The Beginning of the End

~ jtimothyhoward

More than ten years after Fannie Mae and Freddie Mac were placed into conservatorship, and more than two years after Treasury Secretary-designate Steven Mnuchin said to Bloomberg News, “It makes no sense that [the companies] are owned by the government and have been controlled by the government for as long as they have,” and that “we gotta get them out of government control….and we’ll get it done reasonably fast,” the White House made its first formal pronouncement on this issue in a March 27 memorandum on  Federal Housing Finance Reform, saying “The housing finance system of the United States is in urgent need of reform,” and for that reason “the Secretary of Treasury is hereby directed to develop a plan for legislative and administrative reforms” of this system.

Participants in and followers of the secondary mortgage market reform dialogue rightly view the White House memorandum as a significant development, but beyond that there is little agreement as to what it means for how, when or even whether the longstanding battle over the fates of Fannie and Freddie might be resolved. Proper interpretation of the memo, I believe, requires an understanding of the context in which it was produced.

The debate over Fannie and Freddie’s role in U.S housing finance has been going on for decades. It has elements that are ideological, political and competitive. It has cut across administrations, and been driven more by institutions than individuals. Since the Reagan administration the most consistent institutional participant in what I call “the mortgage wars” has been Treasury, whose position for the last forty years has been that Fannie and Freddie’s federal charters give them too much market power and allow them to take too much risk, and that for those reasons their operations should at least be constrained and perhaps eliminated entirely. Supporters of the companies argue that the benefits of their charters flow primarily to low- and moderate-income homebuyers, that their interest rate and credit risks have been well controlled, and that the motive of many of their opponents is to shift market power and profits to primary market lenders at homebuyers’ expense.

The 2008 financial crisis presented Treasury with a unique opportunity to gain control of  two companies it had historically opposed by effectively nationalizing them in the guise of a rescue, then using them to help stabilize the housing market after the private-label securities market imploded and banks had curtailed their lending because of the massive amounts of high-risk mortgages on their books. As I documented in my amicus curiae brief for the Jacobs-Hindes lawsuit in Delaware, Fannie and Freddie were taken over not because they were the weakest sources of mortgage financing going into the crisis but because they were the strongest. The conservatorships of Fannie and Freddie were pre-planned by Treasury for policy purposes, done without statutory authority and against the will of the companies’ managements, then handed to FHFA as a fait accompli to be carried out, which they were.

Treasury’s professed rationale for pushing Fannie and Freddie into conservatorship was that their regulatory capital was overstated because of favorable accounting treatments that made them look far stronger than they “truly” were. Consistent with this contention, FHFA as conservator and at the direction of Treasury booked a series of non-cash accounting expenses at both companies that totaled a mammoth $326 billion through the end of 2011. This wiped out their capital and forced them to draw $187 billion in non-repayable senior preferred stock from Treasury, on which they were required to pay an annual dividend of 10 percent after tax. But because the great majority of the accounting entries were based on extremely pessimistic estimates or only were timing differences, in 2012 they began to reverse, and in huge amounts. In just 18 months Fannie and Freddie recorded a combined $158 billion in book earnings, half again what they had earned over their entire existence. To prevent these earnings from becoming a torrent of returning capital—making it obvious that the companies’ failures had been engineered—in August of 2012 Treasury and FHFA amended the terms of their conservatorships to require all of their earnings to be paid to Treasury in perpetuity, in what was called the net worth sweep.

At the time they agreed to the net worth sweep both Treasury and FHFA were committed to managing Fannie and Freddie in a way that accommodated and would encourage a wind-down of their operations and their ultimate replacement by Congress. A Draft Internal Memorandum to Secretary Geithner produced at Treasury in December 2011 contained “a plan with FHFA to transition the GSEs from their current business model of direct guarantor to a model more aligned with our longer-term vision of housing finance.” Components of this plan included guaranty fee increases that would continue “until pricing reaches levels that are consistent with those charged by private financial institutions with Basel III capital standards,” securitized sharing of credit risk, a single security for Fannie and Freddie and a “faster retained portfolio wind down”—all of which were put into effect. FHFA for its part published a strategic plan in February 2012 titled “The Next Chapter in a Story That Needs an Ending,” one of whose three principal goals was to “Gradually contract the Enterprises’ dominant presence in the marketplace while simplifying and shrinking their operations.”

What Treasury and FHFA wanted for Fannie and Freddie also was what the large banks wanted. To get it, they, their allies, affiliated trade groups and other supporters went to work drafting legislation aimed at replacing the companies with entities or mechanisms less threatening to banks’ underwriting and pricing flexibilities in the primary market. But in executing this task they fell victim to their own fictions. Their self-serving but false mantra of Fannie and Freddie as a “failed business model” ruled out the use of the main structures, elements or techniques the companies had used so successfully for decades. Instead, a series of proposals from Corker-Warner to Johnson-Crapo to the “Promising Road” to the Milken Institute’s “New Secondary Mortgage Market” all relied on new, mostly theoretical, generally incomplete and always unproven features that made them too risky for a $10 trillion market central to the smooth functioning of the U.S. economy. None could gain broad support, and legislative reform stalled.

In the meantime, a second group was thinking about the futures of Fannie and Freddie. The net worth sweep had come as a shock to the companies’ investors, and several of the larger ones filed suit against Treasury and FHFA under various theories of the law. One set of suits claimed that because the sweep violated the Housing and Economic Recovery Act (HERA) that created FHFA and gave it its powers of conservatorship and receivership, the sweep should be reversed and the capital swept by Treasury returned to the companies. Plaintiffs in another set of suits claimed that the sweep was an illegal government taking; these plaintiffs were granted discovery in their cases, and documents produced in that discovery showed Treasury had devised the net worth sweep not for the reason it gave the public at the time—to prevent Fannie and Freddie from a “death spiral” of borrowing to meet their 10 percent annual dividend requirement—but instead to keep them from being able to retain the capital Treasury knew was about to come back to them from the reversal of the effects of the non-cash book entries made by FHFA.

Armed with the facts about the companies’ financial condition and prospects, and confident that the suits challenging the legality of the net worth sweep at some point would meet with success, a group of non-litigating shareholders hired an investment bank, Moelis & Company, to develop a plan to recapitalize Fannie and Freddie and return them to private ownership. Moelis published its “Blueprint for Restoring Safety and Soundness to the GSEs” in June 2017, and updated that plan in November 2018. The Moelis plan does not require legislation; it relies on existing FHFA and Treasury authorities to set new capital standards for Fannie and Freddie, strengthen their regulation, and allow them to exit conservatorship following a series of new equity issues. Moelis also contends that under its plan Treasury, as holder of warrants for 79.9 percent of the companies’ existing common stock, could earn $100 to $125 billion from sales of stock acquired upon exercise of those warrants.

The Moelis administrative reform path developed and supported by investors created a viable alternative to the legislative reform path advocated by banks, and it had one crucial advantage: it was based on fact and market reality and could be implemented immediately, whereas all previous bank-sponsored reform plans had been based on fiction and theory and had failed to gain traction. Secretary Mnuchin did not comment publicly on the Moelis plan, but continued to say he would prefer a legislative solution or an administrative plan with bipartisan Congressional support. After the November mid-terms, however, this posture became untenable. With the Democrats in control of the House of Representatives, even the staunchest bank supporters were not expecting reform legislation before the end of 2020, and the two political parties are known to have different priorities for an administrative solution. As a consequence, Treasury now recognizes that to change the status quo for Fannie and Freddie it will have to take the lead, and make difficult choices.

As it does, Treasury will be working with a new director at FHFA—Mark Calabria, who was nominated to his position last December and confirmed by the Senate on April 4. Calabria appeals to both investors and banks, but for different reasons. Investors like the fact that he is an outspoken critic of the net worth sweep, contending, as one of the principal authors of HERA when he was a staffer for the Senate Banking Committee in 2008, that it violates the plain text of the law as well as established practices of conservatorship and receivership on which the law is based. Banks like the fact that Calabria is a long-time critic of Fannie and Freddie and the roles they play in our financial system. In a paper done for the Urban Institute in 2016, Calabria referred to mortgage securitization as “a false god that failed us,” and argued for mortgage lending to return to the “originate and hold model” of depository institutions, going so far as to recommend that Fannie and Freddie be given bank charters and converted to bank holding companies. And as recently as last week Calabria said he thought part of his job was to “urge Congress to act” to change the companies’ charters, because “I think we should go to a different model.”

