Some Pre-comment Comments

~ jtimothyhoward

On June 12 the Federal Housing Finance Agency (FHFA) issued a notice of proposed rulemaking on “Enterprise [Fannie Mae and Freddie Mac] Capital Requirements.” The proposal is lengthy—263 pages, plus another 105 pages of proposed rule text. Because comments on it are not due until 60 days after it is published in the Federal Register (which as of yet it has not been), I did not attempt to work my way though it before leaving on vacation last month. Now that I’ve been able to finish reading and analyzing it, however, I feel compelled to make some initial comments about it, in advance of the formal comment I will send to FHFA later on in the summer.

It perhaps should not have surprised me, but I found FHFA’s risk-based capital proposal for single-family mortgages to have a pronounced, troubling and entirely avoidable pro-Financial Establishment and anti-homebuyer bias. As I discuss below, the biases fall into three categories: inappropriately basing the risk-based standard on banks’ Basel standard; excessive and counterproductive conservatism in the risk-based standard, and flaws in the 2.5 percent minimum capital alternative and the treatment of credit risk transfers. Taken together, these make it difficult to avoid the conclusion that FHFA backed into its capital numbers, and engineered its proposal to produce what Fannie and Freddie competitors and critics (including careerists at Treasury) have long been asking for: requiring the companies to adhere to capital standards dictated by and advantaging large banks and Wall Street firms, and disadvantaging homebuyers.

Inappropriately basing the risk-based standard on banks’ Basel standard

Despite the fact that banks’ Basel capital standards are designed to cover a very wide range of asset categories that Fannie and Freddie are not permitted to deal in, and that have much higher and less predictable loss rates than home mortgages, “FHFA’s rule is based on a capital framework that is generally consistent with the regulatory capital framework for large banks.” FHFA claims that its proposed capital rule for Fannie and Freddie “appropriately differentiates from other capital requirements based on the actual risks associated with the Enterprises’ businesses,” but even a cursory analysis reveals it comes nowhere close to doing that.

The one place in the proposal where FHFA attempts to numerically “recognize the lower risk” of Fannie and Freddie’s business relative to banks is in its determination of a minimum capital ratio for the companies. And there, instead of using actual loss data, FHFA states bewilderingly, “Risk is defined using Basel risk weights.” In Basel, mortgages get a 50 percent risk weight, while FHFA calculates that the average risk weight of the top 34 bank holding companies (who are subject to enhanced capital standards) is 72 percent. Using these figures, FHFA asserts, “This suggests that the risk-weighted asset density for [Fannie and Freddie’s] assets is about 69 percent (calculated as 50 percent divided by 72 percent) of the risk-weighted asset density for the largest bank holding companies.” Put differently, FHFA is claiming, based on the Basel risk weights, that banks’ assets are only one and a half times as risky as the mortgages owned or guaranteed by Fannie and Freddie.

That is preposterous. There is no justification for FHFA to use Basel risk weights to assess the relative riskiness of Fannie and Freddie’s assets when historical loss data are readily available for the same purpose. And the differences using real data are staggering. In the 20 years before the 2008 mortgage crisis, credit losses at FDIC-insured banks averaged 82 basis points of total assets per year, twenty times the 4 basis point average credit loss rate at Fannie and Freddie. The 2008 mortgage crisis was a true “stress event” that affected losses at Fannie and Freddie (whose assets are limited to mortgages) disproportionately to banks, but even including post-2008 credit losses in the comparison Fannie and Freddie’s 1988-2017 average credit loss rate of 14 basis points is just one-sixth the 84 basis point loss rate of the banks over the same period. And if you adjust Fannie and Freddie’s 2008-2017 losses to exclude the loan products and risk features they no longer are allowed to finance (as even FHFA does in its analyses), the companies’ 1988-2017 average loss rate falls to 8 basis points—one-tenth the comparable average loss rate of commercial banks.

As of the end of 2017, the banking industry as a whole, with $16.2 trillion in assets, had a total equity-to-assets ratio of 11.2 percent. (The four largest banks, with over half of banking industry assets at $8.2 trillion, had average equity capital of 10.2 percent.) The banking industry’s average capital percentage is about 13 times its average annual credit loss rate. It is axiomatic in finance that capital must be related to risk. If FHFA were to use the same 13:1 ratio of capital to annual credit losses for Fannie and Freddie as exists for the banks—which would overstate Fannie and Freddie’s required capital because these two companies take nowhere near as much interest rate risk as banks do—a true “bank-like” capital ratio for them would be between 100 and 180 basis points, with a figure at the lower end of this range being more consistent with the residential mortgage types Dodd-Frank permits the companies to finance today.

It is understandable that competitors and critics of Fannie and Freddie would want to ignore actual comparable loss experience and insist that the companies’ capital be based on the Basel bank standards, but it is not acceptable for Fannie and Freddie’s safety and soundness regulator to do the same thing. And grossly overstating the risk of the companies’ business leads FHFA to make its next major mistake—adding excessive, redundant and unjustified conservatism to its risk-based standard in order to produce a capital number that approaches the simplistic 4.0 percent risk-weighted leverage requirement applied by Basel to bank mortgage holdings.

Excessive and counterproductive conservatism in the risk-based standard

For Fannie and Freddie’s single-family credit guaranty business (the main focus of this comment), there is a simple, effective, and nondistortive way to implement the risk-based capital directive in the Housing and Economic Recovery Act (HERA). FHFA would take the companies’ single-family books at the end of each quarter, and apply the stress loss rates it developed for the various types of loans and risks (in the proposal these are done to a high degree of granularity) over a defined and realistic period of time, and incorporate projected income and expenses to determine the amount of initial capital the companies would need to survive that stress. The minimum capital percentage, and not the risk-based standard, would incorporate any capital cushions deemed appropriate, taking into account the fact that HERA gives the regulator authority to take prompt corrective action when capital falls below either the minimum or the risk-based amounts.

FHFA does determine stress loss rates by loan and risk category, but it then adds numerous and redundant elements of conservatism, both when applying the stress test and in addition to it. These include: (a) declining to count guaranty fee income as an offset to loan losses, (b) not allowing for the tax deductibility of those losses, (c) adding a fixed “going concern” buffer to all assets, irrespective of their risk, and (d) adding a reserve for deferred tax assets, or DTAs, despite the fact that the going concern buffer is designed to ensure the companies’ continued solvency, so that their DTAs always would have value. (FHFA also adds a “market risk” capital charge, but this applies only to the portfolio business.) In a fact sheet FHFA produced that shows the “impact of the proposed capital rule,” the refusal to count income as an offset to credit losses adds an estimated 113 basis points to the risk-based standard for single-family credit guarantees, while the going concern buffer adds another 75 basis points to it.

FHFA’s rationales for not counting revenues in its stress test are exceedingly weak. Its first is that the Basel capital standards don’t count them. That’s true, because Basel uses simple ratios, not a stress test. The Dodd-Frank stress test for banks does count revenues, as any legitimate stress test does and should. A second reason FHFA gives is that, “Inclusion of revenues could result in a very low or zero-risk based capital requirements for specific portfolio segments.” That’s also true, if the loans aren’t very risky. But that’s precisely why FHFA includes a minimum capital level, which kicks in if the aggregate risk-based capital numbers drop below the minimum.

The impact of not counting revenues is huge. Without revenues, FHFA calculates that stress credit losses for Fannie and Freddie’s September 31, 2017 book would be $112.0 billion, or 201 basis points of their combined assets and off-balance sheet guarantees. But with the companies’ current average net guaranty fee of 30 basis points (deducting both administrative expenses and the payroll tax fee), and the stress prepayment rates from the 2008-2012 period, guaranty fee income from that same book would be an estimated $63 billion, leaving credit losses net of revenues of $49 billion, or 88 basis points. That’s the accurate risk-based capital percentage.

There clearly is merit to the concept of a going concern buffer, but FHFA errs badly in adding it to the risk-based standard; it must instead be a component of the minimum, due to the interaction of a risk-based standard that can change over time and the provision in HERA for prompt corrective action by the regulator if Fannie and Freddie do not meet both their risk-based and minimum capital standards.

Fannie and Freddie’s minimum capital standard will be a fixed percentage (FHFA’s two proposed alternatives are discussed briefly below), while the risk-based number will change counter-cyclically—requiring less capital when home prices are rising and more when they are falling. Fannie and Freddie executives know that when home prices are falling it is difficult, expensive and sometimes not possible to raise capital. For that reason they almost certainly will want to hold significantly more capital during good times than is required by their risk-based standard, because when that risk-based requirement rises during periods of stress (and it can rise quickly and considerably) they will want to continue to be in compliance with it to avoid adverse regulatory action, including restrictions on their business.

In the real world in which the companies operate, therefore, FHFA’s proposal to put multiple layers of conservatism inside the risk-based standard is highly problematic. Even though this conservatism is intended as a cushion, in reality it won’t serve as one, because the extra capital can never be drawn down—doing so would push a company under its risk-based requirement (which has the “cushions” built into it) and trigger the prompt corrective action the companies so desperately will be trying to avoid. This means that the conservative set of elements in the FHFA proposal that produced a 3.24 percent risk-based capital requirement at September 31, 2017—a time when the housing environment was very favorable—would in fact lead Fannie and Freddie to hold at least 4 percent and more likely closer to 5 percent capital, including the excess they know they will need when the cycle turns less favorable, and their (overly conservative) risk-based requirement becomes much higher.

FHFA needs to understand that if it takes a true risk-based capital number of 88 basis points, adds unnecessary cushions, and then ignores the impact of its prompt corrective action disciplines on management’s incentive to hold excess capital, the result will be actual capital holdings that cause extreme distortions in the pricing of single-family credit guarantees. Having to price mortgages that have an 8 basis point expected loss rate to earn a market return on 5 percentage points of capital will stretch the affordability of and access to credit guarantees from Fannie and Freddie beyond the breaking point. And there is no reason for it. Fannie and Freddie are not banks, and FHFA should not be trying to smother them with Basel-like required capital, unrelated to the risks of their business. Instead it should subject them to a straightforward and realistic risk-based standard, with no fudges or cushions, then add a minimum standard calibrated to the statistical risk of their business, and that incorporates a going concern buffer sized to reflect the reality that if they fall below this minimum HERA gives the FHFA director discretion to classify them as “critically undercapitalized,” and appoint FHFA as their conservator or receiver.

Flaws in minimum capital and credit risk transfer proposals

Two other aspects of the FHFA capital proposal deserve brief mention here: its alternative minimum standards and its treatment of credit risk transfers.

FHFA suggests two potential approaches for a minimum capital (or leverage) requirement: a “2.5 percent alternative,” which is 2.5 percent of all on-balance sheet assets and off-balance sheet guarantees, and what it calls a “bifurcated alternative,” which effectively is 1.5 percent of all credit guarantees and 4.0 percent of other on-or off-balance sheet items.

Between the two, it is an easy choice. FHFA derived its 2.5 percent alternative by using Basel risk weights to translate bank risk or solvency measures into Fannie and Freddie capital, thus making the egregious mistake noted earlier of ignoring actual historical risk data for Fannie, Freddie and the banks in favor of the inapplicable, imprecise and wildly inaccurate Basel risk-weight comparison. That leaves the bifurcated alternative as the only reasonable one. FHFA does not make a convincing case for why it picked the 1.5 percent and 4.0 percent numbers for this standard, but with the important caveat that these figures be viewed as including a going concern buffer, I would view them as generally acceptable. I plan to do additional work on this topic, however, and to address it in more detail in my comment letter.

FHFA makes great efforts to favor credit risk transfers (CRTs) in its risk-based capital standard. One of these is ironic but harmless: having relied heavily on Basel in deriving credit risk capital, FHFA ignores Basel in giving capital credit to CRTs (Basel does not do so). A second act of favoritism is much more serious. Assessing the worth of CRTs as capital substitutes requires measuring their expected benefits against their costs. In the risk-based standard, FHFA gives credit for the expected benefits of CRTs but does not take their cost into account at all—because it ignores guaranty fee income and expenses, including CRT interest payments. (I’m tempted to think that FHFA’s odd decision to ignore income and expense in the risk-based standard may have had its origin in a desire to create a regulatory incentive for the CRT securities it and Treasury have been forcing Fannie and Freddie to issue). No one disputes that CRT capital is greatly inferior to equity capital, yet the FHFA rule inexplicably and dangerously gives the companies a one-sided capital incentive to substitute the former for the latter. If the companies fall prey to this lure (and they may not, if they look at the economics of the transactions) it will make them riskier, so in the interest of safety and soundness FHFA’s CRT treatment must be changed.

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These are my most important observations on the FHFA capital proposal. I believe it is critical that individuals and groups who have an interest in and a commitment to a mortgage finance system that works well for homebuyers read the FHFA proposal, make sure they understand it, and then give FHFA their comments on it. There can be no doubt that the supporters of large banks and Wall Street interests will flood FHFA with comments praising the wisdom and fairness of its proposal, so it will up to advocates for the ordinary consumer—the affordable housing groups, community banks and others—to point out the flaws and failings of FHFA’s capital plan, and to offer advice as to how it can be fixed in a way that reverses its pro-bank and Wall Street bias, which if not undone will deal a severe blow to the low- moderate- and middle-income homebuyers Fannie and Freddie were chartered to serve.

195 thoughts on “Some Pre-comment Comments”

    1. I’m not sure what aspect of the interview with Frank Raines you’re asking me to comment on. I worked very closely with Frank the entire time he was at Fannie Mae. When he came to Fannie as Vice Chairman in 1991 he had the office to my right, and when he was elected as Fannie’s Chairman in 1999 after serving as Director of the Office of Management and Budget for President Clinton he had the office to my left. I’ve always thought very highly of Frank, and continue to do so. I thought he was treated terribly by critics and the press after FHFA’s predecessor, OFHEO, falsely accused Fannie Mae– and Frank as Chairman and CEO and me as Vice Chairman and CFO–of financial fraud. After we both were dismissed by a judge from the the civil suit against Fannie in 2012, I was able to write my book and return to having a public profile through my pro bono work in the mortgage field, but Frank could never stick his head out of the bunker without people taking shots at him. So I’m very pleased to see him appear in this interview.

