert their mortgages into zero capital-weighted assets, which appears to be a big bank objective) in a way that is consistent with mnuchin’s two principles (remote exposure to taxpayers and a deep secondary market), and allow the GSEs to be fixed along the lines of the moelis blueprint.
if the corkers/warners/fellow travelers of the world think this is an improvement, i would be fine with it, compared to all of their previous hairbrained ideas.
rolg
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If MBS guaranteed by government, big banks control primary and secondary mortgage markets. Little left for FnF because they don’t generate loans. Big banks simply don’t sell loans to FnF. Tim, am I wrong?
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Yes. The government wouldn’t guarantee mortgages directly; under most proposals it would put its guaranty on top of that of a private (or mutually owned) credit guarantor, which would be backed by equity capital. The big bank mortgage originators still would have to swap their loans for a credit guarantor’s mortgage-backed securities in order to get the government guaranty.
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tim
fwiw, here is a recent tweet from joshua rosen that gets at the MBA motivation for federal mbs guarantee: https://twitter.com/JoshRosner/status/933027728391012352
i just think some compromise that incorporates a senior federally guaranteed mbs tranche might coalesce that wouldnt be pareto optimal, but “good enough for government work”.
rolg
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Tim, would the new MBS guaranty by government drive up the Treasury bond rate?
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I do not believe it would.
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Tim,
Any thoughts on this hitting today?
Watt Likely Won’t Act on Zero Capital Buffer This Year, but Consensus Forming on a GSE Bill?
By Paul Muolo
pmuolo@imfpubs.com
Industry stakeholders are increasingly dour on the prospect of Federal Housing Finance Agency Director Mel Watt acting to rectify the GSEs’ capital buffer issue before yearend, but there’s growing hope that bipartisan reform legislation might be enacted next year.
According to one veteran mortgage executive who’s involved in the process: “There’s a movement going on [regarding legislation] and there are plenty of conversations taking place. You have both liberals and conservatives wanting a bill – and basic principles have been agreed to.”
One of those is an explicit federal guarantee for conventional mortgage-backed securities. Republicans are reportedly on board with the federal guarantee on MBS, but reluctant to back future guarantor entities, such as re-constituted versions of Fannie Mae and Freddie Mac.
The executive, requesting anonymity because of the sensitive nature of the talks, noted that Watt is involved and is talking to decision-makers on Capitol Hill and the Treasury Department. For the full story, see the new edition of Inside Mortgage Finance, now available online.
Sean
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I wouldn’t put much credence in a story based on the comments of “one [unnamed] veteran mortgage executive who’s involved in the process.” There are many such executives who advocate replacing Fannie and Freddie with a bank-centric alternative, and who would like Muolo’s readers to believe that there is gathering momentum for this approach. Absent the name of the person whose opinion is being shared–or the names of specific “Republicans…reportedly on board with the federal guarantee on MBS” or other aspects of this plan–there really is no basis on which to evaluate the import or credibility of this article.
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More color below, per my previous comment (only adds to my thought that you should absolutely work with ICBA, CMLA, NAFCU, and other small organizations to create 1 single cohesive approach that fully goes head to head with the MBA/Milken Institute/Urban Institute GSE reform papers:
A 40-Page GSE ‘Draft’ Bill is Circulating in the Senate
By Paul Muolo
pmuolo@imfpubs.com
A roughly 40-page draft of legislation that might finally end the nine-year-old conservatorships of Fannie Mae and Freddie Mac is now circulating among various legislators serving on the Senate Banking Committee, Inside Mortgage Finance has learned.
At press time, details were sketchy, but lobbyists who claim to have knowledge of the draft caution there are several “different pieces” to the measure, though it includes language calling for an explicit government guarantee on conventional MBS.
However, there was a difference of opinion among lobbyists on whether the bill (at this point) tracks closer to a plan advocated by the Mortgage Bankers Association or ideas being promoted by the Milken Institute. One of the authors of the Milken plan is Michael Bright, who is now the acting president of Ginnie Mae.
MBA’s recommended approach to GSE reform calls for the implied government guarantee on conventional MBS to be replaced with an explicit one – but one that also puts more private capital at risk.
A spokesperson for the Senate Banking Committee declined to comment on the matter.
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Been quiet on the blog. Anything going on behind the scenes?