It is against this complex backdrop that the Federal Housing Finance Reform memorandum from the White House can best be assessed. We know it was authored by Larry Kudlow, the Director of the National Economic Council and Assistant to the President for Economic Policy, because it stipulates that “The Treasury Housing Reform Plan shall be submitted to the President for approval, through the Assistant to the President for Economic Policy.” Kudlow is not a neutral participant. He has been unfriendly to Fannie and Freddie since at least the mid-1980s, when he was assistant to David Stockman at the Office of Management and Budget and Stockman’s point person for trying to get Congress to impose what were called “user fees” on the companies’ debt, to raise their cost of borrowing.

I interpret both the timing and the substance of the White House memo as an attempt by Kudlow to insert himself into the mortgage reform process to the benefit of the banks, who now are seeking to achieve through administrative reform what they previously had been seeking through legislation. Numerous elements of the memo reveal a pro-bank bias. Its very first paragraph states that Fannie and Freddie “suffered significant losses due to their structural flaws and lack of sufficient regulatory oversight.” That’s the (provably false) bank argument. The memo then sets as the second goal of mortgage reform, after ending the conservatorships, “Facilitating competition in the housing finance market,” and lists as a sub-objective “authorizing the Federal Housing Finance Agency (FHFA) to approve guarantors of conventional loans in the secondary market.” The multi-guarantor model is what the banks support, and is the opposite of the utility model favored by investors, affordable housing groups and community banks. Making “facilitating competition” a core objective of the reform process rather than an option to be assessed on its merits puts a heavy pro-bank thumb on Treasury’s scale.

Treasury’s institutional history of opposition to Fannie and Freddie, the involvement of Kudlow and Calabria, and the White House directive to Mnuchin to produce the Treasury Housing Reform Plan “as soon as practicable” all strongly suggest that the banks stand an excellent chance of getting what they want from this process. Yet they face a formidable obstacle that I doubt even Treasury fully understands, and I suspect Kudlow and Calabria do not at all: in an administrative reform process the investment community has effective veto power over any significant proposed changes to Fannie and Freddie, because the companies cannot be recapitalized without the new equity these investors must provide. Precisely for this reason, the weak and ineffective versions of Fannie and Freddie that the banks have put forth for so long in legislation simply are not options in an administrative process. For investors to put new capital into Fannie and Freddie, the companies must be set up to succeed, not struggle.

As Treasury and FHFA engage in serious dialogues with plaintiffs in the lawsuits about settlement and institutional investors about recapitalization, I believe they will realize that they and the investment community have very different views about Fannie and Freddie’s business operations, what has been done to them in the past, and what must be done to revive them as private companies in the future. Treasury and FHFA will find that investors do not share the view that Fannie and Freddie need to be drastically overhauled because they are a “failed business model” and caused the financial crisis (they know neither of these claims are true), nor do they share the goal of reducing the companies’ market power for the benefit of primary market lenders. And investors are acutely aware that since 2012 Treasury has been taking (they would say illegally) all of Fannie and Freddie’s profits to keep them in conservatorship while it decides what to do with them, and they will need to be convinced that nothing similar will occur in the future.

I can’t predict what particular set of proposals for Fannie and Freddie’s capital standards and regulatory postures will be deemed acceptable by investors, and thus permit the companies’ reform and recapitalization to go forward. But I do believe that FHFA’s most recent version of its risk-based capital standard and Mark Calabria’s advocacy of having Congress eliminate the companies’ charters each will need to change. As I noted in my public comment, FHFA’s June 2018 risk-based capital proposal has too many elements of conservatism designed to back into a “bank-like” average capital ratio that is incompatible with the risks of the credit guaranty business to which Fannie and Fannie are restricted, and which if not removed will limit the scope of the companies’ business, distort their risk profiles, and make them less profitable for no good reason. FHFA also must eliminate the standard’s extreme procyclicality, caused by linking the companies’ required capital to the market value of their loans (which no other financial regulator does). And, of course, Fannie and Freddie’s regulator cannot be asking investors to put capital into them at the same time as it advocates repealing the charters that give them their market value.

It won’t be an easy process—and it may take the prodding of a reversal by the Fifth Circuit Court of Appeals en banc of the net worth sweep to get there—but I believe Treasury and FHFA ultimately will have no alternative but to shape, and to pledge to regulate, the Fannie and Freddie of the future in a way that gives investors confidence that the companies will be successful, in spite of what the banks want.  If I’m right and this occurs, then the White House memo of March 27 will prove to have been the beginning of the end of Fannie and Freddie’s more than decade-long conservatorships.

 

133 thoughts on “The Beginning of the End”

  1. Pingback: timeless investor repost – GlenBradford.com

  2. Tim

    cutting to the chase, shouldn’t calabria answer this question before he wastes everyone’s time with his congressional Hail Mary:

    who will fund the massive capital to form a “3rd GSE” given the low-income service responsibility of the charter? and if that responsibility is removed, who in congress is going to own that kind of change to the housing finance industry?

    rolg

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  3. “We don’t have to guess as what the ‘multiple credit guarantor’ crowd will call for, since they’ve already done it: taking the common securitization platform away from Fannie and Freddie (who paid $2 billion to construct it), and also making Fannie’s automated underwriting system, Desktop Underwriter, an “‘industry utility.’”

    Tim,

    Your remark reminds me of when Don Barzini wanted to tap into Don Corleone’s control of the New York judges and politicians. At least Barzini had the decency to be willing to pay for the services!

    “If Don Corleone had all the judges, and the politicians in New York, then he must share them, or let us others use them. He must let us draw the water from the well. Certainly he can – present a bill for such services. After all – we are not Communists.” EMILIO BARZINI

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  4. Sen. Sherrod Brown (D-Ohio), the top Democrat on the Senate Banking Committee, told reporters in May that “the people most aggressively pushing GSE reform have to prove to us, to the country, that their proposals are definitely better than the status quo, because the status quo isn’t awful.”

    The banking committee is scheduled to hold a hearing in two weeks examining whether Fannie and Freddie should be designated as systemically important financial institutions, a move that would open them up to greater oversight.

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        1. “The status quo isn’t awful,” except for how we got there, with Treasury concocting a now easily disprovable story about the companies being in financial trouble and needing to be bailed out, and then, when the non-cash expenses shoveled onto their balance sheets by FHFA ran out and began to reverse themselves, making up another story about how the only way to save them from a death spiral was to give all of their profits to Treasury forever. Other than that, Mrs. Lincoln….

          The reason the Financial Stability Oversight Council (FSOC) designates a financial institution as systemically important (i.e., a SIFI) is to ensure that regulators have the tools to keep them safe, sound and solvent during a severe financial crisis. FHFA was given these tools in its enabling statute, HERA, with enhanced regulatory powers and the ability to impose upon Fannie and Freddie a true risk-based capital requirement that FHFA can calibrate to whatever level of stress it chooses–something no other financial regulator has the power to do.

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          2. Legislative and administrative reform aren’t alternative ways to accomplish the same task; they’re different ways to accomplish different tasks. No matter how it’s couched, you choose legislative reform if you believe the mortgage finance system of the future should be fundamentally different from the one we had pre-crisis; if you think that former system can be fixed rather than replaced, you go the administrative route.

            A government guarantee is a fundamental change. So are multiple credit guarantors. Don Layton of Freddie Mac had it exactly right in the interview he gave a few weeks ago; without restrictions or changes imposed on Fannie and Freddie, no new entrants are going to try to compete with them. We don’t have to guess as what the “multiple credit guarantor” crowd will call for, since they’ve already done it: taking the common securitization platform away from Fannie and Freddie (who paid $2 billion to construct it), and also making Fannie’s automated underwriting system, Desktop Underwriter, an “industry utility.” If you do that, though, who’s actually responsible for the integrity of the system? Where would the discipline reside, and what would incent or enforce it? We’ve seen the legislative ship try to sail many times before, and it always runs aground when the theory of what could be meets the reality of what is. I don’t know why it would be any different this time, just because Director Calabria has said, “let’s give this one more try.”