      If you’re asking about the question he was asked, “Would things have been different at Fannie had you stayed after 2004” (when, as Frank said, we allowed our market share to drop significantly after the private-label market became the financing outlet of choice for high-risk loans made in the primary market), I agree with his answer– “Yes.” As I discussed in my book, in 2003 we had put in place a set of publicly announced corporate financial disciplines to which we had pledged to adhere, and I believe we would have continued to do so, even through more years of market share shrinkage. But as Frank said, it’s all speculation, and everyone is free to tell their own story.

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      1. Tim,

        Thank you for your reply and all the work you do.
        I liked the interview overall. Did you catch the one reporter at about 04:12 use the term, “Receivership,” instead of “Conservatorship?” Do you think that this is manipulation or just ignorance of those reporting on this topic?

        Thank you,
        Jon

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        1. The interviewer who used the term “receivership” in asking Frank about “the state Fannie Mae has been in for the last several years” just misspoke. I don’t know the interviewer, but it’s possible he doesn’t know that the company is in conservatorship, or maybe he simply used the wrong term inadvertently. In either case, I don’t think there was any “manipulation” at work.

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        2. It kind of reminded me of the difference between “may” Vs “shall” and how inaccurate reporting may have unintended consequences.

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    1. Rolg / Tim,
      I thought this case had the most promise with the combination of unconstitutionally structured, appointments clause and delegation of authority all strong arguments. I was really surprised when the district judge dismissed all three claims. Do you feel strongly about this appeal having promise? I think if the SCOTUS heard this case, they would rule for the plaintiffs. Any thoughts?

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      2. @jerry

        the bhatti appellate brief is outstanding.

        it includes a scotus case, bowsher, that supports the invalidation of the NWS as a remedy, as opposed to only prospective relief as was case in collins (I assume this case will be argued in any rehearing of collins). as best I can tell, counsel found this somewhat obscure case recently, but it “should” have strong precedential effect. in bowsher, the dc circuit invalidated a graham/rudman sequestration on the basis that it was done at behest of an unconstitutionally structured agency. scotus affirmed that order of invalidation. Bowsher adds to the recent scotus case, lucia, that P’s should obtain relief when they bring successful constitutional challenges.

        the rop case went to a place cases go to die…the bottom of the docket of a judge who doesn’t want to touch it.

        rolg

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        1. ROLG,
          Thanks for the reply. You confirmed what I thought that the case was strong, although I am cautiously optimistic based on what has happened so far.
          The ROP case was the same timing as Bhatti and then everything just stopped. Thanks for the insight. As Belichick would say, moving on to Bhatti. Hines / Jacob is behind us.

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          1. I have figured out. if a judge is neutral, we win; if biased, we lose. This is a simplest case. Conflict of interest, state law violation, constitutional avoidance, non-delegation, takings, unconstitutional FHFA etc. Any of these can void NWS.

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  4. Jacob Hindes 3rd circuit

    [audio src="http://www2.ca3.uscourts.gov/oralargument/audio/17-3794DavidJacobsv.FederalHousingFinanceAgency.mp3" /]

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      1. Someone more optimistic about this recording than me point out a reason to feel good about it. I’m really rooting for a win, but I’m not sure it’s going to come from this court 😦

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        1. Jeff,
          I was very optimistic before oral argument . After hearing the oral argument it sounded to me like the judges aren’t buying that 100% of all earnings is an illegal rate for preferred stock. I went on thinking 75% chance of winning the appeal. After listening, I put the odds at less than 25%. That was my take but maybe I missed something that others felt so optimistic about on other blogs.

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          1. I’ve just listened to the oral argument, and share Jerry’s view of it. On the issue of “100% of all earnings” being an illegal rate for preferred stock, plaintiffs counsel answered that very poorly, taking the judges’ premise that the rate on the net worth sweep was a “rate” of 100%. It’s not. A “rate” is a percentage of some outstanding balance (in this case Treasury’s outstanding senior preferred stock.) The original dividend on the senior preferred was 10% per annum; it’s now “whatever you have this quarter.” Whatever you have this quarter is not a “rate” on the senior preferred; it’s confiscation, and that’s not permitted under Delaware.

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        2. In attempting to remove Ron’s second posting of the same audio (which I wasn’t fully able to do), I inadvertently lost both a comment from “Jerry” and my response to it. Jerry’s comment was, “Jeff, I was very optimistic before oral argument. After hearing the oral argument it sounded to me like the judges aren’t buying that 100% of all earnings is an illegal rate for preferred stock. I went in thinking 75% chance of winning the appeal. After listening, I put the odds at less than 25%. That was my take but maybe I missed something that others felt so optimistic about on other blogs.”

          To Jerry’s comment I responded, “I’ve just listened to the oral argument, and share Jerry’s view of it. On the issue of “100% of all earnings” being an illegal rate for preferred stock, plaintiffs’ counsel answered that very poorly, taking the judges’ premise that the net worth sweep had a “rate” of 100%. It does not. A “rate” is a percentage of some outstanding balance (in this case Treasury’s outstanding senior preferred stock.) The original dividend on the senior preferred had a rate of 10% per annum; it’s now “whatever you have this quarter.” Whatever you have this quarter is not a “rate” on the senior preferred; it’s full confiscation, which is not permitted for a class of preferred stock under Delaware law.

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          1. It was at that point of the argument that I put my head in my hands. Thank you both very much for your replies. I just couldn’t justify the optimism I was reading on twitter and was hoping I missed something in my interpretation of the hearing.

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          2. I won’t be able to listen to the argument for a few days but whether or not NWS terms comply with Section 151 of Delaware corporate statute is a case of first impression under Delaware corporate law, and this should be decided by Delaware Supreme Court under an advisory opinion. all third circuit has to decide is whether or not, assuming the NWS does violate Delaware corporate law, fhfa exceeded authority under HERA. assuming yes, then federal court should look to Delaware court to decide the Delaware corporate law question

            rolg

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          3. Excellent. At the inception of this case I urged an attorney to refine his argument against 100% rate. The judge this afternoon used my very thought process. A rate of 99% still wipes out shareholders, but being less than 100% it cashes out no different than 100%. It wipes out shareholders. If 99% is permissible, being less than 100%, then the net result of wiping out shareholders may be construed as permissible. In which case, there’s no substantial difference between 99 and 200. That makes the case a matter of fiduciary duty and not a matter of power granted by HERA. That’s to play to a weak hand.

            I understand your point. Rate must relate to infusion, not net worth. Do you suppose the judges get that? That’s the 180 billion dollar question, isn’t it?

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          4. Tim,

            That nails it. And that should’ve rolled off the attorney’s tongue with precision and eloquence. Moreover and somewhat ironically, wouldn’t a true rate of 100% – a rate applied to infusion – have caused enormous circular borrowing? 180 billion (or whatever was outstanding) per year?!

            The government is equivocating over what rate means. Somehow the judges need to grasp this concept. You’ve cleared it up for me in a couple sentences.

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          5. I have listened to the oral argument and I find the most interesting direct question to be the preemption question posed by male judge at about 36 minutes, whether federal or state law governs the ultra vires question (the female judge’s initial counsel to fhfa counsel was focused on ultra vires, so clearly two judges are focused on issue). i don’t think treasury counsel was convincing that Delaware corporate law has been preempted by federal law. now it is clear that the judges were probing earlier to P counsel whether NWS did in fact comply with the rate/preference requirements of Delaware law, but as P counsel pointed out, since the NWS is unprecedented it is unclear based upon precedent whether it complies with state law or not (though P counsel did make point that section 151 states that preferred dividends must be in preference to dividends payable on junior stock which is not possible with NWS…all this lack of on-point precedent is all the more reason to remand for Delaware Supreme Court guidance by way of an advisory opinion (one would think the federal judges who conclude that they are indeed bound to apply state law, as I think this merits panel will conclude, would find trepidation and judicial humility in construing how to apply such specialized state law (Delaware corporate law) in such a unique situation as the NWS). in terms of judicial preparation, at least it is clear that the judges had read briefing, given the Saxon oral argument reference that was included in P’s reply brief that the female judge started fhfa counsel off with.

            rolg

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          6. one more point, if I may.

            to avoid the ultra vires analysis, fhfa counsel tried to show how HERA authorizes fhfa to enter into contracts, the NWS is a contract, hence there is no acting ultra vires outside the conservator’s authority. the female judge also pushed P counsel as to whether the succession clause limited fhfa’s authority, and P counsel discussed how there was nothing else in HERA that made clear that fhfa had greater rights than did directors and shareholders in exercising the power to operate the entities.

            while this line of inquiry offers the judges the easy way to decide case without confronting questions of preemption and Delaware corporate law, I didn’t get the sense that was the way they were inclined to go…but unfortunately this saga is littered with judges taking easy ways out.

            rolg

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  5. For what it’s worth, #Fanniegate got a low key callout in the Kavanaugh hearings. Democrat Senator Hirono said “Trump nominee Don Willet – now a Judge on the 5th Circuit – has already voted to curtail
    the independence of a federal agency that helped rescue the economy after the mortgage
    crisis of 2008.”

    She is obviously referring to the Collins decision, though she leaves out that Willet was not alone in that conclusion regarding the constitutionality of the FHFA structure.

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    1. Here’s another NWS shout out. Both Sen Lee and nominee just agreed, laughingly so, that Congress creating then directing an independent body to conduct policy that subverts Constitutional Law with unchecked powers, is the very definition of tyranny. Wow.

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      1. kavanaugh skirts relief question on PHH (during questioning from senator klochubar) insofar as it may apply to fhfa. he says he was in favor of reforming the removal provision and not ordering cfpb to “shut down” as another judge in the original merits majority opinion would do. but majority also held that P would get relief based upon statutory grounds, that cfpb violated its own organic statute as well as being unconstitutionally structured. question for may readers of this blog is what he would do where the fhfa is found to have not violated its organic statute with adoption of NWS (as circuits have so found to date) but also the ffha is found to be unconstitutionally structured. would he invalidate NWS as a constitutional remedy, as Lucia case seems to imply?

        rolg

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    1. This is a good summary of the background of the conservatorship and the sweep, and the current “state of play” legally. Most of us know the history (although those sympathetic with the objectives of FM Watch ignore it in favor of Treasury’s fictionalized account of the “bailout”), but it’s always good for it to be repeated concisely, as Gary does here. I agree with Gary that the takings cases in the Court of Federal Claims pose a significant threat to the government, both because of their solid legal foundation (which admittedly hasn’t helped in the APA cases) and because Sweeney has been a real-time witness to the slow-motion unmasking of Treasury’s made-up story about why they did the sweep and who it benefitted. But I wish I were as confident as Gary that the administration perceives this threat and might as a consequence act preemptively to release Fannie and Freddie from conservatorship before Sweeney can rule. As he and the President say, however, “We’ll see what happens.”

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      1. Tim,

        Please correct me if I’m wrong, but I didn’t discern that Gary thinks the administration perceives the threat of losing big and, therefore, might make a preemptive release in order to mitigate what could be astronomical losses. Indeed, he does point out that if shareholders get their day in Sweeney’s court, the government could lose their opportunity to grab the warrants and even possibly have to pay back dividends (if the conservatorship is ruled illegal). So, yes, if the administration beats Sweeney to the punch and releases the GSEs before rulings in her court, the Treasury could avoid a devastating blow.

        It’s likely the Treasury has considered their losses under such unfavorable (to them) scenarios. There’s also a chance that an administrative solution will come prior to a ruling in Sweeney’s court. But whether the government would act out of fear of this, or whether Gary thinks they will, remains a bit of a mystery to me.

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        1. I perhaps overstated Gary’s confidence in the government’s perception of the risk of losing in the Sweeney court (or elsewhere). I do know from private conversations and correspondence with him that he’s more confident about this than I am, but beyond that I wasn’t intending to characterize his position on this issue any more precisely.

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          1. Tim,

            I’m glad he’s confident. 🙂 I confess I am too! I think it’s fair to assume that Mnuchin is certainly bright enough to calculate the damages they’d incur under various unfavorable scenarios. And although I have no idea what probabilities they might assign to those outcomes, the damages would be so severe I do imagine they would not want to roll the dice. Yet the biggest thing for me is that even if Sweeney would rule in their favor, I can’t see the government gaining more upside than they already enjoy. They have already squandered the dividends and can probably exercise the warrants unjustly. So, I must believe Mnuchin recognizes that he would gain nothing by waiting for Sweeney yet would risk losing much.

            One caveat. If they have any intention to destroy the GSEs and to turn all over to the banks, then I suppose that would be a motive to wait upon Sweeney. But that seems highly risky to me, and would also be an about face given Mnuchin’s expressed desire to get the GSEs out of government control. But, who knows (a) how strong the bank lobby is; (b) how corrupt this administration is; or (c) whether they got to Sweeney. Those three unknowns are significant.

            Many thanks for your service!

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          2. My question goes more to Ron’s comment.

            Does anyone see DJT’s appointment of Sweeney to head the Court of Claims as a spur to her (early) independence and a possible decision for plaintiffs or an attempt to buy her loyalty and support for the government’s position??

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  7. FYI–
    Report out today from CBO:
    Transitioning to Alternative Structures for Housing Finance: An Update August 23, 2018 Report
    https://www.cbo.gov/publication/54218
    CBO analyzes four alternative structures for the secondary mortgage market, in which the government would play varying roles in guaranteeing mortgage-backed securities, and provides estimates of federal costs under each approach.

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      1. The CBO study of “Alternative Structures for Housing Finance” is a good reminder (if any were needed) of how dysfunctional our legislative process has become. Anyone with knowledge about what led up to, and caused, the 2008 mortgage and financial crises would know that mortgages financed by Fannie and Freddie had, by far, the lowest default rates of any major source of mortgage credit. And the CBO’s prescription for the mortgage finance system of the future? ANYTHING but Fannie and Freddie!

        In the first paragraph of the CBO study you’ll read this: “The Congressional Budget Office projects that under current policy, the GSEs will guarantee almost $12 trillion in new MBSs over the next 10 years and that those guarantees will cost the government about $19 billion.” (Only later do we learn that the $19 billion is a theoretical non-cash figure that represents “the estimated amount that the government would have to pay private guarantors to bear the credit risks of the new guarantees.”) That’s what CBO wants its readers to think will be the result of the government’s current policy on Fannie and Freddie. Had CBO had a sudden attack of honesty it would have had a very different take on the situation—more to the effect of, “Under its current policy of sweeping all of the GSEs’ profits to Treasury, the government will earn almost $200 billion over the next 10 years.”