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Not that I’m aware of. As I’m sure you know, Congress currently is consumed with the tax cut/reform plan (and to a lesser extent the pending special election in Alabama), while Treasury is focused on the tax plan as well. I’m one who believes that it’s unlikely the Senate will be able to agree on a specific plan before the end of the year, and expect the tax issue to spill over into 2018.
On the blog, I’ve just begun research on a new post that I’ll probably put up after Thanksgiving. The relative infrequency of posts since mid-year has been the result of two things: there really not being much new or different worth writing about, and my having been unexpectedly busy with non-blog activities. The second is now less of a factor, and that’s clearing the way for the new post in process.
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Tim,
Good evening. During his keynote address at the SFIG – Residential Mortgage Finance Symposium today, Craig Phillips announced that the Trump Admin wants housing finance reform completed before Bob Corker leaves office. Do you have any insight or intuition as to why? It is obvious that Corker has not previously sided with the position the Trump Administration has stated as their housing reform priorities. The statement above by Phillips seems concerning to many.
Thanks
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No, I don’t have any insight into Phillips’ comment. If I had to guess I would say he is drawing on the fact that Corker has put a lot of time and energy into mortgage reform (although not with an objective that I agree with), and believes that once Corker leaves it may be difficult to re-generate enthusiasm or momentum for this issue. And I would agree with you that having Phillips express this view is not a positive for the outcome most of the readers of this blog would like to see (which I continue to believe is the most likely one, given the current dysfunction in Congress).
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Tim – if you’d like to listen to the bank lobby – they’re all here
talking about CRTs like they work, and the MBA plan like it’s workable.
it’s just amazing. these are the purported experts that just have no intellectual honesty.
It’s really sad.
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Particularly funny is Wallison saying that 50% DTI loans wouldn’t be made w/o the GSEs – yet the GSEs are successfully selling CRT deals which are purportedly taking first loss risk on those same 50% DTI loans
How do they not put that together? oh the private market is buying CRTs, which we advocate, because they want the risk or that there really is no risk due to the structure of the CRTs.
Double speaking on major points and not being questioned on it because everyone there is lying for the banks.
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Simple answer.
Old friend Peter just lies. And it’s kept him employed for years.
And the Hill no-nothings are not smart/curious enough to ask him why the banks won’t make home loans when times get tough–as the GSE must–when the banks are so mortgage risk averse unless the Uncle Sam is backing them, i.e. see the MBA’s proposed federal government guarantee on bank MBS losses?
Those hearings are an embarrassment to the nation and anyone who understands mortgage finance and consumer demand.
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Did anyone read through the proposed tax bill to see if there was any loophole to prevent the GSEs from taking a big write-down on their DTAs to mitigate the reduction in the corporate tax rate on them?
Thank you in advance if anyone knows the answer above.
Cheers,
Justin
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I was reading, and maybe not fully understanding, P. 194 and 195 appear to discuss a ‘normalization method’ to spread out the impact of the excess deferred tax assets that would result from the tax cut. So they could spread out the impact of the excess current DTAs over the life of the assets that created the DTAs to begin with. Does that mean they would not take the full hit on the first quarter after the tax cut is passed? They could expense it over the course of some life of the assets that created them? How long are the regulatory lives of the assets that created the DTAs for the GSEs?
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Tim,
Good morning and happy Friday. Christopher Whalen posted a tweet this morning that reads as follows: “We’ll put the GSEs into receivership first… it is discussed frequently at White House…” I was hoping you could comment on the validity and/or substance of that claim. It doesn’t seem to follow the rhetoric we have consistently heard from the likes of Mnuchin, Carson and Cohn.
Thanks
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If putting Fannie and Freddie into receivership is being “discussed frequently at the White House,” it’s by people who have little idea of what they’re talking about. If you put the companies in receivership you liquidate their $5 trillion in business. Who or what will replace that financing, and at what cost? Mortgages don’t finance themselves.