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          3. Tim

            I distinguish between the facacta death-to-the-GSE plans considered by the SBC in the past, largely at corker’s behest, and the current proposal encouraged by calabria. assuming the principal points pushed by calabria will be a somehow-limited fed guarantee and additional charter authority (and as you say, likely some GSE footprint circumscription), I would view this current proposal push as at least somewhat related, and at least not antithetical, to moving the GSEs out of conservatorship with rebuilt capital. having said that, I dont think it will pass in either the HFSC or the SBC.

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    2. as Calabria tries to make the case for congressional action, one can expect democrats in particular to question the benefit of granting fhfa additional chartering authorization. see below for Moody’s comment on the adverse consequences of additional guarantors. in sum, calabria is not only making an equity capital raise more difficult but in Moody’s view creating additional risk for GSE debt and mbs buyers. but wont the limited mbs fed guaranty mitigate the credit risk? but why increase taxpayer exposure to mitigate against the credit risk posed by an underwriting race to the bottom (which only exacerbates the taxpayer risk)? (from Inside Mortgage Finance)

      “Increased competition would reduce the residential mortgage market’s reliance on Fannie and Freddie and reduce their systemic importance within the U.S. financial system, a credit negative for Fannie’s and Freddie’s individual credit profiles,” writes analyst Warren Kornfeld and his team.

      In recent speeches, Calabria has advocated for Congress giving the Federal Housing Finance Agency the ability to charter new government-sponsored enterprises that would go head-to-head against the GSEs as guarantors.

      Calabria believes more competition would ultimately lead to less risk for the nation’s taxpayers.

      But Moody’s sees it differently, stating “more competitors could lead to weaker underwriting standards or price competition, both credit negatives for the GSEs’ creditors. How negative this would be depends on how quickly, and predictably, their market share declined.”

      Over the past few years, Fannie’s origination market share has totaled as high as 28%, Freddie’s 18%, according to Moody’s. “These market shares demonstrate the firms’ role in anchoring this very large market, particularly in periods of prolonged uncertainty,” the company said.

      rolg

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      1. Many (not just Democrats) “question the benefit of granting fhfa additional chartering authorization,” including, as you note here, Moody’s. And Moody’s comment about multiple guarantors weakening the market’s perception of Fannie and Freddie’s credit standing assumes that Congress does not pass a law giving a government guarantee to all the debt and MBS issued by any credit guarantor FHFA may choose to charter (which I think is a correct assumption).

        Moody’s really is making the argument for a utility model for Fannie and Freddie instead of the (bank-sponsored and Calabria-endorsed) “multiple guarantor with government guarantees” model. A utility model puts all of our eggs in two baskets, and watches (and properly capitalizes and competently regulates) those baskets. That’s a relatively minor change to a model we know has worked extremely well for decades, with a much greater chance of success and much less risk than attempting to “redesign the baskets,” for competitive or ideological reasons, with multiple guarantors, different charters from Fannie’s and Freddie’s, and explicit government guarantees for those guarantors’ securities (but not the guarantors themselves).

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  5. Tim,

    Calabria’s introductory letter of the 2018 FHFA report had the below comments about GSE capital. Do you know what he is alluding to? I scanned the HERA legislation and came up empty.

    ” FHFA’s statute, however, requires it to use definitions of some capital terms that are outdated, inappropriate, do not apply to other financial institutions, and constrain FHFA’s flexibility. Applying those definitions requires undesirable work-arounds. Amending or eliminating statutory capital definitions that apply only to the Enterprises, thereby providing FHFA the same flexibility as other financial regulators, would permit FHFA to develop more tailored and appropriate capital and leverage standards, for consideration by Congress, the Administration, and market participants when working toward housing finance reform. “

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    1. Yes. HERA has different definitions of what qualifies as core capital for Fannie and Freddie from those used by bank regulators. That’s true, but I think Fannie’s and Freddie’s capital definitions are more straightforward and conservative– more straightforward in that they aren’t broken into Tier I and Tier II (with debt securities, up to a certain percentage, being allowed as Tier II capital), and more conservative in that to qualify as core capital Fannie and Freddie’s preferred stock has to be non-cumulative (meaning that missed dividends don’t cumulate and get paid later on), whereas that restriction isn’t imposed on bank preferred stock.

      As I’ve noted a number of times recently, Calabria’s continued insistence that Fannie and Freddie be viewed and treated like banks–even though they’re not banks; they’re now essentially mono-line insurance companies–is more than a little worrisome to me. Maybe that’s just his reference point, and what he’s comfortable with. But it also could be that he’s aligned with the banks in their insistence that Fannie and Freddie be subject to bank-like capital and regulation even though they don’t have bank-like asset powers. We should soon know which it is, when we see the government’s reform plan and FHFA’s revised capital proposal for the companies.

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  6. Tim, what is your take on yesterday’s report in Bloomberg on Mnuchin’s call for an explicit government guarantee, which needs Congress? Do you think this makes sense and jibes with enticing capital during admin recap if and when they do it?

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    1. I had two reactions to the Bloomberg article: Mnuchin didn’t say anything he hadn’t said before, but nonetheless both he and FHFA Director Calabria recently have made statements about the recapitalization process that will raise questions in the minds of potential new equity investors as to the administration’s regulatory posture towards them going forward.

      What’s that about? As I discussed in the current post, banks and bank supporters are unalterably opposed to having Fannie and Freddie returned to private ownership without the regulatory equivalent of ankle weights (or worse). But investors won’t put new money into Fannie and Freddie if they think the administration intends to handicap their operations in the secondary market in order to help banks’ activities in the primary market. Both Mnuchin and Calabria have had the option to say nothing about their reform and release plan until it becomes public, but they’ve chosen to make the statements they’ve made. That, to me, means one of two things: either they’re taking the side of the banks, and are attempting to forewarn potential participants in any recap that Fannie and Freddie going forward are going to look and operate very differently from how they did pre-conservatorship, OR they are “saying the right things” from the banks’ perspective, prior to putting out a reform and release plan they know the banks won’t like, but potential investors are more likely to.

      I don’t know which of these is more likely, but if I had to guess I would say some version of the former: Treasury and FHFA will put out a proposal that’s not too objectionable to the banks, and see how investors react to it. If they react favorably, it’s done. If they react unfavorably (which would be my expectation), Treasury and FHFA then will either revise their proposal to investors’ liking, or say, “well, we tried,” and stick with the status quo. Sticking with the status quo, however, only will work for as long as the net worth sweep remains intact. The Fifth Circuit should shortly issue its ruling on the sweep, and if it rules in plaintiffs’ favor I don’t see the government appealing, given Calabria’s stated view that the sweep is in fact illegal.

      So, we wait. We wait to see what the administration’s reform proposal looks like, we wait for FHFA’s revised capital proposal (which will tell us whether the agency is going to continue to engineer the proposal to require Fannie and Freddie to hold unneeded and burdensome excessive capital), and we wait for the Fifth Circuit’s ruling. “Plus ca change, plus c’est la meme chose.”

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      1. Tim

        I just wanted to reinforce your point about flexibility. While the treasury plan should provide a roadmap as to what types of reform can be implemented administratively as opposed to only by congress, per the POTUS memo, I expect it will be short on details as to what items of administrative reform will in fact be implemented, to say nothing of capital levels (fhfa’s remit) and the details of the capital raise (will the treasury line remain in place etc)…other than to state that bankers have been or will be soon retained.

        once it gets time to execute the capital raise, I expect there will be plenty of pushback from investors, both on price as well as terms. in fact, given the somewhat amorphous state of play with respect to GSE “footprint”, capital levels, and other “reform” items, this recapitalization will be unusually squishy, with the public trading prices of the GSE outstanding securities careening around in response to rumor and innuendo. you see it now, and it will only be magnified as the process unfolds.

        rolg

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      2. Paul,
        We all get it, you don’t like Trump or this administration. We get enough of it throughout our lives, can you leave the political hate out of your comments and bring real facts and analysis to this board and leave out the political commentary. Thanks.