        I read as much of the study as I could take before giving up on it. CBO’s retelling of the 2008 crisis focuses on the “weaknesses of the pre-crisis model for the GSEs” that include the “implicit federal guarantee [that] gave Fannie Mae and Freddie Mac lower funding costs than potential competitors in the secondary market.” (Fannie and Freddie’s low funding costs, which benefitted their portfolio business, generated revenues that offset losses from their credit guarantees—before Treasury forced them to drastically shrink that business.) The only mention CBO makes of the inflation and bursting of the private-label securities bubble is the bland observation that “private label securitization virtually ceased,” with no acknowledgement of how or why. Check, please.

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      1. I did not have very high hopes for the Saxton appeal, so I’m not surprised by it. The judges had an easy path–“Four of our sister circuits–the Fifth, Sixth, Seventh and D.C. Circuits–have already rejected materially identical arguments from other shareholders”–and they took it.

        I continue to be puzzled, though, as to how the judges in these rulings can be so insistent that the use of the word “may” gives FHFA unlimited powers, and that Congress intended it that way. You CAN’T, in statute, say that a conservator “shall” conserve the companies’ assets, because that might not be possible, and in the event it is not, that’s where receivership comes in. And when receivership does come in, it brings with it a clear set of rules and procedures for how creditors and shareholders are to be treated. I don’t think the judges are that dense; I think they just don’t want to be the ones to rule against the government in a $100 billion case, so they all parrot the same transparently flawed logic.

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        1. Tim,

          What do you suppose are some reasons a judge wouldn’t want to rule against the government? Career limiting considerations? Physical safety for self and / or family? Why the cowardliness, in other words?

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          1. I wish I knew. I’ve tried to view these rulings objectively, but I keep coming back to the fact that you have to do legal gymnastics to continue to justify the original Perry ruling. To take another example from the Saxton appeal (I noted the problem with the “may” versus “shall” distinction earlier), the judges make a big point of saying that the language in HERA authorizes FHFA “as conservator or receiver…[to] take any action authorized by this section, which the FHFA determines is in the best interests of the regulated entity OR THE FHFA…(emphasis added).” They then go on to say “That is no typo,” meaning, I presume, Congress really intended to say this. I’m sure they did. But the “this section” mentioned in the sentence they quote is called “incidental powers.” I truly can’t understand how a judge could ignore this clearly restrictive delineation of the limits of FHFA’s ability to take actions in its own interest (rather than the companies) and pretend that this permissiveness extends to the statute as a whole (which, if it really did, would render the precise language contained in the rest of the statute meaningless, because FHFA’s unlimited discretion would override it).

            Then there is the fact that Treasury itself didn’t believe HERA gave FHFA the sweeping powers its counsel now claims it does; that’s why it made up the story about the “death spiral” when it announced the sweep to the public. Discovery in the Sweeney cases shows that Treasury intended the sweep to keep Fannie and Freddie from being able to retain the earnings that were about to come boomeranging back to them after the FHFA-imposed book losses either ran out or reversed. If Treasury and FHFA really thought that HERA authorized taking those earnings for themselves, they would have just done it, and not made up a false story about it. This fact, too, goes ignored by the judges who continue to claim that the sweep is legal.

            Liked by 5 people

          2. “incidental powers” allows FHFA to steal two huge companies’ net worth. Hide an elephant in a mouse hole.

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          3. Tim

            a quick anecdote if I may.

            when I was in law school I attended a federal district court trial conducted by f. lee bailey. my own version of field work. at one point Bailey tells federal judge aronovitz to take a position that is not established in precedent, and the judge responds that he has no precedent to support his taking that position. Bailey implores the judge (he actually jumped up and down in his platform shoes) by saying that this is how new law is made, by federal district judges at the cutting edge of the law making new law in appropriate cases. the judge looked at Bailey as if he was from mars.

            with these NWS cases, it seems the “pay grade” for taking such positions has moved up from district courts to scotus, and not just to the appeals courts. my kingdom for a judge below scotus willing to take a stand.

            rolg

            Liked by 3 people

          4. @ROLG. About 25 years ago, I read a commentary on Washington Times by a retired judge. What makes a good judge? Understand justice, not just “laws”. If not understanding justice, he doesn’t understand laws either. A moviegoer with perfect vision and hearing, may fail to get the movie’s main idea.

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        2. Tim

          I agree with your comment in all respects but one. it isn’t a $100B case. given the treasury warrants and their appreciation in value in the event of a P win, it is a +-$30B case.

          the “may” point, that liquidations shall occur successfully, but conservatorships may or may not occur successfully, is such an obvious point that to belabor it any more will just accentuate my nausea.

          we’re on to hindes/jacobs

          rolg

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        3. Is it that or perhaps no judge wants to give credence to the practice of ‘litigation finance’? Specially, when litigating the government.

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    2. Stras’ argument is essentially Chevron deference. I wish the APA case to be reviewed by SCOTUS. Gorsuch and Kavanaugh would show lower courts how to treat it.

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      1. I think it may be more Skidmore deference here since this was not a rulemaking, but Stras does seem to be displaying some sort of deference that he sees as being required by HERA. Under Skidmore, his plain language description … “Congress, intentionally or otherwise, may have created a monster by handing an agency breathtakingly broad powers and insulating the exercise of those powers from judicial review.” should be a great big red flag. These justices all keep stating that an agency doesn’t have power until congress bestows it upon the agency. If congress bestowed powers ‘unintentionally’ to the extent that it ‘created a monster’, Skidmore deference should not be given to an agency’s monstrous actions because such actions exceed the powers intended to be granted by congress. This is not the first judge to have this sort of “raised eyebrows” “did congress really mean that?” reading of HERA. Lamberth in his initial rulings had a similar take. The justices all know that the FHFA actions were horribly wrong, that FHFA should not be that powerful, yet they feel tied down by an abstract interpretation of HERA, the words ‘May’ and ‘itself’, and rulings from other courts. SCOTUS is going to have to sort this out.

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      2. If it ever got to the SCOTUS, don’t bet on it, unless this WH indicates that’s where it wants the decision to go.

        Yes, it is that ugly and odious.

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    3. In the AIG case, Judge Wheeler admonished the Government for making 16 Billion dollars on their investment. It is surprising that not one Judge, has decried the vast amount of money that the government is taking in this grab.

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    1. the third circuit merits panel (still unidentified as far as I can tell) wants counsel to address:

      “Whether the amount of or other consequences to an award of compensatory damages (and restitution, if not considered equitable relief) could be deemed to “restrain or affect the exercise of powers or functions of the Agency as a conservator” and thus be barred by 12 U.S.C. § 4617(f) in a given case, and, if so, whether the allegations of the complaint establish that Appellants’ claims for compensatory damages and restitution would have that effect here.”

      4617(f) language has been understood to be a bar solely against injunctive relief. this question asks whether a damage award can have the same restrain/affect effect as an injunction. this question is somewhat out of left field (so much so that not even fhfa counsel had the temerity to allege it), which might be cause enough for the court to alert counsel in advance for them to be able to address it.

      this is definitely an unfavorable question for Ps to have to address. but my god, if fhfa can’t be enjoined AND it can’t be subjected (or more precisely have treasury be subjected) to a significant damage award, then are we to understand that congress intended fhfa to be completely insulated from judicial review?

      are we really to understand that the 3rd circuit appeals judges think that if fhfa makes a small error that gives rise to a small damage claim, well that’s subject to review under the statute, but if fhfa makes a large error that gives rise to a large damage claim, that is not subject to review under the statute?

      rolg

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      1. secondly, 4617(f) is a bar to an action that restrains or affects the exercise of fhfa’S AUTHORITY AS A CONSERVATOR.

        the hindes/jacobs claim is that fhfa did not exercise authority under the statute AS A CONSERVATOR because fhfa did not have the authority to cause the GSEs to issue preferred stock having the terms set forth in the NWS.

        so really, the simple response for hindes/jacobs is simply to say, our entire claim is that fhfa action in agreeing to the NWS was acting ultra vires, beyond its authority AS A CONSERVATOR. 4617(f) cannot bar any claim made with respect to such ultra vires action.

        simply, 4617(f) is not a bar to any relief whatsoever if the relief is sought with respect to a fhfa action made without statutory authority AS A CONSERVATOR.

        rolg

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        1. My humble opinion. 3rd circuit panel is sure that the NWS violates state law. So no more discussion in the 30 precious minutes. The remaining question is: should plaintiff be compensated?

          If the panel isn’t sure about NWS, they would ask parties to talk about it.

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        2. IMHO Are not damages one of the consequences of the unconstrained arbitrary power of a conservator? No one has the authority to stop the resulting disliked consequences of their actions. If I jump off a tall building without taking steps to ensure my safety, the expected consequence is death or severe injury. Once I jump, I have no authority to control the harmful outcome.

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        1. @q

          yes, the panel is identified in a docketed letter today, thank you, and argument will be held on 9/7 at 9am.

          interestingly, 3rd circuit has asked counsel for a brief summary of issues counsel to be covered in oral argument within 5 days, which summaries will be posted online. also, the argument audio, and without counsel objection video, will also be posted online soon after argument. this is a very organized circuit

          rolg

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    2. if you look at hindes/jacobs reply brief (https://www.dropbox.com/s/l9pnjz42gn974mr/hindes%3Ajacobs%203rd%20c%20reply%20brief.pdf?dl=0)
      you will see a strong focus at the outset arguing that judge sleet below was in error for finding no jurisdiction over a claim for damages.

      the first paragraph: “Despite submitting two separate briefs, Defendants-Appellees are unable to offer persuasive support for the district court’s decision. There is none: Section 4617(f) does not bar damages claims, monetary restitution, or disgorgement, and it thus was an insufficient basis to dismiss the entire case. Defendants-Appellees did not even argue below that Section 4617(f) provides a basis to dismiss the entire case.”

      now the reply brief goes on to point out that an ultra vires action by fhfa as conservator does not benefit from the 4617(f) bar to relief. but if you were a 3rd circuit judge and you had only read the introductory paragraph of the reply brief, you might ask the question asked in the letter.

      rolg

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  10. Tim

    given statute of limitations having run on NWS, “les jeux sont fait”. so I thought I would summarize briefly where I think we stand on litigation front.

    1.separation of powers.
    – collins 5th circuit decision finding fhfa unconstitutionally structured was very important, notwithstanding its disappointing relief (didn’t vacate NWS).
    -relief that collins sought will also be sought by all-American as well, and 5th circuit “should” grant en banc hearing.
    -query whether 5th circuit rehears APA claim en banc as well

    2. illegal exaction (added to 5th A claim)
    -collins finding that fhfa unconstitutionally structured has given rise to a new claim in court of federal claims of illegal exaction. in addition to the 5th A claim (which argues that NWS may be legal but must also give rise to shareholder compensation), the illegal exaction claim piggybacks on the collins holding by arguing NWS not legal (cause fhfa was unconstitutionally structured) and therefore govt cannot retail benefits of illegal action. this is essentially another bite of the apple in front of Judge Sweeney.

    3.APA claim (NWS antithetical to conservator mission under HERA)
    -need to hear from Saxton 8th circuit.
    -hindes/jacobs to argue before 3rd circuit in 3 weeks

    4.additional constitutional claims
    -appointments clause violation and non delegation
    bhatti appealing to 8th circuit
    new wazee filing in ED Pa.

    rolg

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    1. Hume filed a claim by Wazee Street in the Court of Federal Claims on August 1, alleging regulatory takings, illegal exaction, breach of contract and breach of fiduciary duty. This claim, filed on Thursday in the Eastern District of Pennsylvania, alleges constitutional violations–specifically that (a) FHFA is unconstitutionally structured as an independent agency with a single director; (b) FHFA had an acting director, in violation of the appointments clause, at the time it agreed to the Third Amendment, and (c) as conservator, it “was acting pursuant to an unconstitutional delegation that lacks an intelligible principle to guide how the conservator is to exercise the powers given to it by Congress.”

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      1. Tim

        havent read this yet, but just based upon your description, this sounds like bhatti 2.0. wonder why in the ED Pa…this should be the last action filed given statute of limitations

        rolg

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  12. Perry filed a new lawsuit in Claims court which challenges 79.9% warrant: awarding Plaintiff damages for the government’s illegal exaction of its stock.

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        1. this new Perry complaint attacks the NWS, not the treasury warrants. by my estimation, this complaint fits within the statute of limitations by 2 days with respect to the NWS. the S/L has long passed re the warrants for a new action.

          complaint contains an analysis of the “10% moment.”

          104. another way to gauge the financial impact of the Net Worth Sweep is to compare it to what would have happened had the Companies instead been allowed to use their quarterly profits above Treasury’s 10% dividend to partially retire Treasury’s senior preferred stock. In that alternative scenario, Treasury’s remaining investment in Freddie would have been fully redeemed in 2017. Indeed, Freddie has paid Treasury $6.3 billion more than the amount needed to redeem the Government Stock completely. Similarly, had Fannie been allowed to use its profits in excess of Treasury’s original 10% dividend to partially redeem the Government Stock, the remaining liquidation preference on that stock would today stand at only $2.1 billion.

          Gibson dunn as counsel.

          rolg

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          1. Today was a travel day out to the west coast (first for a week in southern California, then another week in northern California). I was driving down the coast for much of the day, and only now am seeing the Perry lawsuit. I will read it as soon as I can fit it in, and if I have any significant reactions or thoughts, I’ll append them to this comment.

            Quick Saturday morning comment. I read this filing last night, and while it is well done and persuasive I didn’t find anything new in it. Re the comment above by ROLG that it addresses the “10 percent moment,” my understanding is that this a concept created by Alex Pollock–who appears by name in this filing, along with Peter Wallison and Ed Pinto, as one of three people called “fellow travelers” by Jim Parrott–in which he attempts to calculate the time at which the various draws from Treasury and dividend payments to it result in a 10 percent internal rate of return. That’s a different calculation from simply assuming that sweep payments in excess of a 10 percent dividend on outstanding senior preferred stock are deemed to be retirements of senior preferred at either company. I haven’t done the math, but I believe Pollock’s “10 percent moment” will occur later than a simple full repayment of the senior preferred does, and it is the latter that is more relevant for assessing the companies’ pre-recapitalization status.