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tim
it seems that fnma’s earnings have not suffered that much from all of the CRT transactions that it has done. are these CRT transactions accounted for currently? that is, are all of the interest payments made to the CRT holders deducted currently as a normal interest expense, or is some portion held in reserve as a deferred expense to be matched up with any future loss recognition (reduction of CRT principal)? apologies in advance for a lawyer asking an accounting question.
rolg
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Fannie discloses exactly how much their credit risk transfers are costing them; whether one thinks its earnings have “suffered much” from them is a matter of judgment. In its third quarter 10Q Fannie said that in the first nine months of 2017 it had made $568 million in interest payments on its outstanding CAS tranches, and $127 million in interest payments on its CIRTs (essentially reinsurance agreements with MIs). This was up from $377 million in interest payments on CAS and $77 million in interest payments on CIRTs during the first nine months of 2016. I personally think that $695 million (which will turn into close to $1.0 billion for the full year) is a lot to pay for insuring very high-quality loans against levels of loss that have extremely low probabilities of occurring. And total CAS and CIRT payments in 2017 are up over 50 percent versus the comparable period in 2016, so this drain on the company’s profitably is rising rapidly.
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tim
but part of this annual $1B interest payment is for use of capital, not just insurance (right?). this gets to my question, exactly what is the cost of insurance above the cost of capital. now, the risk transferred may turn out to be minor, but how much above a normal interest expense is fnma paying for this risk assumption. tia
rolg
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In theory, part of Fannie’s CRT interest cost would represent a substitute for capital costs. But as you know, in a couple of months neither Fannie nor Freddie will hold any capital at all, because of the net worth sweep’s shrinking capital buffer. So the question that should be asked while the companies remain in conservatorship is: are taxpayers better off with Fannie and Freddie paying this CRT interest (reducing the income transferred to Treasury each quarter), or not paying it and leaving taxpayers exposed to possible future reductions in net income (and sweep payments) should credit losses exceed the (very high) thresholds at which the CAS and CIRT payments kick in? Framed this way, I believe the question answers itself.
The calculus will be different if the companies are released from conservatorship. In this case, though, the concept of “capital equivalency” becomes critical. As I discuss in the current post, a dollar of CRTs is not worth anything close to a dollar of equity capital, because CRT “capital” only can be used on the books of business against which it has been issued, and only in the event that credit losses exceed certain thresholds before the CRT tranche pays down; a dollar of equity can be used to cover all losses from any book of business at any time. If Fannie and Freddie’s regulator (presumably still FHFA) allows them to substitute CRTs for equity on a dollar-for-dollar basis, then, yes, that would be a significant offset to their CRT interest costs—but it also would greatly undermine their safety and soundness, and be terrible public policy. If, on the other hand, FHFA only allows them to reduce their equity capital by a true “equity equivalent” percentage of the CRTs’ face value, for the CRTs the companies have issued to date the capital offset to their interest costs would be relatively minor.
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Tim,
Both Bob Corker & Craig Philipps will have opening speeches at next weeks Residential Mortgage Finance Symposium hosted by SFIG. Later in the day there is a segment on CRT & the following day there is a think tank on GSE reform, amongst several other sessions. This looks like one where you should be on a panel!! https://www.events.sfindustry.org/ehome/rmbs-2017/579561/
Sean
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Tim,
Any thoughts on the Paul Muolo Inside Mortgage Finance report that (sources say) an administrative solution will likely not allow the GSEs to retain any portfolio?
Fannie has noted on several occasions that its business has largely shifted from portfolio-centric business to guaranty-centric—most of its net income from interest now comes from guaranty fees (it gets for taking on credit risk on loans underlying MBS) and not interest income generated by retained mortgage portfolio assets. (The most recent figure I could find from Q1 2016 stated that 2/3 of Fannie’s business was from G-fees).
Given that this shift has twin causes: 1) G-fee increases that began in 2012, 2) the FHFA-mandated reduction of retained mortgage portfolio per SPSA agreement, what kind of future do you think possible for the GSEs in an environment in which its revenue exclusively comes from G-fees?
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Most supporters of Fannie and Freddie agree that their on-balance sheet mortgage portfolios should be limited to purposes incidental to the credit guaranty business. This would include an aggregation function prior to pooling, which would permit the companies to support community banks and other small lenders by purchasing their loans for cash, then pooling them as Fannie MBS or Freddie PCs. The companies also need a portfolio to hold the non-performing loans they buy out of MBS or PC pools in their loss mitigation efforts. And I have suggested that it’s also a good idea to let them use their portfolios to support innovative new mortgage products, with the goal of making the market for them large enough to permit them to have their own MBS/PC prefix (at which time the products could be securitized).