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      3. Tim

        this WSJ article is germane to your last comment: https://www.wsj.com/articles/regulator-to-press-congress-to-act-on-mortgage-finance-revamp-11560337204?mod=hp_lead_pos6

        the gist is that calabria is going to send to congress some to-do items that calabria wants congress to act on, such as giving calabria power to charter additional guarantors (much like banking regulators can charter additional banks), and enacting some form of mbs govt guarantee. the article identifies the guarantee as something that should improve mbs pricing, which therefore should make a recapitalization somewhat easier to execute. calabria also intimated that the treasury plan will identify separate admin and congressional tracks for reform.

        my takeaway from the article is that both calabria and mnuchin are prepared to take admin action to implement reforms (to be identified in detail next week) that they have the power to implement, while suggesting congressional action that could be layered onto admin action that would seem to improve their ability to execute a capital raise and release GSEs from conservatorship.

        the article also referred to an interview with sen. brown in which he said his prior objection to SBC proposals was that they were “Rube Goldberg-esque”, which may even be an understatement. one may think that if any congressional action is done (ie brown…and even the HFSC goes along), it will be more limited in scope to what calabria and mnuchin will request.

        since the article stated that calabria would be presenting his to do list to congress next week, I would assume that would be the timing we would expect for the treasury plan. so yes we wait for the details, but I find this article to provide more coherence to Bloomberg’s recent misleading article on Mnuchin’s statements

        rolg

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          1. Tim

            I admit that I am subject to confirmation bias with the best of them, but I am getting comfortable with what I see as the two main asks of congress from calabria/mnuchin: competition and mbs backstop govt guaranty

            any govt guaranty should help GSEs in short term, especially with capital raise. I am sure that is what institutional investors have been asking fo (no surprise there), and it will only help GSEs in short term.

            in longer term, the govt guaranty may help other financial institutions enter the secondary mortgage finance market. I sure wouldn’t want to compete against a $5T duopoly without help. but longer term is post capital raise, and while the specter of competition is a negative, I think it is far overshadowed by the capital raise benefit of an mbs guaranty in favor of GSE mbs

            there has been a lot of antagonism against GSEs over past 7 years, and so it is natural that one is suspicious of calabria/mnuchin motives in asking for congressional action. I am warming up to it.

            the third pillar, GSE capital levels, is something that calabria may or may not surprise us on, but one hopes he understands the fine line he has to draw between capital markets acceptability and taxpayer protection.

            Tim, perhaps you will knock some sense into me.

            rolg

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          2. ROLG: You take more comfort from Calabria’s recent pronouncements than I do. On his call for legislation, I am troubled by his blanket statements that there was something seriously wrong with the pre-conservatorship model of Fannie and Freddie that needs a Congressional fix. That’s the banks’ line; it’s based on a fiction, and it leads directly to having Congress make the “fix” that the banks are asking for. Knowingly or not, this is what Calabria is endorsing. To me, there really were only two things wrong with the companies pre-crisis: their credit guaranty capital requirement was too low, and they had adversarial and incompetent regulation. FHFA has the power to fix both, and I think the chance of Congress devising and passing mortgage reform legislation that inspires enough investor confidence to pull $100 billion-plus into the sector is exceedingly small.

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          3. Tim

            so it comes down to motive and intent. clearly in previous iterations, congressional considerations of GSE “reform” were fellow-traveller inspired and GSE antagonistic. whether what we shall see in the next few weeks is a good faith attempt to improve the prospects for a capital raise as well as a neutral attempt to expand fhfa chartering powers, or a wolf in sheep’s clothing, will eventually be revealed…knowing that in the end, capital markets buyers of GSE stock in the recap effort hold the strong hand.

            rolg

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          4. FHFA & Treasury are playing a high stakes game of poker.

            Calabria says he/FHFA intends to continue the NWS into December.

            Calabria also said he would like congress to modify the GSEs business model.

            What chance is there for any of that happening?

            Most here are of the opinion the 5th circuit court en banc will decide in favor of the plaintiffs. If that happens the NWS ends, right?

            Does anyone in FHFA and/or Treasury really believe that congress is capable of changing the GSE’s business model, e.g. adding new guarantors?

            And with all that going on, going to an investment banker seeking a +$100 billion secondary stock
            offering?

            Paul is correct about one thing: POTUS is leading this recap from the rear. He is keeping a distance from it for reasons only he knows.

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  7. ROLG,
    the provision 6.12 of the SPSPA: Non-Severability. If a judge finds any provision illegal, all the PA is deemed null and void and everything is unwound.

    If 5th circuit en banc finds 3rd amendment illegal, what happens?

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  8. Fannie Mae just posted its April summary, showing delinquency rate in 2009-2019 (post-crisis) merely 0.33%. It demonstrates once again, even without any reforms Fannie Mae (and Freddie Mac) simply following strict lending standards would be a stable force for the housing market. To require capital similar to TBTF banks would be gross overkill and impede affordability of housing finance by driving up mortgage rates.

    I am not a lawyer or financial expert. Even I understand that.

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    1. For those who don’t follow Fannie Mae’s monthly summary of business activity (which I suspect is almost everyone), Fannie has published what it calls its “serious delinquency rate” on single-family loans– the percentage of those loans where it bears risk of loss that are three months or more past due–for at least forty years. For the years I was Fannie’s CFO (1990-2004) the serious delinquency rate averaged around 55 basis points, with a low of 41 basis points (June of 2002) and a high of 64 basis points (the month I left, December of 2004). At the worst of the crisis Fannie’s single-family serious delinquency rate hit 5.59 percent (in February 2010); since that time it first dropped, then drifted down to where it is now as of April 2019–72 basis points.

      Starting in 2017, Fannie added additional detail to its single-family serious delinquency tables. One new breakout was by book of business. In addition to the total serious delinquency rate, it also now gives the rate for loans Fannie acquired in 2004 and prior years, loans acquired from 2005 through 2008, and loans acquired from 2009 to date. It is this last category that hll7575 is referring to when he quotes a serious delinquency rate of “merely 0.33%.” That is indeed low; it’s well below anything we experienced during the time I was there.

      Fannie also discloses that the 2009-to-date book of business now makes up 93 percent of all of its credit guaranty business. The pre-2009 business has an average serious delinquency rate of 3.67 percent, and even though it makes up only 7 percent of Fannie’s total book today that’s what pushes Fannie’s overall serious delinquency rate to 0.72 percent. There is not much Fannie can do about the delinquency rate on its pre-2009 book other than watch that book run off or default. But the fact that 93 percent of its business (and growing) has a delinquency rate of just 33 basis points does highlight, as hll7575 notes, the folly of requiring Fannie and Freddie to have “bank-like” capital. As of the first quarter of 2019, the serious delinquency rate on all commercial bank loans (which is readily available to anyone who cares to look at it) was 1.74 percent, and the serious delinquency rate on banks’ residential mortgages was 2.67 percent (this is comparable to the 72 basis points on Fannie’s total book, not the 33 basis points on its post-2008 loans). Capital, as I’ve said forever, must be related to risk. Contrary to what the bank supporters say, a “level playing field” doesn’t mean equal capital, it means capital that bears an equal relationship to the risks incurred by the entities in question.

      I’ll make one other point about Fannie’s new delinquency tables. The company also breaks out the serious delinquency rate on loans included in the reference pools for its credit risk transfer (CRT) securities. As of April 2019, the serious delinquency rate on those loans was a mere 23 basis points. No wonder investors love Fannie’s CRT program! Virtually none of the books of business Fannie guaranteed when I was CFO–which had an average serious delinquency rate of 55 basis points–reached the credit loss threshold at which CRT investors become subject to the risk of loss (50 basis points of the unpaid principal balance of the reference pool). What is the chance that books with an average serious delinquency of 23 basis points will reach that threshold? (Three guesses, and the first two don’t count.) Fannie is now paying over a billion dollars a year in interest on these CRTs.