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          2. Tim

            I don’t understand the math difference you posit. I would think that to understand how much of a NWS distribution should be recharacterized as a pre-NWS 10% dividend and the excess a partial redemption of preferred principal, one must use 10% of the declining balance of the preferred…hence deriving a return of and on principal (an IRR) of 10%.

            rolg

            Liked by 1 person

          3. The difference between the simple “paying down the outstanding SPS with dividend payments in excess of the (annualized) 10 percent dividend” and an IRR calculation is that the timing of each draw and dividend payment matters in an IRR calculation, where in the simple repayment calculation it doesn’t. As I was looking for an easy way to illustrate that, I came upon this statement in Investopedia: “Because of the nature of the formula, however, IRR cannot be calculated analytically and must instead be calculated either through trial-and-error or using software programmed to calculate IRR.” In contrast, you can calculate the simple SPS repayment on a piece of paper (or a spreadsheet).

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          4. I have run across a spreadsheet that attempts to answer this question.

            https://ethercalc.org/r9ddbdfjw46x

            It takes the numbers from the two FHFA tables that show the amount and timing of the draws and dividends, applies a user-set interest rate in cells O3 and P3 to calculate how much interest would be owed on the seniors in each quarter, and applies any overage to reducing the senior balance (columns G and M).

            Using 10% for O3 and P3 and estimated dividend payments for September 30, 2018 we see a $7.2B overage for Freddie and $1.3B overage for Fannie. That is what Treasury would have to pay back to the companies if the NWS is unwound and dividends past the 10% moment are returned.

            You can get Treasury’s IRR by guess and check: putting 11.465% in cells O3 and P3 leads to a total overage of zero. 13.461% is Treasury’s iRR on Freddie alone (it makes cell G43 zero), and 10.197% is Treasury’s IRR on Fannie (it makes cell M43 zero, or close enough to it). All numbers assume the full NWS dividend is paid on September 30.

            Freddie passed the 10% moment on June 30, 2017 (when column G goes negative) and Fannie will pass it on September 30 of this year (column M will finally go negative). I’m not sure if this matters for the administration’s timing, but I think an argument can be made that cancelling the seniors was not feasible before September 30 anyway.

            Also, there are two interest rates because some other bailout terms called for different interest rates in the first five years and thereafter; the user can test different scenarios under this assumption. To use the same rate for all years, just put the same number in O3 and P3. I have noticed that the interest rate in cell P3 has very little effect compared to the one in O3 anyway.

            Liked by 1 person

  13. Tim

    all American check cashing has filed an unopposed motion before 5th circuit for an initial en banc hearing of its appeal that the cfpb is unconstitutionally structured: https://www.consumerfinancemonitor.com/wp-content/uploads/sites/14/2018/08/CFPB_5th-Circuit.pdf

    given collins’ own motion for en banc rehearing, I think this makes it more likely that the 5th circuit will hear either collins or all American (arguably maybe even both on some consolidated basis) en banc. I say possibly consolidated because fhfa=cfpb insofar as single agency director removable only for cause and agency not subject to congressional appropriation.

    rolg

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    1. ROLG , did you notice that Ted Olson is the lawyer of All American et all ? He is the lawyer of Perry as well.
      What is the next important event that you expect to happen in FnF shareholders law suits ? is it in the Delaware case?
      Thanks

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        1. @JB

          1. the all American motion, since unopposed and since collins has moved for en banc reconsideration, means that it is reasonably likely that the 5th cir will hear the separation of powers claim en banc within next say 6 months, likely on a consolidated basis.

          two more things about this. one may wonder whether the collins APA claim will fall by the wayside in any consolidated en banc hearing, as this would be the non-common claim. of course, 5th cir could hear that claim as well en banc, either together with the consolidated separation of powers claims or separately as a severed claim. note that unlike PHH, all American will not be granted relief on a statutory basis (interlocutory appeal…meaning statutory claim hasn’t even been fully decided yet). so both collins and all American would likely be seeking same remedy: vacating the agency action due to unconstitutional structure. one would hope counsel for collins/all American would coordinate arguments and prayers for relief in any consolidated hearing.

          2. first week of September hindes/jacobs argues to 3rd circuit. this is an oral argument to pay close attention to.

          3. as Peter mentions, saxton should come out with a decision in the next few months (weeks?)

          rolg

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  14. Tim,

    Bill Ackman released his fund’s quarterly letter this past week and in it he said,

    “In order to raise the large amount of private capital that will eventually be needed to recapitalize the enterprises, we believe that all final capital rules should avoid complexity and procyclicality, as well as balance the requirement for a fortress balance sheet with the need to deliver market returns to investors, and affordable mortgage rates to consumers.”

    Is he referring to the same things as you, when you say too much capital is not efficient for the mortgage system, when he says ” avoid complexity and procyclicality”? Because holding too much capital makes the enterprises procyclical?

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    1. “Too much capital,” complexity in a capital standard and procyclicality in a capital standard are three different things. Ackman cautions against each in his quarterly letter, and I agree with him.

      “Too much capital” is significantly more than is required to survive a defined worst-case loss scenario. A complex capital standard is one that has many elements, determinants or formulas that can interact in unpredictable ways. And a procyclical standard is one that requires a smaller amount of capital during good times, and a larger amount during bad times. All three can negatively affect the companies upon whom they are inflicted, but procyclicality is in my view the worst.

      I’ll use a very simple example. Let’s say Fannie and Freddie are required to hold 250 basis points of capital against all of their credit guarantees, no matter what. I would say that’s “too much” relative to the risk of the assets they guarantee, but the companies should be able to find a way to manage with that–although it would hurt the volume of business they do (because they would be overcharging for the value they provide) and be more expensive for homebuyers. If their standard also were complex, that might mean that, based on the interaction of its components, Fannie and Freddie wouldn’t know whether their required capital will be 250 basis points, 200 (let’s say) or 300. Since there are negative regulatory consequences for falling short of required capital, they would need to hold 300 basis points of capital to guard against the consequences of the standard’s complexity.

      Procyclicality in the proposed FHFA standard arises from tying a loan’s required capital to its market value. Using market values, Fannie’s and Freddie’s risk-based capital requirement would fall during times when home prices are rising, and then the reverse would happen during a downturn. Again using a simple example, instead of having a steady 300 basis points of capital throughout the cycle, a capital standard tied to market values might reduce a company’s required capital to 200 basis points during a healthy housing market, but then require the company to hold 400 basis points during a bad market, when home prices are falling.

      There is a very big difference between having to maintain a steady percentage of capital during a bad housing market and having to double your capital under the same circumstances. Even with a steady capital percentage, a company is going to have to tap the capital markets to replace the equity it loses because of “stress” credit losses. If in addition it also has to get more equity because its required capital is doubling pro-cyclically, that is likely to be more capital than investors will be willing to give it. In this case the company will fall short of its requirements and trigger regulatory actions, including the possibility of conservatorship or receivership. I see no reason for any company to be given a capital standard that is pro-cyclical, and I will make the arguments against this feature in my comment letter to FHFA.

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      1. hey Tim

        we know there will be an audience for your comments. but what I think this audience will want to see is a quantification, if possible, of the added cost to the homebuyer of excessive capital and misguided, pro-cyclical rules.

        thought experiment: democrats retake house and ms waters is chairwoman of the house FSC. she needs her staff to know what I think few other than you can tell them.

        the surest way to strengthen middle class, imo, is to promote safe-mortgage lending at the least possible cost. few can promote this worthwhile objective better than you.

        godspeed.

        rolg

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        1. Finding the the right “entry point” for this sort of analysis has been a challenge. There hasn’t been much interest from the Democratic side in the House, given Hensarling’s chairmanship of the Financial Services Committee, his control of that committee’s agenda and his staunch opposition to Fannie and Freddie, while variants of pro-bank bills sponsored by Corker and Warner have been sucking up all the oxygen on the Senate side (where the goal has been to keep something bad from happening). And of course anything that happens with administrative reform has to be acceptable to Treasury. The top officials there know and understand my arguments for a pro-consumer mortgage finance system, but their political, competitive and ideological imperatives have them supporting goals and making feeble arguments that go in the other direction–giving more market power to the banks at consumer expense. It’s possible that the mid-term elections will change the congressional dynamic, but I continue to the think the most likely path to getting Fannie and Freddie out of conservatorship is administrative, with the informed involvement of the affordable housing groups, community banks and investors in the companies being necessary to cause Treasury (and FHFA) to support some middle-ground proposal that gives the large banks much of what they want but still allows Fannie and Freddie to function in a way that supports the access to and affordability of mortgages for low- moderate- and middle-income homebuyers. It’s going to be an uphill battle, though.

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  15. Tim

    I believe the 6 year federal statute of limitations for filing claims relating to the NWS runs out 8/17/18, so this is the last window for filing suits, and a new one has been filed with court of federal claims that has an interesting twist: http://gselinks.com/wp-content/uploads/2018/08/18-01150-0001-Complaint-Filed-8-8-18.pdf

    the twist is that the complaint claims that FHFA offered, and the boards accepted, a conservatorship that obligated fhfa as conservator to conserve and preserve assets…so that notwithstanding any “may” in the statute, fhfa obligated itself to conduct the conservatorship as if there was no “may”, in effect.

    see complaint paragraph 107: “FHFA offered, and the boards of the Enterprises accepted, a conservatorship that would aim to “preserve and conserve the [Enterprises’] assets and property” and restore the Enterprises to a “sound and solvent condition.” See 12 U.S.C. § 4617(b)(2)(D). The offer was also of a conservatorship that would end when that goal was achieved. Neither of these conditions was ambiguous, and both would benefit the known and distinct class of stockholders of the Enterprises, on whose behalf the boards of directors of the Enterprises had a fiduciary duty to act. In fact, FHFA obtained the boards’ consent on the ground, in part, that conservatorship would serve the interests of the Enterprises’ stockholders.

    this is essentially a breach of contract claim, in addition to the other more usual claims.

    the other noteworthy aspect of this action is that the law firm involved is a preeminent federal appellate litigation shop.

    rolg

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  16. Tim

    you may have an interest in Moelis’s presentation to fhfa re proposed capital rules: https://www.dropbox.com/s/nmai61sw62bcue2/moelis%3Afhfa.pdf?dl=0

    we would have an interest in your reaction to it. in particular I would be interested in your thoughts regarding the discussion of the amount of capital relief provided by CRTs. see eg p. 21

    my “money line” from the moelis presentation (p.31): “The projected capital build outlined in the Blueprint would allow the Enterprises to achieve and exceed the minimum capital standards prescribed in FHFA’s proposed capital rule in a 3-4 year timeframe”

    rolg

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    1. I just saw this. My initial reaction is that this is very good news for current investors in the companies’ securities, but less good news for mortgage borrowers and, potentially, the purchasers of the new equity the companies will issue if as Moelis advocates they are allowed to build capital and are released from conservatorship.

      I’ve only skimmed the Moelis presentation–and will analyze it in much more depth shortly–but I already get its import: something very close to the capital proposal FHFA put out in June will be the “price” for getting the Financial Establishment (the banks and Wall Street firms, and also Treasury) to accept an administrative solution to mortgage reform in which the companies are allowed to emerge from conservatorship. I already suspected as much when I saw that the risk-based capital numbers FHFA contortedly had backed into in its June proposal were very close to the capital numbers Moelis had advocated in its plan last year. And the statement Moelis makes in their Summary of Conclusions on page 7 leaves little doubt that this is the consensus “way out” for the companies: “The differences between FHFA’s rule and U.S. bank capital requirements, or the requirements proposed in the Moelis Blueprint, are minor, explainable and defensible.”

      So this is the very good news: it looks as if a broad-based consensus has emerged on a path to getting Fannie and Freddie out of conservatorship, which will require settling the lawsuits.

      I made three major criticisms of the FHFA capital proposal in my latest post: it is a mistake to align the Fannie-Freddie capital requirements with bank capital regulations (since the companies deal only in a single product whose losses are much less than the assets banks finance); the cushions FHFA has built into the risk-based standard, coupled with the procyclical nature of that standard, will force Fannie and Freddie to hold large amounts of excess capital, which FHFA isn’t taking into account; and its treatment of CRTs is one-sided (not counting their expense), and thus gives Fannie and Freddie an incentive to substitute an inferior form of capital for a superior one.

      Of these, Moelis only addresses the third. Again, I get not addressing the “bank-like capital” criticism–overcapitalizing the companies is the price that will have to be paid to get them out of conservatorship. The excessive conservatism of the risk-based standard is a different matter. I sent a note to the Moelis team about this the day I did my blog post, so I know they’re aware of the issue. I believe they either don’t agree with my analysis of it, or think if it becomes a problem FHFA can fix it later, by regulation. (If FHFA doesn’t fix this, I believe the “reformed” companies will have to price their new business in a way that will have a significant negative impact on their business volumes, and hence their value as going concerns.) I would lean toward the second explanation: let’s not put any obstacles in the path of getting a deal done. On CRTs, I see Moelis does think FHFA is giving the companies too much credit for them, and proposes giving less capital credit.

      I’m going do more work on the risk-based capital dynamic (the fact that the way FHFA has structured the test will require much more capital just at the time that capital will be hard to come by, which I don’t think FHFA understands or intends), and address this in more detail in my comment letter to FHFA. And I’ll still make the point about the illogic (and damaging effect on mortgage rates) of using bank capital ratios for mortgages that have one-tenth the loss rates of the types of loans banks make, but I understand I’m not going to win that one.

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      1. Tim

        1. it is not surprising that a capital markets banker such as Moelis would regard CRTs as a positive. business generating.
        2. I agree that it is a plus for Moelis and FHFA to have a rough consensus. I had to chuckle when Moelis states that the SPS has to be deemed paid off “or reduced”, and in another place, either eliminated “or converted to common equity”. Moelis playing nice and political at this stage, not that this is a bad thing.

        rolg

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        1. The way FHFA (with at least the acquiescence of Moelis) has the capital standard and CRT relief set up looks deliberate, and in my view is dangerous, because it decouples Fannie and Freddie’s capital management from their management of business risk. The risk-based standard is artificially inflated (among other things by indefensibly ignoring the ability of revenues to absorb credit losses during the stress test), which pushes the companies’ “risk-based” capital requirement to a level where it no longer corresponds with the risk of the loans being financed. The only tool FHFA gives Fannie and Freddie to eliminate this unnecessary capital is doing large numbers of CRTs, which the companies would NOT do if they were free to make the decision themselves and looked at them economically (i.e., by comparing the interest cost of the CRTs to the credit losses they expected to be able to transfer). This is a blatant give-away to Wall Street, which gets a massive flow of CRT securities that will be profitable to investors (and thus costly to the issuers), paid for by homeowners, and that wouldn’t exist without the regulatory relief from excessive capital requirements granted by FHFA.