How large Fannie and Freddie’s portfolios need to be in order to carry out these functions is an open question. Treasury set a goal in 2008 of having them reduce their portfolios to $250 billion through annual shrinkage, first at a rate of 10 percent per year, then increased to 15 percent. Fannie’s portfolio is now below that level (at $244.0 billion in August), while Freddie’s is close to it ($266.7 billion in September). Perhaps for that reason some people may now be beginning to speculate about a new maximum size for the portfolios, per the Muolo article. I would be very surprised, however, if any serious analysts or policymakers are considering a goal of ZERO on-balance sheet mortgages, since as noted above that would impede the workings of the companies’ credit guaranty businesses.
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What, in your analysis, should the dollar amount be for the retained portfolio, or should it fluctuate with total market cap?
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The portfolio limit would best be expressed as a percentage of outstanding credit guarantees. (A fixed dollar amount would have to be changed as the business grows, and market cap–stock price times shares outstanding–has no predictable relationship with the size of the credit guaranty business.) I personally think that a liberal percentage amount, say ten percent, is best, provided there also are specific limitations on the purposes and functions of that portfolio. The limit will be a maximum, and restrictions will reduce the chance that either Fannie or Freddie would run their portfolios up to that maximum with spread-based investments done purely for profit.
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What I implied by “fluctuate with total market cap” was it’s use as a gauge of business risk. Sorry I wasn’t clearer,but your answer was what I was looking for! Thanks
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tim
hume’s petition to scotus for cert points to an undeniable circuit split as to whether plaintiffs can pursue derivative claims where conservator is subject to conflict of interest: http://www.gselinks.com/Court_Filings/Cacciapalle/17-578-0001.pdf
adds to prior two cert petitions and may help influence scotus
rolg
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from p. 33 of hume petition:
“Two other plaintiffs-appellants in the case below—
Fairholme Funds, Inc. and Perry Capital LLC—are
separately petitioning this Court for writs of certiorari
on these grounds. Petitioners join in those petitions
and incorporate those arguments, and would
respectfully request that all three cases be consolidated
for consideration on the merits.”
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I agree that taken together these three petitions make a compelling argument for cert. Now we’ll wait to see what SCOTUS thinks.
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the missing piece from the prior two petitions was an unambiguous circuit conflict; hume’s petition supplies it. question is whether scotus consolidates and hears the questions raised by the prior two petitions, which are (imo) more important questions than the derivative claim/conflict of interest question that gives rise to the unambiguous circuit conflict.
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Tim,
During today’s House of Rep meeting on housing reform, it is apparent that small lenders are at a huge disadvantage to discuss in depth, the issue of GSE risk transfer vs the proper capital levels needed – and how to potentially solve the taxpayer issue efficiently. It all started with very pointed questions by Sean Duffy at the open of the hearing and was hammered at a several other times during the testimony. You need to lend your expertise to the smaller lender community @ICBA @NAFCU @the_CMLA @nardotrealtor, etc, as they need to be able to go head to head with the MBA and TBTF hardcore who have developed a much deeper narrative on these topics along with their massive / false narrative “blueprints” that most in Congress have a copy of – which Congress kept referencing during the meeting.
Sean
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It is very telling, IMHO, how hard that these bank funded congressmen hit at these small lenders for intricate technicalities in their lines of questioning. They were clearly trying to show that the panelists were out of their depth, and frankly many seemed to be.
Predictable, but problematic. I 2nd the idea that these small lending groups need someone who can hit back.
More troubling is that there was no mention of shareholders or shareholder rights or anything relating to the discovery disclosures showing that the entire thing was a premeditated sham.
Nothing in D.C. is ever actually substantive it’s framing and backroom deals. This cannot continue.
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I know and have met with a number of the leaders of the community banking groups, and would be pleased to offer them further advice and support.
I didn’t see the House hearing (I’ll try to catch it if it’s been recorded somewhere), but these events are not easy to manage. The members want to hear from the principals of the invited institutions, not me, and they generally have questions that are scripted by staff (with the assistance of lobbyists that have access to them). Even if the panelists give a good answer, it has no effect on the position taken by the member asking the question. And good answers almost never get follow-up questions, or any acknowledgement that the answer WAS good– the member just goes on to his or her next scripted question (I made several appearances on the Hill when I was at Fannie, and speak from experience).