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      1. Tim

        this granular analysis of delinquency rate for post 2009 book of business is exactly what I think should be submitted to calabria in a letter…and I hereby nominate you to deliver such letter to him. these numbers ARE ASTOUNDING, and I feel certain that calabria is unaware of them. while one may think it rich that I should appoint you to this present task, I also feel certain that given your historical understanding of Fannie delinquency rates over the past three decades, frankly there is no one else other than you that can make the case authoritatively.

        rolg

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        1. I second the motion with one emendation. Copy Mnuchin, though he probably knows this already. Maybe Calabria does too and is sick over it!

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          1. A letter to Calabria on the subject of minimum capital for Fannie and Freddie versus banks (which according to my FHFA contacts I’d need to submit through their rulemaking process), in which I would make the points about relative delinquencies as well as a couple of other ones, certainly wouldn’t hurt, and I’ll do that. I do know, though, that most of the people who advocate the same percentage of capital for Fannie and Freddie as for banks know that the companies’ risks are far less, but for political or competitive reasons they ignore this, and insist that anything different from an equal percentage capital requirement for Fannie and Freddie’s credit guaranty business as for banks’ on-balance sheet mortgages (which have considerable interest rate risk) gives an “unfair advantage” to the companies. I wish I knew whether Calabria was one of those people. We’ll soon find out, I suspect.

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    1. If the folks at Urban Institute hoist a white flag, where is it written that they can’t still be shot??

      (Just asking for a friend.)

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    2. as you might expect from a conference put together by parrott and goodman of the urban institute, there was a fair amount of absurd unreality to How We Should Think about Administrative Reform of the GSEs.

      first, except for Calhoun of the Inst for Responsible Lending, no one discussed the central point of administrative reform, releasing the GSEs from conservatorship, and the capital levels required to do so. one might have thought there would be substantial discussion about fhfa’s proposed capital regulation, but I would guess that time spent discussing CRTs and the common securitization platform was 50X the amount of time spent on GSE capital necessary to terminate conservatorship…and no time discussed how that GSE equity capital might be raised in the capital markets.

      second, while Demarco and Kaplan (Milken Inst) went on at length as to how the CSP might become useable by additional mortgage guarantors and even issuers in the PLS market, the annaly cio (Finkelstein) brought a little reality to the subject by saying no one wants to trust PLS issuers anymore, and having those issuers use the CSP wont change things (though Kaplan did suggest that “best practice rules” could be incorporated into the CSP in the future, which Zandi thought unrealistic). the annaly cio went on to make the best point of the conference, that private capital hasn’t retreated from mortgage credit markets, it has just gotten smart, that REITs such as annaly and insurance companies and other institutional investors have established their own underwriting capabilities and are conducting their own due diligence and selecting for their own desired credit profile, and holding whole loans, and even beginning to engage in their own CRT-like transactions as sellers of risk from their retained pools.

      so you had urban institute holding forth on subjects visible in their rear view mirror that are relevant to GSE operations in conservatorship as the whole GSE landscape shifts to exiting from conservatorship and the constraints that made CRTs necessary. as I said, absurd unreality.

      rolg

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      1. ROLG: Thanks for the recap. I’m still in Europe (returning tomorrow afternoon) and wasn’t tempted to stay up to listen to the webcast. It sounds from your summary as if I made the right choice.

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        1. Tim

          in effect the answer to the implicit question of the conference title, How We Should Think about Administrative Reform of the GSEs, was: let’s just not think about administrative reform.

          I left the video webcast mildly infuriated. here was a former government official to whom we entrusted much responsibility, mr. parrott, who orchestrated a process with the NWS that had no viable resolution and that was illegal, as I expect the collins en banc court will soon tell us. he now has the hubris to organize a conference where the putative topic is how, 11 years after his miscarriage of justice, the administration may actually resolve the no-exit mess he put housing finance into, and he has the temerity to reduce the topic of conversation to the hamstrung financing CRT option as if CRTs are a feature rather than a bug of a dysfunctional 11 year conservatorship for which he is principally responsible.

          only in the swamp of DC.

          rolg

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          1. I’m now at Heathrow airport, waiting for the departure of our flight back to Washington. The notion that what’s now happening with Fannie and Freddie is an “only in the swamp of DC” phenomenon was convincingly put into perspective by having attended last night the superbly crafted and acted three and a half hour tour de force play “The Lehman Trilogy” at The Piccadilly Theatre, which traces the history of American capitalism and finance since before the Civil War. High finance has always been about money, and been ruthless. The fact that Mr. Parrot could have been discovered crafting the lie about why Treasury imposed the net worth sweep on Fannie and Freddie and yet still be embraced by the Financial Establishment and afforded credibility as a spokesman for what should be done with the companies in the future is unsurprising in this broader context.

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          2. Tim

            from Parrott to Whalen, the anti-GSE Financial Establishment is losing its mojo.

            herewith a twitter exchange I had with chris whalen, a long time tbtf apologist and GSE hater.

            https://twitter.com/RuleofLawGuy1/status/1134497407973122049

            https://twitter.com/RuleofLawGuy1/status/1134499799242354690

            there is a huge amount of execution risk to the recap/release plan that treasury will soon proffer, but at least for once it can be said that the GSE-haters are left with nothing meaningful in reply

            rolg

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          3. Tim I took your advice and saw ” The Lehman Trilogy” at Piccadilly. As you noted it was fantastic in both conceptual design and the performance of the cast. I was trying to find a character that would be fitting of Mr. Parrot. I think when Ben Miles embodied a petulant child is the best fit line.

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  11. Tim

    A simple question about capital and Calabria:

    Calabria has been talking frequently in his first month as FHFA director about capital levels for GSEs, and it appears to me that his remarks have been made in the generic and abstract, as if he was a policy advisor proffering his views as a matter of first impression.

    however, his agency has already proposed a capital regulation in substantial detail, and has received many detailed comments on the proposed rule. isn’t the agency capital setting process past the half-way turnaround (for the road runners and bikers among us)? doesn’t the administrative procedure act compel the fhfa to proceed to completion of its current process? all this to say that shouldn’t Calabria’s comments about capital be grounded in fhfa’s actual proposed rule and the already received actual comments thereon, and not pulled by calabria as it were like the ether from the air?

    rolg

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    1. Calabria’s comments to date about Fannie and Freddie’s capital have been the standard Cato-AEI rhetoric, whether it’s saying the companies should have the same capital requirements the Federal Reserve requires for banks (notwithstanding the fact that they’re NOT banks), or his oft-repeated line that “It was insufficient capital that triggered the conservatorship, and it’s going to be sufficient capital that triggers an exit” (which is factually inaccurate: both companies fully met their statutory capital requirements when Treasury forced them to accept conservatorship). Nothing Calabria has said on this topic gives me any indication that he’s yet had a briefing on the nature and status of the capital rule-making process FHFA has been engaged in for the past few of years.

      I have no doubt that FHFA will soon issue its revised proposal on Fannie and Freddie capital, but I am not confident at all that I can predict what it will look like. It’s entirely possible that Calabria’s prior views on Fannie and Freddie capital will lead him to not remove the many layers of conservatism that were built into the June 2018 proposal to inflate the capital number–such as not counting guaranty fee income as an offset to credit losses in the stress test–which I and many others pointed out in our comment letters. If that turns out to be the case, then the investment community will have to judge whether FHFA’s revised capital standard will enable the companies to continue to do business at volumes and fee rates that make them reasonable investments. If their answer is “no,” Calabria and FHFA will need to remove enough conservatism to get them to say “yes,” or there won’t be a recap.

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      1. Tim

        I expect an administrative recap/release to be accomplished. the administration’s credibility will be on line, so it will be done. I also suspect that calabria will claim partial credit, just like those who take credit for things that get done in spite, rather than because, of them. we’ve all seen this tiresome act before, but let success have an undeserving father if need be.

        rolg

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        1. Paul, I understand the cynicism after 10 years of morass.

          But: placing a ham sandwich under c’ship? What kind of metaphor is that? ha ha!

          Secondly, who the heck accepts any “blame” when it comes to politics? Your credibility has suffered a blow! lol lol!