          Putting my former Fannie Mae CFO and de facto chief risk officer hat back on, the question I ask is, “How will the companies respond to the powerful non-economic incentives produced by the FHFA capital rule, if adopted as proposed?” For example, how do you price your business, by risk type, if your “risk-based” standard does not really correspond to the economic risk of the loans you are guaranteeing? And do you in fact issue securitized CRTs on which you expect to lose money, with the sole purpose of getting an artificially inflated capital requirement down, even though doing so will weaken your ability to absorb actual credit losses?

          One of the comments I’ll make in my letter to FHFA will be for them to seek the candid comments of Fannie and Freddie business people on their proposed capital standard. I truly do believe that the people at FHFA who devised this standard–which almost certainly was reverse-engineered to produce a pre-determined capital number–don’t have a detailed understanding of the dynamics of the credit guaranty business, and how a complex new capital standard can affect it. The business people at Fannie and Freddie should be able to help with that.

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          1. Sorry – I’m not a financial guy so forgive my ignorance. You said their comments are good for shareholders, but not as good for the companies/mortgage borrowers, etc. I think I see why you think the latter. But why the former? If their capital requirements are higher than warranted, won’t that dilute shareholders (or delay dividends if retaining capital) versus a more reasonable capital standard? Or is the “good” part simply the fact that these numbers are already sort of “priced-in” and momentum toward a resolution is the positive?

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          2. Yes; having Moelis and FHFA in so close agreement is in my view an indication there has been serious work behind the scenes to come up with a formulation for returning the companies to private hands that the banks, Treasury and existing investors all can accept. I would think that would be seen as a positive by existing shareholders.

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        1. It’s not just Moelis and FHFA. Moelis represents the “non-litigating shareholders” of Fannie and Freddie, who in turn are allied with the litigating shareholders, and FHFA would not have put out a capital proposal that Treasury opposed. Moelis also noted that the FHFA proposal and Moelis Blueprint were “consistent with other GSE reform proposals put forward by other major market participants (e.g., the Mortgage Bankers Association),” which I interpret to mean the large banks have been consulted and if not on board at least are not actively in opposition.

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          1. Thanks for your reply. One more quick question, are you fairly confident that Treasury is on the same page with FHFA as far as this plan? The reason why I ask is that Mnuchin and Watt seem to be at odds at least in the news….maybe that is just as it relates to things such as affordable housing goals

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          2. I have two reasons for thinking FHFA and Treasury are on the same page on the capital proposal: (1) I can’t recall anything FHFA has done in the past ten years that didn’t have the approval of Treasury (or anything FHFA has done over Treasury’s objection), and (2) the FHFA standard is very “bank-like,” which Treasury wants.

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      3. Would be nice, but I doubt TS joins you this deep in the weeds, at this time. I could be wrong, but I ain’t in doubt. How you haven’t made an appearance on Fox by now is beyond me, but telling in it’s own right. You set the bar. Let’s see if anyone dares jump it. As always, your latitude (read:patience) is appreciated.

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      4. Hi Tim,

        Your comments are all very professional and clear points, however I’m not sure that the lay person understands what Basel standards are meant to address. When you present your comments, would it be beneficial to team with some sort of communications professional to sort of explain things to the lay person with analogies? Sort of like, “Banks loan on everything, including beer and hot wings. Consumers are more likely to default on the beer and hot wings they put on their credit card than on their homes. Fannie and Freddie can only buy mortgages for homes, where there is much less risk than where TBTF banks are loaning. Basel standards are meant to address the higher risk that TBTF banks take on because of all the things they finance, like beer and hot wings.” Or something like that?

        Cheers,
        Justin

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        1. I haven’t begun to write my comment letter to FHFA yet, but the Moelis comment makes it less likely that I’ll go the “layperson route” on my submission. This is turning into an inside game, where a small number of key individuals representing regulators, investors and special interests are going to be the ones who decide how Fannie and Freddie reform turns out.

          As I’ve noted above, the FHFA/Moelis/MBA capital plan has a mix of problematic components. Most of them are intentional–and thus will not be readily influenced by comments, no matter from whom or how well presented–but a few are inadvertent. For the inadvertent ones, I’m going to aim my comments at the people who are in the best position to fix them once they understand what they did wrong (as well as those who are supporting something that doesn’t do what they think it does).

          After reading the Moelis comment thoroughly, I was very surprised with the impression I was left with. It really wasn’t a comment letter; it was an explanatory presentation that reads like a sales document (including four pages discussing the arcane and insignificant topic of the treatment of deferred tax assets and other comprehensive income in the standard). It seems to be aimed at an audience who might think the FHFA standard isn’t bank-like enough, rather than focusing on the areas in which it is TOO bank-like, and in that way is seriously flawed.

          And I think I know what the problem is. Both the FHFA authors of the proposed capital standard and virtually everyone who has commented on it so far have relatively little understanding of how Fannie and Freddie’s business actually works, and almost as little familiarity with the data on that business the companies publish.

          One area in which this unfamiliarity is glaring is the notion in the FHFA proposal that the companies’ capital requirements should be based on mark-to-market LTVs. FHFA does seem to be aware that this might be a problem–they ask in one of their questions if the standard should be modified to reduce its pro-cyclicality–but had anyone on their team looked at the historical data Fannie publishes on mark-to-market and original LTV ratios (which I suspect they aren’t even aware of), and used that data to examine how mark-to-market LTVs would behave during a repeat of the last crisis, they never would have proposed them in the first place. I plan to address this issue, and others, in my comment letter, but to have the intended impact on my target audience I’ll need to be somewhat technical; it’s not going to be “ding-dong school.”

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          1. Tim

            I also sensed the “cheerleading” tone of Moelis. my mindset is that if this furthers an administrative reform to end conservatorship, understanding that no full faith and credit mbs guarantee can be part of an administrative reform, then this is a worthwhile horse to ride, warts and all.

            rolg

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          2. The mark-to-market LTV problem is much more than a “wart;” it’s more like a cancer. And it’s exacerbated by the way FHFA has artificially inflated the risk-based capital number to produce a “bank-like” total capital percentage on Fannie and Freddie’s 2017 book of business, which for Fannie had the largest difference between average original LTV (75 percent) and average mark-to-market LTV (58 percent) in the company’s history. If there is a repeat of the last housing crisis–which the new capital standard is supposed to protect against–mark-to-market LTVs will soar, and Fannie’s risk-based capital requirement will more than double, during a time when that amount of new capital will either be prohibitively expensive or not available at all. No other capital standard is aggressively pro-cyclical in this way, including banks’. I’m sure this feature is inadvertent and unintended, and I believe that when it is pointed out to FHFA it will be fixed without objection.

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          3. Tim,

            I think you’ve hit the nail on the head here. The Moelis presentation shows that reasonable capital standards are not their goal. It’s consensus-building and the idea of not letting the perfect be the enemy of the good (or the mediocre in this case).

            It’s unfortunate that you’re in the position of having to correct what you can, while recognizing that there are some things that won’t change.

            To play devil’s advocate, can you think of a way to back into a number that can be justified as “bank-like” while being better for homebuyers and not as pro-cyclical?

            Liked by 1 person

          4. The short answer is “yes,” and that’s what I’ll attempt to do in my comment letter (emphasizing the mark-to-market LTV problem and suggesting ways to correct it, but also not giving up on my arguments for making the capital standard more truly risk-based, and less bank-like).

            Liked by 3 people

  17. ROLG –
    To the best of your knowledge, seemingly to me Fairholme’s inclusion of an “exaction” would put the onus on the government to provide specific’s (nexus) for the NWS imposition. As opposed to the takings claim the Onus is on p’s to prove.

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    1. @Elliot

      I am not an expert on the tucker act and suing the govt in court of federal claims. however, given that collins court found fhfa unconstitutionally structured but denied remedy (improperly in light of Lucia imo), this exaction claim is another avenue to obtain a remedy if the unconstitutionally structured holding is not reversed. simply, if fhfa didn’t have authority to act, then there is federal caselaw to argue that the benefits of that unauthorized govtal action is an exaction if retained by govt. in collins giving Ps relief involves a while other analysis concerning whether the statute can be fixed prospectively or must be struck down, and Ps get relief only in latter case.

      rolg

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    1. Yes. Plaintiffs are seeking a rehearing on two issues: “Whether federal law authorizes the Federal Housing Finance Agency, as conservator of Fannie Mae and Freddie Mac, to transfer virtually all of the Companies’ massive profits (totaling over $220 billion so far) to the United States Treasury” and, “Whether Petitioners are entitled to meaningful relief from an action taken by a federal agency acting in violation of constitutional separation of powers principles.”

      The author of the brief (I suspect David Thompson) used excerpts from Judge Willett’s strong dissent to very good advantage in making the case for a rehearing on the first issue, and on the second issue was able to draw on the recent statement from the Supreme Court (in Lucia v. SEC) that remedies for violations of the Appointments Clause need to “create incentives” to bring challenges in such cases.

      So, excellent brief; let’s hope it has the intended result.

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    2. this from collins motion for en banc hearing:

      HERA spells out FHFA’s conservatorship mission: FHFA may only do what is “necessary to put the [Companies] in a safe and sound condition” and “appropriate to carry on the business of the [Companies] and preserve and conserve [their] assets and property.” 12 U.S.C. §4617(b)(2)(D). “By contrast, §4617(b)(2)(E), (F) enumerates powers reserved to FHFA as receiver—which include liquidating the GSE and organizing a ‘successor enterprise’ to operate the GSE.” Op. 64 (Willet, J., dissenting). Numerous features of the statutory text make clear that FHFA’s conservatorship and receivership roles are distinct, including the statute’s use of “the disjunctive ‘or,’ ” id. at 63; see 12 U.S.C. § 4617(a)(2), its reference to the “powers and authorities specifically granted to conservators and receivers, respectively,” id. at 64 (quoting 12 U.S.C. § 4617(b)(2)(J)), and its enumeration of procedures a receiver must follow when “winding up” its ward, id. at 64-65; see 12 U.S.C.
      § 4617(b)(3)–(9), (c).

      This Court has interpreted materially identical language in FIRREA to “state[ ] explicitly that a conservator only has the power to take actions necessary to restore a financially troubles institution to solvency.” McAllister v. RTC, 201 F.3d 570, 579 (5th Cir. 2000).

      I am not sure why McAllister doesn’t control this case in 5th circuit. I am also not sure why Ps are not banging the table with it.

      rolg

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      1. just to follow up on my prior comment: “I am not sure why McAllister doesn’t control this case in 5th circuit.”

        this is best addressed to the collins majority, which certainly did not distinguish McAllister and really just punted on doing any independent analysis of the APA claim. a very embarrassing performance by the 2 judge majority especially in face of judge willett’s withering and well-reasoned dissent.

        as for any en banc review, the entire 5th circuit could hold that McAllister is not persuasive snd uphold the majority, since an en banc hearing can “reverse” a 3 judge merits panel decision that it is rehearing. I just don’t know how the merits panel majority could ignore McAllister. and if the 5th circuit grants en banc review, I don’t see how it could avoid addressing McAllister straight on.

        rolg

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  19. Tim

    interesting new request to amend complaint in Fairholme in court of federal claims: http://gselinks.com/wp-content/uploads/2018/08/13-465-0412-Motion-to-Amend-Complaint-8-3-18.pdf (govt opposes motion to amend)

    essentially, Fairholme seeks to piggyback onto the collins 5th circuit holding that fhfa was unconstitutionally structured. if so, then NWS may be considered to be an illegal exaction by govt, which is in addition to the takings claim already being asserted. this is a whole new claim.

    net net, this is some smart lawyering by Cooper & Kirk and provides another basis for recovery (in addition to appealing the collins denial of remedy on what I think is an improper severability ground)

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    1. I saw Fairholme’s request to Sweeney to amend their complaint. I also reviewed the government’s omnibus motion to dismiss this and the related Court of Claims cases (including Washington Federal), filed on August 1. As I’m sure you know, the government gives ten reasons for dismissal in this motion–six that argue Sweeney’s Court of Federal Claims does not have jurisdiction in the cases, and another four that argue plaintiffs fail to state claims upon which relief can be granted. As a layperson, I read all of these arguments without a solid basis for evaluating them, but while doing so couldn’t help thinking that the government only has to hit on one of them for the case to end. I’ll be very interested to read plaintiffs’ response to this motion, which is due to be filed on October 23.

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      2. Tim

        “I’ll be very interested to read plaintiffs’ response to this motion, which is due to be filed on October 23.”

        yes, it seems to me that this motion should contain all of the factual discovery that Fairholme has obtained the last few years in order to rebut the government’s arguments in its motion to dismiss…and I hope it doesn’t have to be redacted in part due to judge Sweeney’s prior seal. this 10/23 reply should be the culmination of the entire Fairholme discovery process undertaken to date.

        it should be a whopper.

        rolg

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        1. Rolg,

          Even if Fairholme’s motion response is a “whopper,” if the Government convinces Sweeney the Court of Claims has no jurisdiction or remedy, does it make a difference?

          BG

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          1. The goals of a “whopper” response by plaintiffs’ counsel to defendants’ motion to dismiss would be to ensure that the court accepts jurisdiction in the cases, and allows them to go to trial.