I am very skeptical that anything good for Fannie and Freddie can come out of Congress; there are far too many members who have chosen to align themselves with the objectives of the large bank lobbies. You can make all the good arguments you want to with these people, and (a) they won’t understand them, and (b) they don’t want to understand them, because they’ve already made up their minds. This sounds cynical, but it’s unfortunately the reality. I strongly believe that if Congress does in fact surprise me and legislate something, it will be to turn Fannie and Freddie into creatures that operate in a way the big banks want them to. Administrative reform, in my view, is the only path to preserving the value of the companies, for homebuyers and other stakeholders.
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Tim,
Don’t underestimate your ability along with small community lenders & others to potentially influence Congress. You have a wealth of knowledge that’s not fully disseminated or understood at your intricate level. I truly believe what’s been missing at this point of the debate is a detailed published report that goes toe to toe against the ones submitted by MBA, Milken Institute, Urban Institute, etc. A report that Congress can hold in its hands that properly addresses the flaws of the other proposals on capital retention, risk sharing transactions, how to minimize taxpayer risks, etc – and one single collective report issued by ICBA, NAFCU, CMLA, National Association of Realtors, Center of Responsible Lending, and many others (lending your expertise to help them publish it). As today’s House of Reps hearing clearly revealed, these small organizations are fragmented and also not well versed against the battle machine of TBTF banks via MBA who directly influence Congress. These smaller lenders & related organizations desperately need your in-depth knowledge of the TBTF’s back door tricks in order to publish a unified, concrete, & de facto rebuttal that can properly educate Congress & bring the truth to light in a very impactful way. Not to mention, just leaving all hopes on Steven Mnuchin is risky given how bumpy Trump’s tenure is going, hence publishing this grand report would also provide a very important hedge if Congress is the one that completes GSE reform. I know it’s a lot to ask but you truly are the only person uniquely qualified to indirectly help these small organizations become more astute & level the playing field against TBTF banks and their influence on Congress.
Sean
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Tim,
If you do collaborate with the small lenders to write an in-depth plan/proposal to go toe to toe against MBA/Milken/Urbgan Institute etc. (that I highlighted above), consider including Sarah Edelman of The Center of American Progress as she is very passionate on the good of the GSEs and she will be in front of Congress tomorrow for their second housing hearing. Attached is a great piece she wrote earlier this year. https://www.americanprogress.org/issues/economy/reports/2017/04/13/430424/2008-housing-crisis/
Sean
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Amen
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Don’t underestimate impact of your work. Without your opinion, people would still require 5% capital for GSEs.
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Hi Tim or ROLG,
I saw the released Sweeney Order granting the quick peek procedure on the 1,500 docs. In one of the past orders, such as asking about why the government should not pay plaintiffs fees, there was legal speak for “quit wasting everyone’s time and resources” underlying the order. Did you notice any such underlying notes from the most recent order? Seems to me Sweeney would be losing her patience, so maybe the justification of using it being “to bring discovery to an end” and to not use scarce court resources is similar legal speak? I have a hard time seeing the tonality in court orders.
Cheers,
Justin
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As I read it, this was a neutral ruling in its tone (while in substance obviously favorable for plaintiffs). Plaintiffs counsel paved the way for this stance by Sweeney in framing the issue in its initial motion as follows: “While we do not suggest that Government counsel has failed to make a good faith effort to comply with this Court’s orders, the rate at which another review led the Government to abandon its privilege assertions is troubling and highlights the inherent difficulty of advocates for the Government determining which information Plaintiffs most need in this important and factually complex case.”
My layperson’s view is that the government in this case has done everything it can to “slow walk” the discovery process, which is now some three and a half years along and still not complete. But they’re playing by the rules, and with plaintiffs making only mild objections Sweeney seems to be taking her cue from that. In any event, her characterization of the ruling speaks for itself: “[T]he court has already stated that its use of the quick peek procedure is not intended as a sanction for any behavior on defendant’s part but rather as a means of expediting the completion of jurisdictional discovery in this case and conserving the court’s limited resources.”
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what tim said. the man deserves an honorary law degree. rolg
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Well, having spent eight years with top-notch lawyers (successfully) battling allegations of accounting fraud, some of their professionalism and expertise may have rubbed off on me….
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We’ve been hearing about the concept of “Recap and Release” for years.