          Blow or not, I appreciate your perspective.

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      1. I’ve stopped commenting on articles by Alex Pollock. He is an inveterate opponent of Fannie and Freddie who seems to spend a good deal of time thinking up rationales for burdening them with costs, fees, restrictions and capital requirements whose intent is to render them ineffective in what now, after the elimination by Treasury of their stand-alone portfolio business, is the one activity their charter allows them—mortgage credit guarantees.

        But I will make a comment on one thing Pollock said. What he claims is the “internationally recognized standard for mortgage risk” of 4 percent applies to loans held by financial institutions on their balance sheets. Fannie and Freddie have a 2 percent capital requirement for the interest rate risk associated with the mortgages they hold in portfolio (which is minimal, because those portfolios are well hedged), so this should make the capital requirement for their mortgage credit guarantees, which have only credit risk, 2 percent. But I suspect Pollock would not sign up for that. He would advocate 4 percent capital for Fannie and Freddie’s credit guarantees, then invent some reason why the companies’ capital requirement for their on-balance mortgages should be half again as much as banks, at 6 percent.

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  13. Somebody tell the current CEO of Freddie that, No, the FHFA leaders in 2012 will not be going down as the good guys in the history books. Guy has to be in on the take here …. either that or he does not have a clue about what he’s doing – promoting UMBS, CRTs and the FHFA circa 2012….

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    1. I’m still in Romania, but I finally have had time to watch the Don Layton interview, and have a couple of reactions I thought I’d share.

      First, I like the doses of reality he adds to the discussion of how to get Fannie and Freddie out of conservatorship. You have to pick an approach that’s workable. He was very good on the multiple guarantor issue. As long as Fannie and Freddie have their current charters, be believes it is highly unlikely that anyone else would risk starting up a new entity to compete with them; they have too many entrenched advantages. One is their expertise. I was very surprised to hear Layton say that Freddie buys half of its loans using Fannie’s automated underwriting system, Desktop Underwriter (DU). Your underwriting system is how you assess, grade and ultimately price credit risk. If all a new entrant is doing is using Fannie’s DU to determine how to grade the mortgages it puts its guaranty on, what value would it be adding? Obviously even Freddie hasn’t been able to come up with anything comparable to DU—at least in the eyes of lenders—itself. (And Freddie didn’t have the option of doing what it did with the single security: get FHFA to mandate that both Fannie and Freddie spend $2.0 billion, according to Layton, over seven years to fix the remittance problem Freddie had with its Participation Certificates [PCs], that caused them to trade at a discount to Fannie’s MBS.) If what you want is multiple guarantors, you’ve got to throw out the current system and create a new one, which Congress has consistently (and wisely) shown itself to be unwilling to attempt.

      And I have to make a brief comment on Layton’s remarks on risk-sharing. In the beginning of his interview he discussed how he thought Freddie (and by implication Fannie) under conservatorship had fixed what he called the weaknesses of the “old model” of Fannie and Freddie. One of those was that you had two companies taking $5.0 trillion of single-family credit risk. He said that to remedy this defect, he and a member of his finance staff created the securitized credit risk transfer (CRT) to move large volumes of credit risk from Freddie to capital market investors. I hadn’t realized that this was a Freddie initiative (if indeed it was); I thought it was something Treasury had insisted upon, and FHFA required. But whatever the case, Layton did not say how or why he thought CRTs made taxpayers (today) or Freddie (in the future) better off. As readers know, I believe programmatic CRT issuance benefits neither; yes, it does transfer credit risk, but the risk transferred is remote, and Freddie (and Fannie) vastly overpay for the protection they receive. I wished the interviewer—a former Freddie board member I didn’t recognize—had asked Layton, “Do you believe that over the life of your CRT program investors will absorb more dollars in credit losses than you will make in interest payments?” Had his answer been yes, the follow-up should have been, “Then why do you think they’re buying them,” and had the answer been no, the follow-up should have been, “Then why have you been issuing them?” When Fannie and Freddie exit conservatorship, they will need to think much more deeply and analytically about the role of CRTs in a company whose objective is to maximize the return on their invested capital.

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    1. Here and elsewhere, Calabria continues to put forth a vision for a reformed mortgage finance system that includes more competition for Fannie and Freddie and an explicit government guaranty, despite the fact that this vision requires legislation that isn’t going to happen for the foreseeable future. Yes, he does talk about a possible common stock offering for the companies, giving owners of existing junior preferred stock the option to convert to common stock, and the need for Treasury to decide how it wants to handle the warrants, but he seems not to have grasped that these potential elements of the task he’s been asked to execute–getting Fannie and Freddie out of conservatorship–are incompatible with and will be made more difficult by his vision, which he characterized in his recent speech to the Mortgage Bankers Association by saying, “if there’s one thing I know for sure it’s that Fannie and Freddie will look much different at the end of my five-year term than they do today.” If I’m one of the investors who will be asked to put upwards of $100 billion into these companies, my reaction would be, “Okay, tell me what they will look like then, and I’ll tell you whether I’ll put any money into them.”

      My advice to Dr. Calabria would be to stop giving interviews and making speeches about how he’s going to transform the mortgage finance system, and instead roll up his sleeves, learn what’s possible and what’s not, then get to work with Treasury and its investment bankers on a plan for getting Fannie and Freddie out of conservatorship that can be accomplished in the real world.

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      1. It’s a dangerous game but my bet is that he is paying lip service to these ideas in order to keep congress out of while the inevitability of exit gathers momentum.

        It’s funny, Paulson et al assumed legislation could have the best chance during a ‘time-out’ conservatorship; Calabria is now suggesting the opposite.

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      2. Exactly! who will invest in company when the CEO is promising to create competitors! and make things difficult.

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      1. My brief review of the President’s speech to the NAR revealed two types of comment: a generic “It’s a problem, but we’ve got geniuses looking at this and they’ll do a great job fixing it,” along with more detailed statements about Fannie and Freddie almost certainly written by Larry Kudlow. In my view, neither has any significance for what actually will happen in the next few months.

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    1. I thought the most important aspect to the Politico article was Calabria’s softening his stance on the advocacy of a multi-guarantor model. He said, “Whether Congress wants to create a utility or a multi-guarantor model, I see my role as offering input as to what I think would work and what I would not think would work,” adding, “We we will not be putting forth a proposal for, ‘OK, this is what we think you should do with the overall system’.” Calabria’s earlier statements had made it sound as if he as director of FHFA would be advocating for legislation to permit multiple guarantors, which would not sit well with investors being asked to put new capital into the companies. Investors know that Congress could change the companies’ charters at any time, and it’s a risk they’ve come to accept as remote.

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      2. I still get the impression calabria thinks as he speaks rather than before he speaks, and when you are soon to go to institutional investors for a lot of money, this is suboptimal. but the more he speaks, the more I like what he seems to be thinking.

        rolg

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        1. Yes, he draws a bright line between regulatory requirements (HERA) and future housing finance system. This distinction has been missing from public discourse for some time.

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  17. Tim

    I noticed that Sen Brown has indicated today that he is not in favor of legislation re GSEs; the headline is that he is not in favor of “privatization”. https://seekingalpha.com/news/3463049-frannie-privatization-unlikely-says-sherrod-brown-ft?dr=1#email_link

    it is remarkable how confused the discussion of GSEs is in press and even on capital hill, where the word “privatization” can mean apparently whatever the speaker wants it to mean. to my lights, Sen. Brown is suggesting that legislation on a bipartisan basis is highly unlikely (after all, Sen. Brown is the ranking member of SBC), which means to me that calabria and Treasury are on their glide path towards administrative reform without congressional passage for charter competition…which, I take it, is a positive development with respect to lowering execution risk for capital raising. and yet, some is press (and market) seem to read this as a negative development for the prospects of administrative reform.

    rolg

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    1. During the time I was at Fannie Mae members of both parties in Congress used the word privatization as shorthand for “full privatization,” which meant removal of the benefits in the companies’ charters that gave their debt and mortgage-backed securities federal agency status in the financial markets, thus lowering their costs and broadening their base of investors. I suspect Senator Brown is using the word in this sense, rather than the sense most of us likely associate with it–returning Fannie and Freddie to (private) shareholder ownership through recapitalization. If Brown means privatization in this former sense, then his preference for what he calls the “status quo” would mean keeping their charters as is, not maintaining them in perpetual conservatorship with the net worth sweep.