            Liked by 1 person

        2. yes. the jurisdictional issues are mostly factual. I suppose judge Sweeney could determine that fhfa as conservator is not a govtal actor etc, but my view is that the old phrase, be careful for what you wish for, will be applicable to govt. govt contested jurisdiction on factual grounds and now 3 years of factual discovery will come out in the Ps response. sometimes when you contest on factual grounds you don’t have a good sense of the totality of the facts at play, you are merely parrying and ducking. it is my hope that judge Sweeney will read the facts and say that there is enough here to have a trial.

          rolg

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    1. I saw that. This delay was expected, as it was requested by a group of 14 trade associations and organizations—including the American Bankers Association and the Mortgage Bankers Association, but also the Center for Responsible Lending and the Consumer Mortgage Coalition—in a letter sent to FHFA on June 25. The signees to this letter cited the length (368 pages) and complexity of the proposed regulation, and said, “…our respective organizations hope to review and provide the FHFA with a wide range of detailed responses that provide useful information from mortgage/financial institutions, third-party stakeholders and vendors, and consumers. As such, the assessment of the Proposed Rule and development of complete responses will require expansive consultation within individual organizations, and possibly questions directed to FHFA. A 60-day deadline will discourage comprehensive responses and increase the risk that the FHFA will make policy decisions without having received detailed and thoughtful feedback from all interested parties.”

      With an original deadline for comments of September 17 I was thinking I would try to get my comment in before I left for a two-week trip to California on August 17. Now that the deadline has been pushed out to November 16, however, I’ll more likely submit something to FHFA in September.

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      1. Diversification in the face of uncertainty. I also cut my mid six figure share count as well. Why wouldn’t anyone do the same in light of such verbal variance?

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    2. My two cents……..a TS of the United States making numerous release statements on GSE’s only to repeatedly defer without explanation, is no small thing by any measure. Existentialists would be happy to know a lonely GSE tree can repeatedly fall in a forest and apparently doesn’t make a peep. Look to any reason any of us refrain from any act we’re in complete control of. There is always a singular, prevalent reason. Just as there is a singular, prevalent catalyst for a RnR. Imo, the reason TS deferred is identical reason GSE’s still in captivity. We don’t know what reason is but rest assured changing this POTUS mind on any issue, like a snail on a fence post, doesn’t happen by itself. Mid terms, GSE revenue, Congress, Bi Partisanship, FHFA etc, meaningless to this POTUS. Those are undeniable facts. Anyone’s guess if they ever escape Chateau D’If. Have a safe trip to Cali, Tim.

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    1. It’s very unlikely to happen, if for no other reason that as part of a (costless) settlement in 2008 of a frivolous lawsuit filed against me in 2006 by FHFA’s predecessor agency, OFHEO, I agreed not to be employed by Fannie Mae at any time in the future.

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        1. If I may, Imho, there is no “going back” for Tim. In this light, one could assert the integrity required to spend countless pro bono hours Tim has devoted to educating the public about the health and welfare of GSE’s, and by consequence US Housing, easily translates into never having left his integral role at Fannie, proving the sound financial integrity of the companies themselves was and is far from a coincidence. This exercise is as reputational for Tim as it is financial for us. Both of us would like a bump in that category, if for no other reasons than that is what’s right. But as we all know, if what’s right always happened then Tim would still be there just as we wouldn’t be here. In the immortal words of Dan Coats.”it is what it is” We’re all right where we’re supposed to be.

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        2. Assuming that FHFA both had the power and was willing to drop the condition imposed by OFHEO that I not be employed at Fannie, and that it asked me to consider being Fannie’s CEO at some point in the future, I certainly would be willing to discuss it with them. Going in, however, my goal would be to convince them that it would be better for all parties for me to assist them in an advisory capacity rather than take the CEO job. But as I noted above, I think this is very unlikely to happen

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        1. Bill—I did. I’ve found Steve to be an astute observer of our financial scene, and I always read his columns when I see one of them.

          Today’s column (“The Junk Debt That Tanked the Economy? It’s Back in a Big Way”) addressed what he believes is an emerging bubble in “leveraged loans,” which are loans made by banks to companies with lots of debt, and which then are sold to investors through “collateralized loan obligations,” the generic equivalent of the collateralized debt obligations (CDOs) that fueled the mortgage bubble and in my view (and that of many others) caused the financial crisis.

          I thought Pearlstein had two convincing observations. His first was that even though the credit quality of leveraged loan packages has deteriorated significantly in the last couple of years, money continues to pour into them because hedge funds and private equity firms—who earn 20 percent of investors’ profits when things go well and give back nothing when they don’t—are putting unsophisticated retail investors into them. That will not end well.

          I knew this first fact, but the second key point in Pearlstein’s article was new to me. That was the decision by three judges in the D.C. Court of Appeals (which included Supreme Court nominee Brett Kavanaugh) that collateralized loan obligations could be exempted from the requirement in Dodd-Frank that they retain a 5 percent interest in the securities they issue. According to Pearlstein, the argument that won the day for the CLOs was that because CLO managers can earn bonuses if their investments perform well, they don’t need to retain an interest in them to guard against their losing money. I found that to be astounding: the judges essentially said that being able to make a large amount of money in good scenarios while still making some money in disastrous ones is sufficient discipline against taking excessive risk that real “skin in the game” isn’t necessary. That doesn’t pass the laugh test. Pearlstein pointed out that all three judges in this case—none of whom have any background in the subject matter—have a long association with the Federalist Society. Wait; where have we seen that before? Oh, yes, the decision in the Perry Capital appeal. Rather than rule objectively on the facts of the case, better to check in with your ideological buddies and ask, “What’s the right answer to this one?” and go that way. Oddly enough, it’s not much comfort to learn that Perry isn’t the only recent decision that uses fun-house mirrors to produce a result that gives the Financial Establishment what it asked for.

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          1. I was surprised that you imply the Federalist Society has a pernicious influence on the judges in these cases.

            Would be interested to know why you feel that way.

            As a note, Judge Willett, whose Collins dissent is simply fantastic and very pro-shareholder, is also a Federalist Society member and on the advisory board of the Austin chapter.

            I can’t tell if Judge Brown, the pro-shareholder dissenter in the Perry case and author of “[investors] are betting the rule of law will prevail. In this country, everyone is entitled to win that bet”, was herself a member, but she has given speeches for the Federalist Society in the past. Federalist Society is pretty much a must-have on the resume for anyone right of center with aspirations to the district courts or SCOTUS. GOP doesn’t trust judges who weren’t Federalist Society members thanks to being burned badly by judges like Blackmun (that’s right, a REPUBLICAN appointee wrote the Roe v Wade opinion), Souter, and Kennedy.

            The most remarkable thing to me about “#Fanniegate” is how nonpartisan, (or multipartisan?), it is, bringing on the same team the likes of Ralph Nader and Pat Toomey, or Liz Warren and Bill Ackman, or the RNC and affordable housing groups. It doesn’t fit particularly well within typical partisan allegiances (I myself am usually a fan of “enemies” like Corker and Hensarling).

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          2. The intent of my comment was not as you interpreted it. It was Pearlstein who mentioned the Federalist Society connection as a possible explanation for the puzzling decision by the three DC Circuit judges to exempt CLOs from the risk-retention rules of Dodd-Frank. I don’t have a view on that myself. What I found interesting was the parallel between two cases in the DC Circuit on critical issues involving the financial system that were decided (in my view) contrary to the obvious merits of the arguments in the cases, but consistent with the ideological beliefs of one or more of the judges (in Perry Capital, Ginsburg as influenced by Peter Wallison, and in the CLO case–according to Pearlstein–the Federalist Society ties).

            Liked by 2 people

          3. Brian Adams–Curious, on what basis do you put Senator Elizabeth Warren on your pro-GSE team?

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          4. I may be mistaken, but here is a video of Elizabeth Warren speaking on Fannie Mae:

            The shareholders’ resolution and FnF resolution are not the same topics, and I know Mr. Howard focuses on the latter here. And indeed, it sounds like Senator Warren divorces the two and would happily throw out the shareholders if she could:

            https://nypost.com/2015/09/14/elizabeth-warren-changes-mind-sides-with-fannie-and-freddie/

            But I think I could characterize her general philosophy as aligned with FnF interests.

            Liked by 1 person

  22. Hi Tim –
    Many thanks for your thoughtful analysis and insights over the literally years.
    I can’t find your reply to a comment which basically asked about the accounting treatment of the NWS. Commenter asked if the accumulated deficit would be reversed, and your simple reply was ‘yes’.

    I am wondering if you could elaborate and review. I am an accountant, but not in your league.

    Would not this balance-sheet item be the result of all accumulated profits and losses, since inception, net of distributed dividends?

    The initial entry(s) would impact the revenue / expense in any given period; the huge losses vs. the historical earnings (pre-2008) caused the accumulated deficit to balloon, from what would have been measly by comparison net accumulated profits. Still, the initial entries over the years were credit losses (inflated) and interest expense (on the inflated losses).

    In 2018 (or other year), I believe the accounting entry would need to reflect the reversal of the NWS in one of a few ways:
    a) Interest expense reversal – i.e. impact would be income
    b) gain on extinguishment of debt (if the $180 sr. pfd. was zeroed out)
    c) some other extraordinary event

    This is not trivial. It would effectively grant $180B in released capital, and would set the GSEs up with the needed (or most of it) capital reserves.

    What would the accounting entries be?

    Thanks in advance, and thanks again!
    Chris

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    1. I’m not certain which comment you’re referring to, but there are two basic ways the government could respond to a ruling that the net worth sweep was illegal: (a) it could write Fannie and Freddie checks for the cumulative amount of dividends each company paid that exceeded their quarterly required PSPA dividends, calculated as 10 percent (at an annual rate) of their senior preferred stock outstanding as of the end of that quarter, or (b) it could retroactively view these excess dividend payments as retirements of their outstanding senior preferred stock, and not have any obligation to give them cash payments until all of their senior preferred was paid off.

      Most people believe the government would be more likely to do the latter (as do I). If it did, Freddie’s senior preferred stock would be paid down completely and the government would owe it a small amount of money; Fannie’s senior preferred would be very close to paid down (I’ve kept a running total of this but haven’t updated it recently, and currently am away from where this paper calculation is kept). A retroactive pay down of the senior preferred would cause the companies’ current equity deficit (equal to Treasury’s liquidation preference) to disappear. They wouldn’t actually receive any significant amount of capital from this—as your comment suggests they might—but they would be able to begin to recapitalize through retained earnings and new issues of common and junior preferred stock.

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      1. Many thanks, Tim for response. I can’t seem to get away from the actual, nuts-and-bolts entries that would be made to record the end of NWS.

        If, as you say, they ‘write a check’ or write-down the debt to zero, there would have to be a revenue / expense, asset / liability entry.

        My contention would be that that a reversal of interest expense to-date or a gain on the extinguish of debt would be the income side and the balance sheet side would be add assets (write check) or lower liability (cancel debt).

        As the balance sheet adjusts by $180B, I then wonder how the excess-capital (i.e. buffer) would be affected. Perhaps, you are saying this would not be affected, and would only clear the decks for a recap… still do wonder though if the capital doesn’t adjust (way up).

        The reason I say these things, is that if you replicate the entries as the interest charges were made (i.e. losses 2008-2012) and the capital decreased and the loan ballooned to meet the capital shortfall; the reversal would be the same steps: reverse the interest, book the income, and capital increases.

        Maybe I am all wet. Thanks again.

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        1. I’ll try to address this briefly. Fannie’s payments under the net worth sweep aren’t recorded as “interest expense;” they’re “dividends distributed or available for distribution to senior preferred shareholder,” and when they are made they reduce “total shareholders’ equity” on the balance sheet.

          I am not an accountant, and do not know exactly how a reversal of the net worth sweep would be recorded on Fannie’s books. My guess is that it would require a restatement of prior period earnings. In the event that payments under the net worth sweep in excess of a ten percent dividend on the then-outstanding senior preferred were applied to pay down that preferred, this would be done retroactively, on a quarter-by-quarter basis. The accounting on the income statement would be the reversal of the entry “dividends distributed or available for distribution to senior preferred shareholder;” on the balance sheet, the same dollar amount would be used to reduce the entry labeled “senior preferred stock.” And since the senior preferred was issued to offset a cumulative loss shown on the balance sheet as “accumulated deficit,” as the senior preferred is paid down the “accumulated deficit” also would be reduced on a dollar-for-dollar basis, until the senior preferred is completely paid off; at that point any remaining excess net worth sweep payments still owed by Treasury would go onto the balance sheet as retained earnings.

          If Treasury instead were to write Fannie a check for the excess net worth sweep payments I assume this payment would be recorded “below the line” (where it would not be taxable), and it would flow directly into retained earnings, increasing equity by about $120 billion. This may seem like a good thing, but it would not be because Treasury’s senior preferred stock would remain outstanding, giving it both a $121 billion liquidation preference on Fannie’s assets and requiring the company to pay $12.1 billion per year in after-tax dividends—close to what it’s likely to be able to earn over time on a consistent basis. So Fannie would be well capitalized, but its shareholders would (a) own a very small percentage of the company’s assets (due to Treasury’s liquidation preference), (b) have very few retained earnings from which preferred stock and then common stock dividends could be paid (because of Treasury’s $12.1 billion senior preferred dividend), AND Treasury still would hold warrants for 79.9 percent of the company’s common shares.

          Fortunately, the “write them big checks” option is not likely to be the one Treasury picks were the net worth sweep to be reversed, because of the large and immediate effect that would have on the deficit. The retroactive application of the excess sweep proceeds won’t add much immediate equity, but by removing both Treasury’s liquidation preference and the (crushing) annual dividend payment, it would leave Fannie (and Freddie) in a position to raise capital, based on the strong earnings they have today and are likely to continue to have in the future.

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          1. Thanks, again Tim. The excess of the NWS payments is roughly the same as the Sr Pfd. stock. Your example with Fannie is $121 in capital (agreed) but then also still the $121B in debt. There has never been any way to pay down the debt – Rep. Capuano touches on that occasionally – a loan they cannot repay.

            However, the highlight here is that they have found capital. The opposite of a hole, but a capital cushion. *IF* they were to take that newfound $121B in capital and then payoff the $121 in Sr. Pfd., I think the net-effect comes out to be the same. No capital, but then no sr. pfd. debt. The net-net is $121 as RE.

            (I am an accountant, but do not deal in this area)

            My premise is that if the NWS is invalidated / restructured the way a court may force them to do – or even Moelis intends – the government rolls back to 10% payback – considering the sr. pfd. to be zero, there is basically a capital surplus left in the wake.