It seems that the simplest political move in the short term is that FHFA and Treasury agree to just recap. This way they buy time, the GSE’s remain sound, but no one needs to rock the boat.
Can you explain your thoughts on the feasibility and consequences of just recapitalizing the GSE’s?
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Fannie and Freddie cannot be recapitalized without resolution of the lawsuits against the net worth sweep, or a Fourth Amendment to the PSPAs that cancels the sweep to the satisfaction of the plaintiffs in those suits. These are unlikely to happen outside the context of a full administrative reform proposal supported by Treasury. Largely because of politics—the large banks, for economic and competitive reasons, are opposed to preserving Fannie and Freddie as independent, shareholder-owned entities in anything close to their pre-crisis state—Treasury currently has a strong incentive to support the status quo of keeping the companies in conservatorship. But as I’ve stated earlier, at some point the combination of evident failure on the part of Congress to proceed with legislative mortgage reform, some development or developments in one or more of the court cases threatening the sustainability of the sweep (with the possibility of the Supreme Court granting cert in the Perry Capital appeal now added to the list of those threats), and the lure of $100 billion or so in value from warrants on Fannie and Freddie’s common stock should lead Treasury to take the initiative to resolve the conservatorship impasse administratively, preserving and strengthening the companies despite the banks’ objections.
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Thank you for your thoughts Tim.
Could you explain why the plaintiffs must be satisfied before FHFA/Treasury could act to recapitalize the GSE’s?
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What I meant by the use of the phrase “to the satisfaction of the plaintiffs” is that any Fourth Amendment to the PSPAs must decisively deal with the currently binding ruling by the DC District Court of Appeals that FHFA has unfettered discretion as to how it treats Fannie and Freddie in conservatorship. Investors will not put capital into Fannie and Freddie if FHFA can, at its sole discretion, allow Treasury to take that capital right back out again. The plaintiffs in the net worth sweep cases are in the best position to determine whether this essential condition has been met.
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I don’t believe you’ve answered this question fully.
While it would be adverse to the plaintiffs, it seems FHFA and Treasury can unilaterally pass a forth amendment and do a short-term fix to allow the GSEs to hold some capital. Capital not from stakeholders, but from profits.
It simply is irrelevant that there are outstanding court cases today. Previous court rulings have stated that the government has de facto complete authority over the GSEs.
If you believe the government could not legally make this move, I would love to hear why you [or any one else] believes so.
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Could Treasury and FHFA simply cancel the net worth sweep and allow Fannie and Freddie to begin to build capital through retained earnings? Yes. But without a plan to reach an agreed-upon level of capitalization through large and frequent issues of new equity, they would have to remain in conservatorship. While legally and theoretically possible, a fourth amendment that cancels the net worth sweep but is not associated with a definitive plan to either replace the companies or allow them to be released from conservatorship after quickly building capital through new equity issues (which requires settlement of the lawsuits) is highly unlikely.
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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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I’ve now read the transcript of the podcast Davidson did with Knowledge@Wharton, as well as the September 2017 paper he co-authored with Richard Cooperstein (“Is There a Competitive Equilibrium for the GSEs?”). Although the paper is quite theoretical, I agree with almost all of its practical conclusions as they relate to Fannie and Freddie.
Davidson was one of a couple of dozen mortgage market analysts (I was another) who submitted an essay to the Urban Institute’s “Housing Finance Reform Incubator” series last spring. In that essay he had three primary recommendations: that Fannie and Freddie’s governance should be changed from private shareholder ownership to mutual ownership by the originators who use them; that their securities should be “wrapped” with a Ginnie Mae government guaranty, and that “up to 75 percent of risk on new GSE loans” should be covered with some form of risk sharing arrangements.
In his latest paper and its related podcast, Davidson makes no mention either of an explicit government guaranty or programatic risk sharing. If that means he no longer recommends these (which I hope is the case), that’s a good development. I believe an explicit government guaranty for the companies’ securities is unnecessary and would set a dangerous precedent, and as I discuss in my current post I believe programatic risk sharing is unworkable.