      Between now and the time Treasury comes out with its housing reform plan, I’m sure we will see numerous statements from official figures and individuals in positions of influence, giving their views or preferences on key aspects of the reform process. I caution against reading too much into most of them. Some will be deliberately provocative, some ill-informed, and only a relatively few informative or helpful. And this might be a good time to mention to readers of this blog that tomorrow I’ll be leaving on a trip to Europe, where I’ll be for the balance for the month. During this time I’ll be away from the site for fairly long periods each day, and there may be a few days during the week of May 20 (while I’m cycling through small towns in and the countryside of Romania) when I won’t have access to a computer at all. I’ll keep up as best I can with goings on in the mortgage world, but it will be with a time lag.

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    1. His mistake on capital requirements is so obviously uninformed that I’m tempted to look for some ill motive that favors the banks. However, if he’s willing to saddle the banks with the same 4.5%, then as the old adage goes, let’s not chalk up to malice that which may adequately be attributed to incompetence.

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      1. The article does not fully convey what was said regarding capital. Interviewer said 4.5%. He was generally evasive. He even said “3, 4, 5%” at one point. He also never said “bank like”. He said like “other financial institutions”. It’s all part of the same exchange.

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        1. For ROLG: The difference between the 4.5 percent capital ratio Calabria called for in his recent Fox Business interview and the FHFA proposal isn’t quite that simple. FHFA’s June 2018 capital proposal was for a dynamic, risk-based capital requirement. In that proposal, FHFA calculated Fannie and Freddie’s average capital requirement to have been 3.25 percent based on the companies’ September 31, 2017 books of business. Since that date, though, the companies’ required “conservatorship capital” percentage has fallen substantially. Both Fannie and Freddie reported on that in their first quarter 2019 earnings releases: Fannie said its conservatorship capital was $87 billion, and Freddie said its was $52.4 billion. For both companies, that’s a little over 2.50 percent of their total assets–well below the 3.25 figure produced by the same risk-based methodology in September of 2017.

          I am one who believes that this level of volatility in Fannie and Freddie’s capital ratio is not a benefit to the companies; it’s a problem that needs to be fixed, as I discussed in my comment to FHFA on its June 2018 proposal. A required capital ratio that can fall this far this quickly in a good housing market can, and will, rise even further and faster in a bad market. And in a bad market the companies may well need to be raising equity to offset their credit losses. Making them raise even more equity to keep up with a pro-cyclically escalating capital requirement is a horrible idea, and easily could push them right back in to conservatorship if (and more likely when) the market won’t provide that additional equity.

          So in my view the problem is even worse than you state. Not only is the director of FHFA proposing a simplistic 4.50 percent capital ratio so that Fannie and Freddie’s capital will be like “other large financial institutions”–which it shouldn’t be, because Fannie and Freddie are single-asset credit guarantors, not multinational banks–but the staff at FHFA seems to have not understood the dynamic implications of the capital standard it proposed for the companies last year. This is all going to have to get straightened out before new investors will put any new money into Fannie or Freddie.

          For Ron: Applying a 4.50 percent capital requirement equally to Fannie, Freddie and the large banks would not be a “level playing field.” Banks hold their mortgages on balance sheet, where they are funded with short-term consumer deposits and purchased funds, and thus have considerable interest rate risk. Today, Fannie and Freddie are required to hold an extra 2.00 percent, above their capital requirement for credit risk-taking, for any mortgage or MBS they have in portfolio, and they match-fund those mortgages and rebalance their funding as interest rates change. The supporters of banks consistently, and erroneously, ignore this huge differential in interest rate risk-taking when they insist that Fannie and Freddie should have the same capital ratio applied to their mortgage credit guarantees (which have credit risk only) as applies to bank holdings of mortgages (which have interest rate as well as credit risk).

          For Jim: You’re correct. We’re getting much of this third hand. These are comments coming from an individual who doesn’t yet have a detailed understanding of what he’s talking about (Calabria), being transcribed by reporters with little understanding of it either. We should all recognize that Calabria has a learning curve ahead of him, and not get too spun up about reports like the one from Fox Business.

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          1. Tim,
            Do you think Adolfo, who worked for you before and was just appointed as a deputy at FHFA, can be able to explain to the rest of the FHFA staff what you are saying, given his background and knowledge?

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          2. Yes. Adolfo Marzol–who was appointed Principal Deputy Director of FHFA, reporting to Mark Calabria, in the middle of last month–will be in an excellent position to explain the nuances of the risk-based capital standard both to the staff and to the director. (And, to anticipate a possible follow-up question, I have a policy not to comment on any of my private interactions with people involved in the reform dialogue.)

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          3. Ok, so it’s worse than I thought. When the FHFA echo chamber talks about a level playing field for GSEs and artificially creating Bank competition, they are not breaking out the existing bank mortgage business, let alone any future business they might be able to secure if charters are revoked, and comparing apples to apples.

            The amount of high risk business the banks currently have (relative to GSE type business) will enable them to absorb into a blob stew portfolio GSE type business and actually allow them reduce capital reserves in the housing space below that which GSEs could be required to hold, gaining a competitive advantage?

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          4. No, I don’t think the large banks want to get into the mortgage credit guaranty business themselves–it’s too low-margin relative to the business they can get elsewhere. I think their motive for (unreasonably) insisting on “bank-like” capital for Fannie and Freddie is to make their credit guaranty business less efficient, drive up mortgage rates (and thus the spreads on the mortgages banks hold in portfolio), increase the popularity of adjustable-rate mortgages relative to fixed-rate mortgages, and generally shift business from the secondary to the primary market, which the banks control.

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        2. Jim is right, the printed article and the taped interview are very different, the taped interview is important to watch so you can see him speak his own words. He acknowledges he isn’t into the details on things to comment yet. He is also deferential to Treasury on certain matters. He wants to give Congress their chance while retaining capital. They best take notice. Stakeholders have been paying for Congressional dysfunction long enough.

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    2. there is one aspect to Calabria’s musings out loud that I liked….saying that he felt obligated by HERA to proceed with administrative reform if congress doesn’t act…meaning he interprets the conservator’s role as a mandate to restore soundness…so how can the litigation proceed with fhfa counsel claiming the exact opposite?

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      1. Calabria also said (at 14:45): “They [Treasury] wanna look out and make sure we maximize the taxpayers investment”. First time I recall hearing it from anyone in government.

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    3. Does 4.5% of risk-weighted assets for an asset category that gets a 50% risk-weighting actually amount to 2.25% of total assets? If so that would be in line with a reasonable capital standard.

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      1. No. The 4.5 percent figure is after the application of a 50 percent risk weight (which has been the risk weight applied to residential mortgages by all the versions of the Basel bank standards).

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    1. I had a couple of reactions to it. The first is that I didn’t think he said anything new. The comment that “Congress will get ‘at least an entire Congress’ to act before the companies are freed” wasn’t a condition or even a prediction–the timeline on recapitalization in the Moelis plan is over two years, which is “at least an entire Congress.” Beyond that, Calabria continues to make statements that I’m sure he believes are accurate and are consistent with what he will be asked to do in the recap, but in reality are not–including his statement that the capital ratios Fannie and Freddie will be asked to meet should “look like any other large financial institution.” That’s not what’s in the HERA statute he claims to have co-authored: they are given a unique stress-based capital standard that reflects their charter limitation to a single line of business, whose default risks are a predictable function of home price changes. Hopefully Calabria will learn this as he spends more time in his new job. If he insists on putting a “bank-like” capital requirement on two companies that are prohibited from taking bank-like risks, Treasury is going to have difficulty rounding up new investors for any IPO.