            (You can just say, “You’re wrong, Chris” – and I will accept that)

            Thanks again, Tim for all your knowledge and willingness to share… Chris

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          2. Unfortunately, were Treasury to respond to a ruling that the net worth sweep was illegal (which is by no means a given) by making a cash payment to the companies of the excess dividends collected from the sweep (the less likely option), Fannie would not be able to use the proceeds to pay down Treasury’s senior preferred unless Treasury gives its approval. And if Treasury had any intention of giving that approval it would not have made the cash payment in the first place–it would have followed “option one” and retroactively credited the excess payments as paydowns of the senior preferred.

            Let’s make this the final comment on this topic.

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          3. Mr Howard

            Recap, NWS, are all important going forward but, aren’t ultimate losses post-2006 the item that first must be addressed first in order to finalize the rest? Could you sure a guess on that number?

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          4. I track Fannie’s December 2007 book, not the 2006 book, and have a pretty good idea of what the 2008-2017 single-family losses on that book have been. Through 2013 Fannie gave losses by origination year; for the last four years they’ve broken it out pre-2009 and 2009 and later, so I have to estimate the 2008 losses and back them out to get estimates for the 2007 book (the loss rates on the 2008 book have now flattened out, so estimating its losses shouldn’t throw off my totals by more than a few hundred million). In any event, I have the “ever-to-date” credit losses on Fannie’s December 31, 2007 credit guaranty book at $91.2 billion, or 3.60 percent of the $2.53 trillion outstanding at the time (that book has now paid down to about $250 billion).

            But that’s not the whole story. Both Fannie and FHFA have said that about half of the credit losses on the December 2007 book came from loan types and risk features–such as interest only ARMs and low- or no-documentation loans–that Fannie no longer is permitted to finance. Making that adjustment, you’re down to a little over $45 billion in losses, or about 1.8 percent of the book. And then, if you’re trying to determine the capital required to survive a stress comparable to 2008-2012, you also have to factor the net guaranty fee income (single-family guaranty fees less administrative expenses) on the book, which to date has been about $18 billion. That gets the “adjusted losses less guaranty fees” on the book down to $27 billion, or 107 basis points. FHFA (and Fannie) would have a more accurate number, because they have loan-level detail on losses by product and risk type that I don’t have. But a stress capital number of 100-125 basis points would seem to be consistent with what would be needed to survive a repeat of the 2008-2012 meltdown.

            This 100-125 basis point range doesn’t include any going concern cushion, but that’s not as aggressive as it seems. While Fannie’s 2007 book was suffering losses and paying down, the company also was putting on new business. It was charging higher guaranty fees on that business, and suffering very few losses on it. I estimate that since the beginning of 2008, Fannie’s new single-family credit guaranty book–now over $2.6 trillion–has earned $35 billion more in guaranty fees than it’s recorded in credit losses and administrative expenses combined. That’s the real going concern cushion–and it would have been capital for the company if Treasury hadn’t been sweeping it all.

            Liked by 1 person

      2. Tim,

        Can you provide some insight here. If the Govt agrees to use excess dividends as principal paydowns on the senior preferreds, they would wipe that out completely. They could then exercise the warrants for 4.64B shares of Fannie. If the stock trades at $20/share after exercise, wouldn’t that result it $90B of capital? Fannie would be well on its way to meeting the new capital buffer (if the FHFA proposal is implemented). Why would they need to issue new stock?

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        1. You’re forgetting that Treasury can exercise the warrants by paying Fannie a negligible amount of money—one one-thousandth of a cent per share. So if in your example the stock trades for $20 per share post warrant-exercise (and I think that price estimate is too high), Treasury’s shares would be worth $92.8 billion (4.64 billion shares times $20 per share), but Fannie would receive….less than $50,000 (4.64 billion times $0.00001). It would essentially be starting its recapitalization from a base of zero.

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          1. Shouldn’t the government prefer a recap via retained earnings over say ten years rather than issue new stock because it would dilute its stake and the ultimate return to taxpayers? Why would they push for such a clearly excessive capital reserve if 1) it is unnecessary even in a worst case scenario and 2) would reduce the amount of cash they could get from the warrants?

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          2. “The government” isn’t in a position to resolve the Fannie and Freddie issue; it either will be Congress through legislation or Treasury through administrative action. Congress has not yet been able to agree on what it wants to do with the companies, while Treasury either hasn’t decided or doesn’t yet want to make their choice known publicly. It’s hard to opine on the best way to do something that hasn’t been identified yet. To take capital as an example, it clearly would be counterproductive to knowingly overcapitalize the companies if the objective is to make them low-cost and efficient providers of mortgages to a wide range of borrowers, while meeting a defined standard of taxpayer protection. But if the objective of reform is to drive more mortgage business to depository institutions at wider spreads over their cost of funds, burdening the credit guarantors that are essential to the functioning of the securitization channel with excessive capital requirements is exactly what you would want to do.

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  23. Highly unlikely. For the four years 2017-2020, $62 billion would be a decent estimate for Fannie’s normalized pre-tax net income, but even after the drop in the marginal tax rate from 35 percent to 21 percent the company’s retained earnings on that amount of pre-tax earnings would be a little under $50 billion. And Fannie (and Freddie, and all other financial institutions) also are likely to have a bite taken out of their earnings in 2020 by the implementation of the new FASB standard for credit losses–the Current Expected Credit Loss standard–which will take effect that year. So, no.

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    2. 1. I think SCOTUS will review it because of circuit conflicts (5th and DC circuits)

      2. I don’t understand why a major decision of an unconstitutional FHFA is not voided. This conflicts with recent SCOTUS decision on Lucia v. SEC.

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      1. I like it. Settlement is more in play. Mnuchin might’ve needed a win. Curious, when today was this “officially” released?

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      2. in collins 5th circuit granted relief on the constitutional claim limited to striking for cause removal prospectively. this even though HERA doesn’t have a separability clause. So NWS not stricken on constitutional claim. But this opinion on the constitutional claim likely to be appealed by fhfa, and the APA claim denial and the denial of invalidation of NWS as relief for the constitutional claim also likely to be appealed by Ps, and I think scotus takes case.

        question is whether scotus reviews denial of APA claim (both dc and 5th circuits had one judge dissenting) or only the separation of powers claim. assuming Kavanaugh is confirmed, he is a solid vote for upholding the unconstitutionally structured argument, but he called for severing the for cause provision prospectively in his cfpb case (PHH). however, the cfpb statute had a severability clause in the statute and HERA does not, and scotus has said recently in Lucia that in a separation of powers case (appointments clause), relief should be granted that encourages Ps to bring challenges.

        so thin gruel, but gruel nonetheless. up to now, we have been grueless, just like Oliver Twist.

        rolg

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          2. Perry plaintiff sent a brief/motion after initial DC circuit decision. Then the circuit revised the decision to correct obvious mistake. Can Collins do similar? Judge Haynes’ action conflicts with SCOTUS decision on Lucia.

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          3. @qui

            Perry class action P did do a follow up brief on a part of the majority holding that was not briefed by parties and which P claimed was in error.

            you raise a very interesting question in the context of collins: Lucia was decided just before the collins opinion was released. could collins P ask court for debriefing on implications of Lucia to the relief awarded by collins court? perhaps collins P will do exactly that in the context of a rehearing petition, whether before the same merits panel out en banc.

            rolg

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    3. An incredibly powerful dissent (like Browns) by Judge Willett (on the Trump SCOTUS short list) who sides with shareholders on the NWS. Presumably both parties will appeal to an en banc or SCOTUS, yet again.

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      1. couple more thoughts on collins if I may.

        there is a small chance that fhfa may not appeal. this is the result the administration (solicitor general) wanted, and presumably cfpb, which is also affected by this decision by analogy, now has a director who is fine with it as well. but fhfa is still an independent agency, and the administration also would probably prefer this holding from scotus than just from 5th circuit, so lets assume both parties appeal and scotus grants cert.

        assuming kavanaugh is confirmed, I think there is a lock of 5 votes affirming the separation of powers/unconstitutionally structured holding. kavanaugh plowed this field initially with his merits panel opinion in PHH, and it is clear to me that Roberts approves of this line of thinking from the Free Enterprise/PCAOB case in which Roberts wrote the majority opinion tracking Kavanaugh’s dissent below. Gorsuch hasn’t written an opinion on point but it is clear he is not enamored with the growing administrative state, so he would be a solid third, which leaves you Alito and Thomas as arch conservatives supplying the last two votes. by implication, if Kavanaugh is not confirmed then you have a 4-4 vote and the 5th circuit holding still stands.

        now comes the question of the relief granted on the separation of powers holding. in PHH, Kavanaugh found that the cfpb had violated the statute, so the merits panel could grant the P its relief on the statutory basis. Kavanaugh was able to take the politically easier route of applying a prospective only remedy for the constitutional claim therefor, since P already had its relief. not so with this collins opinion, in which statutory relief was denied. so collins tees up the constitutional claim relief question in a stark manner.

        I think the collins majority is wrong when it says it can excise the unconstitutional term and HERA still hangs together as a coherent statute. the first sentence of HERA with respect to the fhfa is:
        “SEC. 1311. ESTABLISHMENT OF THE FEDERAL HOUSING FINANCE AGENCY.
        (a) Establishment- There is established the Federal Housing Finance Agency, which shall be an independent agency of the Federal Government.” shall be an INDEPENDENT AGENCY.

        plus there is no severability clause in HERA (as there was in dodd/frank) so the judicial act of rewriting the statute instead of invalidating it has not been preapproved in advance by congress.

        plus scotus just last month in Lucia indicates that courts should provide Ps remedies that encourage constitutional separation of powers claims. prospective relief offers no encouragement to Ps.

        so I think collins gets cert and scotus will need to address the constitutional relief question directly, and I will look forward to this.

        rolg

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        1. ROLG: Thanks; that’s very useful and insightful analysis.

          I’ve just finished reading the decision (and no, I’m not that slow a reader; it took me a while to get to it….) and was struck by the extreme contrast in how the majority addressed the two issues before it: the APA claims and the constitutionality of FHFA as an independent agency.

          I found the discussion on the constitutionality question accessible, informative and lucid. I learned a lot from reading it, and after doing so found the majority’s decision to be persuasive (and Judge Stewart’s dissent less so).

          The majority’s decision on the APA claims was another matter entirely. It said, “The Shareholders’ statutory [APA] claims mirror the claims made against the FHFA that the D.C., Sixth, and Seventh Circuits have all rejected. We reject the Shareholders’ statutory claims on the same well-reasoned basis common to those courts’ opinions.” That might have be a defensible position had it not been for the stinging dissent authored by Judge Willett amended to the majority decision, to which the majority obviously had access.

          Willett begins by stating, “This case concerns whether the net worth sweep falls within the scope of the FHFA’s statutory authority as conservator. To answer the question before us, we need only look at HERA’s plain text.” I won’t attempt to summarize or excerpt from Willet’s argument–readers should read it for themselves (it begins on page 58)–but I find it very hard to understand how the other two judges (Chief Judge Haynes and Judge Stewart) could have read Willet’s dissent and said, “Sorry, we don’t agree with any of that; we read HERA as being free of the judicial history of the FIRREA statute upon which it is based, and that it allows FHFA to blur the distinction between conservator and receiver in whatever manner it chooses, with no judicial review permitted.”

          On the silver lining side, in addition to the likelihood of SCOTUS accepting cert on the constitutional aspects of the decision (assuming FHFA appeals it), the Collins appellate judges finding that, “Divesting the Shareholders’ property rights caused a direct injury [to shareholders]” is a very good one for the regulatory takings claims now being pursued (with “all deliberate speed”) in Judge Sweeney’s court.

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          1. Tim

            I would love for scotus to grant cert on the APA claim as well. not likely in the absence of a split in the circuits, though the willet and brown dissents certainly provide scotus the type of “analytic percolation” that it looks for in multiple circuit court opinions…just no conflict between circuits (so for scotus, which normally doesn’t reach out to decide cases it doesn’t “have” to decide, this would be a situation where at least four justices want to say something about statutory interpretation…and scouts cares more about constitutional than statutory interpretation).

            as for the separation of powers claim, Mark above is right in that there is now a conflict in the circuits; while the dc circuit held with respect to the cfpb and 5th circuit with respect to fhfa, the principle at stake is the same and the difference in agencies is a distinction without a difference for purposes of constitutional analysis. I don’t see how scotus doesn’t grant cert on that claim.

            rolg

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          2. Judges know well how other judges make decisions. And they may gently expose the motivation and mistakes.

            Brown:
            “I cannot conclude the anti-injunction provision protects FHFA’s actions here or, more generally, endorses FHFA’s stunningly broad view of its own power. Plaintiffs — not all innocent and ill-informed investors, to be sure — are betting the rule of law will prevail. In this country, everyone is entitled to win that bet.”

            After reading this, you know why most of those judges do not like plaintiffs — opportunists taking advantage of government’s mistakes.

            Willet:

            There is a textual hook in finding that Congress granted the FHFA discretionary authority. HERA provides that the FHFA “may . . . take such action as may be . . . necessary to put the regulated entity in a sound and solvent condition; and . . . appropriate to carry on the business of the regulated
            entity and preserve and conserve the assets and property of the regulated entity.” Typically, “may” implies discretion. I do not doubt that “may means may” or that “‘may is, of course, ‘permissive rather than obligatory.’” But courts seeking a forthright interpretation should not myopically focus on “may” at the expense of reading HERA as a cohesive, contextual whole. In divining statutory meaning, courts must never divorce text from context.

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  25. Tim: I understand that Mnuchin mentioned in testimony today that he favors competition for the GSEs. I’m curious if you think it’s possible to have a solution, perhaps with the right capital requirements, that fosters competition, but doesn’t increase the price of mortgages for ordinary consumers?

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  27. Tim – As you may have read, the FHFA has asked a number of questions in their proposed rule making.

    Having worked with government entities, this is how they communicate where they have latitude.

    It would be my humble suggestion that you submit your comment as a PDF (attachments are allowed). In this PDF you should write your comments with references to that it answers question 1, question 2, etc.

    Someone, at a lower level is going to have to read this and summarize this for their boss, who will have to present it to their boss, who will then bring it to the Director for a decision (look at who was on the call, who their boss is, and the degrees of separation from the director).

    To make their jobs easier, I would include an appendix (reference that there is one at the beginning) that lists FHFA’s questions, verbatim, and concise answer, and a reference back to the longer answer in the main document.