I have three concerns about changing Fannie and Freddie from shareholder ownership to a mutual structure. First, I believe there is considerable danger that mutually owned credit guarantors would become “captured” by their large originator-owners, and exert less independent discipline on underwriting than shareholder-owned guarantors would. Second, during times of stress capital raising could become problematic for a mutually owned guarantor. A shareholder-owned company can raise needed capital in advance (when it tends to be cheaper and more available); a mutual company raises it as it is used by its members, and during times of stress originators may either be unwilling or unable to provide that capital. Finally, changing to mutual ownership requires legislation; recapitalizing Fannie and Freddie as shareholder-owned companies does not.
But other than the mutual ownership recommendation, I agree with Davidson’s other substantive prescriptions. I think Fannie and Freddie should be subject to utility-like regulation, including regulation on the prices they can charge for their credit guarantees. (In exchange for that regulation, though, they should be allowed to keep the benefits conveyed to them in their existing charters.) And I agree with Davidson that the combination of utility-like regulation and open competition–as recommended by the MBA–is both internally inconsistent and unwise as public policy.
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Tim,
When Davidson was asked (on the podcast) about the changes that would need to happen to make anything like his proposal feasible, he responded by arguing: “we’re really going to need Congress to act.”
The action he thinks necessary:
1) “it needs to change the charter to allow this type of governance structure.”
2) “it needs to move to a situation *where there’s an explicit guarantee on the mortgage-backed securities* so that the market can continue to function the way it is right now. Right now, we’re relying on treasury providing capital to Fannie and Freddie in a very indirect fashion, and an explicit guarantee would really help to move the whole process forward.”
3) “we need to have a capital rule to say how much capital these entities really need to protect the taxpayers.”
While I’m curious about your assessment of 1), it’s 2) that’s really interesting. On the one hand, he argues that an explicit guarantee is needed…but in the same breath avers the *reason* for the guarantee is to maintain Fannie’s current function.
So, it appears he’s not evolved on the issue of the guarantee (as you hoped). While hos position is internally consistent, I wonder what’s driving him to push for Congressional action when, as you’ve pointed out, administrative action both seems more likely and better able to accomplish something like what he has in mind without unnecessary dilution.
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I read the podcast transcript too quickly—I see that Davidson did say in an answer near the end that there needs to be “an explicit guarantee on the mortgage-backed securities so that the market can continue to function the way it is right now.”
Davidson says that we need Congress to provide that guaranty (which is true), but also that Congress needs to “say how much capital these entities really need to protect the taxpayers.” Congress already has done that in HERA, and it wisely left it to FHFA to specify those capital standards, based on the risk of the mortgages the companies guarantee.
I don’t understand the contention that Fannie and Freddie will need a government guaranty on their securities in the future to provide the same sort of support in the secondary market as they have in the past. If FHFA sets a true risk-based capital requirement for them—designed to withstand a defined stress environment (I’ve recommended a 25 percent decline in home prices over a 5-year period)—and Treasury endorses this capital requirement, that should give investors enough confidence in the quality of Fannie and Freddie’s guarantees to enable the companies to issue very large volumes of MBS that trade at levels close to Ginnie Mae securities. And if for some reason that doesn’t happen, the companies should be able to respond by getting catastrophic loss reinsurance from property and casualty companies at a relatively low cost (which would be passed on to homebuyers).
The insistence by so many mortgage analysts (and also, I should note, by FHFA Director Watt) that the resolution of Fannie and Freddie’s conservatorships must involve Congress is in my view a legacy of the earliest days of the mortgage reform dialogue, when opponents of the companies succeeded in falsely blaming them for the 2008 mortgage and financial crises. We now know that is not true. Fannie and Freddie were not “rescued and bailed out;” they were “seized and decapped”—i.e., taken over at the initiative of Treasury against their will and without statutory authority, then stripped of their capital by accounting entries booked by FHFA that temporarily or artificially ballooned their expenses and forced them to take huge amounts of unneeded but non-repayable senior preferred stock from Treasury.
While the appropriate response to a rescue and bailout might indeed be legislation designed to remedy the defects and weaknesses of the previous system, the correct way to unwind an instance of “seize and decap” is to do the reverse—that is, to “recap and release.” Recap and release, however, has become a verboten phrase (it’s not “real reform”). The closest thing to it that’s still on the table is administrative reform, which fortunately is not just the best alternative but also, given the current dysfunction in Congress, the only one with a realistic chance of being implemented.