    Assume they take your comments, in whole, they can use your appendix for a summary to their boss, who then can make a presentation to their boss using the “short answers” in a PowerPoint to their boss, and finally, use the PowerPoint for their the Director, relying on the “short answers”, and attaching the long answers as their appendix. It will look well researched by the FHFA employees by simply reverse engineering your work.

    My main point, you have excellent information. It has to be consumable by the 34 year old reading it and actionable enough for them to use it, over other comments, to sell it up the food chain.

    Let me know if you have any questions.

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    1. Brolin–That’s helpful; thank you.

      I haven’t started working on the comment letter yet. My preliminary thought is that I’ll have three or four major points that I’ll tie to specific questions out of the 40 they’ve asked, and also have comments on a few other minor points (also tied to specific questions)–although as I get to work on the comment letter this may change.

      As for getting my comments in front of the right people, I’m intending to use an informal as well as the formal channel. A couple of senior FHFA officials are on the mailing list for my blog (and read my posts), and I know there are other FHFA employees who follow me as well. Because of this current post the basic substance of my official comments won’t come as a surprise to them, but as I did with my comments on guaranty fees (July 2014) and credit risk transfers (September 2016) I’ll send a copy of my comment letter directly to the two senior FHFA officials (in addition to the formal submission), so they’ll know it’s been sent in as well as what it says.

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      1. Tim

        in my over 30 years negotiating deals, I have found that the strongest position for any advocate to maintain is that of an honest broker. that honest broker can (and should) have a point of view, strongly held, but if the analysis is fair and incisive, and the advocate proceeds in good faith, that advocate rises above mere client-interest advocacy and accomplishes a beneficial result. this is not easy to do, and I wish you continued success in doing just that.

        rolg

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  28. Tim–It doesn’t change the challenge for the “pro-GSE” types, but the ugly truth is that there has been since Day 1 of OFHEO/FHFA regulation a cadre of “GSE haters,” at the Fed, Treasury, and most certainly FHFA.

    To pick one person, Treasury Secretary Steve Mnuchin, what is his incentive to finally get this stuff right and encourage the regulatory decisions which you suggest??

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  30. Tim, Have you ever considered using graphic data? I presume that official comment on the FHFA plan may, but as I read the following:

    “In the 20 years before the 2008 mortgage crisis, credit losses at FDIC-insured banks averaged 82 basis points of total assets per year, twenty times the 4 basis point average credit loss rate at Fannie and Freddie. ”

    People familiar with the narrative can get that, but a 20-year plot illustrating the trickle of credit loss on F&F assets when compared to the muddy river of credit loss at the FDIC-insured banks might be powerful. Just curious, and thanks for the blog!

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    1. I unfortunately am a victim of my past status as a long-time senior financial executive; whenever I needed an eye-catching (or any sort of) graphic, I had access to very capable people who could produce and format it for me. I’m sure I could teach myself how to do those things, but to date that hasn’t been high on my priority list. Perhaps I should move it up, though, because I agree with you that a compelling graphic can drive home a point better than prose, even if that prose is well written.

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  31. Could the GSE’s exit conservatorship with bank like charters so the competition would be a level playing field ?

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    1. That’s not practical. Fannie and Freddie are wholesale, specialized institutions, dealing in a single asset type (residential mortgages) in one country, with about 7000 employees each (Fannie a little more, Freddie less). The large banks that are driving efforts to curtail their activities are multi-product, multinational companies with huge retail operations, and the four largest (JP Morgan Chase, B of A, Wells and Citibank) each have over 200,000 employees worldwide. There is no reason to think that the executives of Fannie and Freddie would be able to acquire the skills, knowledge and experience to successfully turn their companies into full-service banks. Giving them bank charters and telling them, “Good luck,” would be a prescription for their demise.

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      2. Morning Tim,
        Do you know of any web site where one can see the daily price and the yields of bonds issued by FnF ?

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  32. Great commentary Tim.

    A question I know the layman will ask.

    What’s wrong with imposing say a 5% capital requirement for the GSE’s?

    Yes it is unfair to impose bank standards to a non banking entity. But that’s life. After some time the GSE’s will reach that requirement. They will be extremely well positioned for the future.

    Politically the cost to homebuyers in the short term will be bigger. But they won’t understand any of this. They already don’t notice the hidden surcharge that treasury imposed.

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    1. As your comment illustrates, there is some degree of misalignment in the objectives for mortgage reform of investors in Fannie and Freddie common and preferred stock and the affordable housing community, but it is not as much as you might think.

      The crude expression of the investor perspective is, “I don’t really care about the cost or availability of Fannie and Freddie’s credit guarantees, as long as the companies are released from conservatorship, allowed to recapitalize, and I can make money on my investment,” and besides (as you say), “homebuyers…won’t understand any of this.” The affordable housing groups (and most economists and policy analysts) obviously view that differently.

      The intersection of the two groups’ interests, though, is that if you require Fannie and Freddie to overcapitalize too much, the system doesn’t work for anyone– investors or homeowners. As I’ve alluded to in past posts and comments, I believe the agenda of the big banks in mortgage reform is to cripple Fannie and Freddie’s credit guaranty function so that bank-owned originators control both the underwriting and pricing of mortgages, to their advantage.

      To earn a market rate of return on 5 percent capital, Fannie or Freddie would have to charge an average guaranty fee rate of about 70 basis points. A high quality residential mortgage will have an expected loss rate of about 2 basis points. A bank originator will say, “Why should I pay 70 basis points to insure a loan with an expected loss of 2 basis points? I can keep it in portfolio, save the 70 basis points, and at the same time earn 300-400 basis points of spread income without incurring any extra capital cost at all, because my Basel capital requirement doesn’t explicitly charge me for taking interest rate risk.” These good loans won’t come to Fannie or Freddie to be guaranteed. As for the riskier loans, the problem will be the borrower, who will say, “I can barely afford a mortgage now; how can I afford the extra 70 basis points (or more, if the low risk-loans flee and all Fannie and Freddie are left with are the riskier ones) it’s going to cost me to get a credit guaranty?” For this reason, Fannie and Freddie will get fewer high-risk loans, too.

      And this will cycle into the value of the business. Right now Fannie and Freddie have $5.4 trillion in credit guarantees. That volume will certainly shrink if the companies’ product isn’t competitive (because of overcapitalization). At $5.4 trillion, Fannie and Freddie would need $270 billion in capital to meet a 5 percent capital requirement. Is there really a realistic chance new investors would put that amount of money into a shrinking business, controlled by the large banks, and in which Treasury has an 80 percent ownership stake (because of the warrants)?

      Everyone–investors, homebuyers, the affordable housing community, and those concerned about the health of our economy and financial system in general–has an interest in economically sensible reform of the secondary mortgage market. The challenge is going to be getting that to happen.

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      1. Tim

        even if Fannie and Freddie are forced to overprice their guarantee relative to the risk being insured, wouldn’t most mortgage originators, especially nonbanks which seem to have a large share of the origination business, still use Fannie and Freddie (and any competition that arises) as takeout buyers, letting the originators keep their origination fee income and recoup their capital for another deployment? arguably all banks but the large tbtf banks would have to do this as well, no?

        put another way, are you saying that the tbtf banks will squeeze out small banks and nonbanks from mortgage origination because tbtf banks will underprice all originators who need to sell to Fannie and Freddie (and any competition that arises), or that overpricing the G fee simply gives tbtf banks an added profit opportunity for loans that they will keep in portfolio in any event?

        either way, I would encourage you to frame your comment to fhfa’s proposal not simply as a disagreement over financial/capital structuring best practice, but as making explicit that fhfa proposes to adopt a framework that advantages a few tbtf banks and disadvantages millions of homeowners, in direct contravention to its statutory mission.

        thanks for your work of the fhfa capital proposal and I am sure that your comment will be the best analysis that fhfa will see. (wonder why fhfa hasn’t printed its proposal in the fed reg yet?)

        rolg

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        1. I tend to wonder about the big banks “wanting F&F’s business” Do they not also sell to F&F? They sure settled for vast sums when sued so it seems to me they must. So what percentage of their paper is sold to F&F? What is the benefit to them? Is it only the low margin paper, and they keep the more profitable paper? And then, since they do sell to F&F, why would they want to get rid of F&F completely? There must be some benefit to them, so why kill something that also helps them? F&F tend to make everyone play by the same rules. They set up the appraisal requirements, the paperwork (which maybe could be less) but the point is they do a lot to synchronize the system, that seems to me to be a major benefit of F&F since without them there is no “ref calling the game”. Everyone starts making their own rules, and forms and it would quickly be a mess. As for rates. I checked a few advertised today. Wells is at 4.625 for 30 Fixed, BB&T at 4.75, BofA at 4.5, one of our local credtit unions at 4.90, Quicken at 4.56. So Quicken is by a hair the least and I would assume they sell a lot to F&F as they are not a bank. The point to take though in reply tor rule of law guy is what would Quicken’s rate be if they couldn’t sell to F&F? I imagine higher as any private money is going to want more return. So yes F&F do benefit the smaller players. Am I wrong in any of those ideas? If I am not can anyone tell me why other than ideological hatred they want to get rid of F&F?

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          1. The big banks don’t want to “get rid of Fannie and Freddie,” because they do want to be able to use them as credit guarantors. But as I’ve mentioned in both blog posts and in responses to comments, having the companies be overcapitalized–and have to unnecessarily raise their guaranty fees– helps the large banks financially in two primary ways. First, the higher guaranty fees will get built in to lenders’ mortgage quotes (as they already have), and this will widen the spreads on the loans banks choose to keep in portfolio. Banks have greatly increased their holdings of residential mortgages and MBS in the last few years (they now hold 37 percent of outstanding residential mortgages, up from 26 percent ten years ago)–I think in large part because guaranty fees are so much higher. Pushing them up even further should cause banks to retain even more mortgages. Second, having guaranty fee pricing distorted by a too-high capital requirement will allow banks to hold down their single-family credit losses by keeping their higher-quality mortgages on their balance sheet, and swapping their risker loans (on which the mismatch between loan risk and guaranty fee won’t be as great) and selling those as MBS to other investors. Banks win in two ways, and homebuyers foot the bill for both.

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      2. Tim the horror (or beauty) of dramatically increasing capital requirements is that it works on both a media, legal, and political front.

        Politically this rule can be imposed via regulation through FHFA. No need for Congress to be involved. Cynically they will never act they can’t be seen as responsible for any problems.

        Legally FHFA can do this. They and treasury can pay lip service to recap and release. Which could neuter many court cases? Even legally we’ve seen judges stretch interpretations of the law.

        And the media is already primed to blame the GSE’s for any sort of housing issues/crisis. And it’s hard for us to win when the narrative is “Fannie and Freddie caused the last crisis. We’re making them safer. Are you against safety and soundness?”. It worked in getting CRT’s created.

        The biggest help will be from housing advocates. But let’s be honest they aren’t Capital Markets or accounting experts. They won’t win against the narrative of safety and soundness. They don’t have the lobbying prowess of the banks. They’re too busy actually helping homeowners.

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        1. I agree with you on the housing advocates, although I think it’s important for them to comment (I’m in contact with many of them). But my post also is aimed at the key supporters of the Moelis plan, many of whom I also know, and will be reaching out to. My analysis leads me to believe that the FHFA capital proposal has two sets of impacts–one intentional and one unintentional. The intentional one is pushing Fannie and Freddie’s required capital towards “Basel-like” levels, even though that’s not what a true risk-based approach would do or require. I get that, and also get that the politics make a true risk-based requirement for the companies out of reach–at least for now, in the current environment.

          The unintentional consequences–stemming from FHFA not realizing the interplay of an overly conservative but binding risk-based standard, which moves counter-cyclically, and a prompt corrective action regime that punishes failure to comply with that standard–are a different matter. If sufficient political consensus exists or develops for something like the Moelis plan to go forward, its supporters won’t want to have signed on to a capital scheme that makes it difficult or impossible for the companies to operate successfully. Fixing unintended consequences is easier than trying to change intended ones. I’ll also suggest to FHFA (and some Fannie executives) that it get Fannie’s comments as well. Even though it’s been a long time since I was there, I’m sure they have people in their credit risk analytic group who understand the intricacies and subtleties of how the structure and mechanics of a risk-based capital standard affect guaranty fee pricing and credit risk management, and who could say to FHFA, “This really won’t work the way you think it will, and you need to fix it.”

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          1. Thanks for posting this analysis, Tim, greatly appreciate the feedback you’ll provide to FHFA. One question I’m not sure has been addressed is in a capital raise, doesn’t the buck stop with potential investors, who would say this is not a feasible capital standard? If there is a lack of demand from the market, FHFA would be forced back to the drawing board. But most treat the capital raise as definitively possible, regardless of the terms, as long as it’s authorized by FHFA/Treasury.

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          2. Yes; if it turns out that I’m right about the FHFA capital standard, and FHFA doesn’t fix it, then it’s highly unlikely investors will put up the capital required to bring the companies out of conservatorship. In my view, that’s all the more reason to bring these problems to the attention of supporters of the Moelis plan now. If the current capital proposal gets adopted as made (and I don’t think it will), it will become harder for FHFA to change it. What would seem more likely to happen is that whoever has the lead on this in the administration will say, “Well, recapitalizing the companies and releasing them from conservatorship won’t to work; let’s try to restructure the secondary mortgage market around mutually owned credit guarantors, with capital supplied by the banks.” For banks, it would make sense to invest in credit guaranty companies, even with burdensome capital requirements that make a stand-alone guarantor a poor investment. Large banks can raise capital at the holding company level, and would view the equity infusion into the credit guarantors as a sensible proposition from the perspective of their overall mortgage business (origination, cross-selling to other products, servicing and portfolio investment)–the poor economics of credit guarantees alone would be more than offset by the associated increases in profitability that guaranty process control would permit in these other areas.

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          3. Thanks for your reply.

            If there’s any charting/excel work you think I could assist with in putting together your response to FHFA, please feel free to reach out. My job more or less revolves around putting together presentations for investment committees.

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          4. Tim

            in a rational world, fhfa would have “taken the temperature” of the capital markets before putting out a capital proposal, to see what was practical and feasible. but we are in this nevereverland of conservatorship hiatus where fhfa seems to think it can propose capital targets in a vacuum and with no input from the parties who will raise this capital. DC/Wall Street disconnect.

            rolg

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