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A mutual ownership structure sounds enticing in theory but has a glaring, oft-overlooked key flaw: non-depository mortgage bankers, the true “private capital” in mortgage banking (no deposit insurance, no Fed window $$, no TARP) cannot capitalize such an entity because their cost of funds is often greater than what a coop could return to them.
There’s a reason non-deps don’t belong to the FHLB system, in other words.
Folks in Congress are well aware of this limitation, esp at a time when non-deps have a greater market share than in the recent past.
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Rob–I agree with your observation about the impact mutual ownership of Fannie and Freddie (or any credit guarantor) would have on non-depository mortgage bankers. For this and other reasons, that’s why we’re seeing an alignment of the large banks in support of the MBA’s proposal to significantly restructure Fannie and Freddie (to the large banks’ benefit), and an alignment of smaller community banks and non-depository lenders around administrative reform that would make Fannie and Freddie stronger and more effective.
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Can anybody explain why Fairholme could/would file cert petition while the lawsuit is still going on at the Claim Court (a.k.a., Judge Sweeney, Discovery, etc.)?
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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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Thanks Tim. Still, I am confused why Fairholme chose to file the cert petition at this point, while the Claim Court activities are still ongoing.
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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.
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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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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.
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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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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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Tim, why do you think that SCOTUS is most likely to decline to hear the case? The issues in this case seem to be a perfect fit for the Supreme Court.
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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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perry scotus cert filing: http://gselinks.com/Court_Filings/Perry/Perry_Capital_Certiorari_Petition_as_filed.pdf
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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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fairholme’s cert petition: http://www.gselinks.com/Court_Filings/Fairholme/Fairholme_Cert_Petition.pdf
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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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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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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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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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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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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.
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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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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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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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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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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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Tim a tangential question. Have you considered having your book The Mortgage Wars turned into an audio book?
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I hadn’t, and doubt that I will. I’m satisfied that it’s available either in hard copy or as an e-book (perhaps I’d feel differently if I were a customer of audio books myself, but I’m not…).
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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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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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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
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Maybe we’re talking about two different things?? He said outside c-ship GSE’s should have 3-5% capital. Short tape:
https://mobile.twitter.com/ethan2369/status/915272039132405760/video/1
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Yes, he originally said 2%-3% for GSEs vs 4%-5% for banks if you go back much earlier in the hearing
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I am curious if this was the first time Watt suggested 2-3% capital buffet is sufficient? If so, wouldn’t it align with Moelis & Co.’s blueprint proposed back in June 2017? Would this be some sort of a trial balloon?
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My guess is Watt was informed by experts.
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Here is where he says 2-3%. https://mobile.twitter.com/POTUSwon/status/915240486951985153/video/1
The other tape where he said 3-5% is later in the hearing. Having now watched them both I think his more considered answer was the 2-3% and he erred in saying the latter.
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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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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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If you get there for the wrong reason it’s not the right answer….
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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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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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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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I’m not familiar with the term “CECL modeling.”
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I just googled CECL, Current expected credit loss. https://advisory.kpmg.us/topics/cecl-modeling-and-accounting.html?gclid=EAIaIQobChMIjY67ourX1gIVCIR-Ch3d1wlgEAAYASAAEgIpAPD_BwE
It would appear to be a new model set up by the FASB that effects allowance and impairment processes.
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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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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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What would Watt’s incentive be to go along with anything that you just mentioned?
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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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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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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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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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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?
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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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Both Fannie and Freddie are on a calendar fiscal year.
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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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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
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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.
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Very insightful comments Tim, thanks for sharing them with us.
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Tim
It appears as though FHFA is accepting public comments until Oct 27th on risk sharing securities per the attached article. A great opportunity to weigh in!
https://bankingjournal.aba.com/2017/09/fhfa-releases-fannie-freddie-strategic-plan/
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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.
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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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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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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.
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“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.
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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.
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Sweep was made 😦
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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?
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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.
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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?
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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.
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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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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.
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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?
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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.
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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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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
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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.
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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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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.
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I’ve just seen this article involving CIRT transactions on YahooNews
https://finance.yahoo.com/news/fannie-mae-announces-two-credit-150000985.html?.tsrc=applewf
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Can anyone with a straight face possibly argue with the facts and proposals made by TH? Now the hard part, get FHFA and Treasury on board.
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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.
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Learned a lot. Thanks for writing this.
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Two Thumbs up! Thanks!
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