      I also noted some whistling past the graveyard on the subject of the net worth sweep. The article says that Calabria “brushed off concerns about the legality of Treasury’s net worth sweep, which is the subject of legal challenges. ‘I think if we can get them out of conservatorship and then we can set a path, I think a lot of those issues will go away, he said.” Uh, no. That’s precisely backwards. You won’t “get them out of conservatorship” until they are recapitalized, and they can’t be recapitalized until the net worth sweep is dealt with to the satisfaction of the investment community, and Fannie and Freddie’s regulatory and capital schemes are specified in a manner that convinces these same investors that the companies’ business will be not just viable but healthy and profitable. These issues won’t “go away;” they will need to be painstakingly analyzed, worked on and solved.

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      1. Tim

        far be it for me to defend calabria, but I inferred, from the lawsuits “will go away,” that calabria understands no capital can be raised unless the NWS is retroactively terminated, either by judicial decision or administrative agreement, and that if treasury and FHFA agree to retroactively revoke the NWS as the first step of the capital raising regimen, the plaintiffs will have obtained the relief (from the administration) that they are seeking from the courts. I took this as the first indication of calabrian sanity that I have witnessed since becoming his becoming fhfa director.

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          1. You beat me to it, JT!

            Why would anyone assume that Calabria–or anyone else in the Admin–has done all of the detailed work to comprehend HERA and its GSE operational impact, when it is easier to convey the “Lambert lie,” which is the federal government can do anything it wants to the GSEs, via regulation?

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          2. Tim, your blog is the gold standard for GSE information and comments. Invaluable, thank you .

            I have a question. For Investors to put 100 billion into recapitalisation of the GSE’s would it not be incumbent for Investors to demand the following as a prerequisite to any capital raise discussion:
            1. Immediate release after the capital raise due to a lack of trust
            2. Suitable capital standard by FHFA & not a fudged bank capital requirement.
            3. No other Credit Guarantors to be created
            4. No change to Charters

            What would be your views on the achievability and the possible guarantees that could be offered to satisfy these demands ?

            Liked by 1 person

          3. I wouldn’t bet on those four specific requests, but I agree with your general point that something along these lines will need to be agreed to among Treasury, FHFA and the investment community before a recapitalization can go forward. I am certain that the difficult work on this will be completed before any capital raising begins, and the way that will happen is through face-to-face discussions between representatives of the large U.S. money managers and the investment bankers retained by Treasury to do the capital raising. It will be at this stage that any simplified notions Treasury or FHFA may have about how Fannie and Freddie might be able to function in the future will be identified and assessed. Treasury won’t go forward with a capital raising process that is unlikely to succeed, and the investment community is not going to agree to restrictions placed on the “reformed” companies that would make them unlikely to be successful. Through an iterative process, I believe all parties ultimately will be able to come up with a plan for reform, recapitalization and release of the companies that will meet the test of the market.

            Liked by 2 people

        2. ROLG and Tim,

          What did you think about congress having plenty of time to come up with their own plan “at least an entire congress”. That puts recap out to after the 2020 election. Wouldn’t that put the reins in the hands of the next administration that possibly might not be Trump or Mnuchin? And that with the “for cause removal” rulings, possibly not be Calabria either?

          Cheers,
          Justin

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          1. I may not have been clear on this in my earlier response: I don’t think Calabria was saying that the recapitalization process would be delayed until after the 2020 election, only that he felt Fannie and Freddie’s release from conservatorship would take at least that long–during which time Congress would be free to pass legislation if it felt Treasury and FHFA were heading in the wrong direction. I doubt that Treasury and FHFA would agree to release the companies until they raise sufficient capital to either fully meet their new (and as yet unknown) capital requirements or reach some threshold level close to that. So even were a plan to reform, recapitalize and release Fannie and Freddie to be announced tomorrow, the companies likely would remain under government control through the end of next year, because it should take at least that long for them to rebuild their capital through retained earnings (after the net worth sweep has somehow been cancelled or unwound) and new issuance of equity.

            Liked by 1 person

          2. @juice

            and following Tim’s response, therein lies the capital raise dilemma. hard to sell stock to new investors if congress has the opportunity (nay, the invitation by fhfa director) to muck up the works before the capital raise is over…and yet, once the capital raise begins, the practical likelihood of congress doing something diminishes (assuming congress had the bipartisan wherewithal to address it ex ante).

            so to my eyes, this political accommodation posture simply makes the capital raise harder without any real likelihood that the accommodation will ever be acted upon by congress…adding an unnecessary transaction cost. perhaps that is the realistic political price that needs to be paid.

            if I may make a speculative investment observation, this might explain while the junior prefs are outperforming the common currently. my view is that the market expects the IPO price to be disadvantaged by this cockamamie process, which will dilute the existing common. on the other hand, the junior pref, expected to be made an offe to convert into new common that the junior pref cant refuse, will participate in the new common received upon conversion at the price of the depressed IPO. I have been wrong before.

            rolg

            Liked by 2 people

  20. Tim,

    Maybe I am crazy, but it seems to me that there is an alternative scenario that no one is talking about. Maybe it’s unworkable, and then again, maybe it just makes too much sense for it to be a Government plan. That is why I come to the guru for counsel.

    The short question: why can’t Treasury and FHFA declare the senior preferred paid off, return the excess proceeds (or not), and then (for a hefty fee) declare that the original line of credit is still available to the companies while they are building capital through retained earnings, combined with the issuance of additional preferred stock if deemed necessary? After all, the Government has already declared that the line of credit is as good as actual capital. Why does that instantly stop being true because they are released from conservatorship?

    Short of another economic crisis, we all know the companies wouldn’t need to draw one penny from the Government for the foreseeable future. And let’s be honest, if another economic crisis hits any time soon, the solvency of the GSE’s will be the least of our (as a country) concerns. But I digress.

    Seriously, why isn’t this being floated as at least an option? I know the street doesn’t get to benefit from buying common (theoretically) on the cheap and that the preferred owners might not get their dividends back as quickly…and that some might say the Government is still on the hook for any catastrophic loses but doesn’t this make the most sense for everyone? The release can happen now, the value of the Government warrants is maximized, the current common holder’s value is preserved, the preferred holders go back to near par, and the market regains faith in how the Government treats private industry. What am I missing here?

    After 11 years in purgatory, why does the solution have to involve immediate recapitalization by any means?

    Thanks, as always.

    Cicero

    Liked by 2 people

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    1. What you’re missing are the politics and the reality of the current situation. Critics of Fannie and Freddie have contended for decades that the companies’ federal charters give private shareholders too favorable a position in the mortgage market, allowing them to earn “undeserved” returns and take too much risk. I think the latter charge is without foundation (if the companies’ charter is so valuable, the incentive would be to NOT take excessive risk, so as not to jeopardize its benefits), but I do think there is some basis for the former—that’s why I favor utility-like return limits as a condition of returning them to private ownership.

      Adding to the imbalance of benefits argument is the fact that, putting aside how we got here, Treasury now has a $193 billion liquidation preference in the companies and is getting all of their earnings as senior preferred stock dividends, which their opponents and critics have consistently (albeit falsely) characterized as just compensation to taxpayers for having saved them from failure in 2008.

      Yet as I discuss in the current post, even though Treasury has been a long-time critic of Fannie and Freddie’s role in the secondary market, I believe that it and FHFA will find they have no alternative but to return them to shareholder ownership, and in a way that capital market investors find acceptable. But they won’t just say to current shareholders, “Okay, we’re cancelling the senior preferred, we’ll release you from conservatorship, we’ll keep our backstop in place for a fee, and you can have as long as it takes you to reach our new capital requirements through retained earnings without our imposing any restrictions on your business.” For institutional, political and regulatory reasons, I think the recap process will work the other way, with Treasury and FHFA effectively saying, “What is the least we can give to these two companies and still have something that new shareholders will be willing to put $100 billion of new capital into?” I wish it were otherwise, but Treasury is in the driver’s seat in this process, and that’s how I think it will play it. (And it may even choose to wait to see if the Fifth Circuit makes its job easier by ruling against the government on the net worth sweep before it comes forth with its reform and recapitalization plan.)

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      1. @cicero

        I believe as a practical matter, the fed backstop line will need to stay in place as capital is built up (by retained earnings and primary stock issuances). otherwise I don’t see the capital raising process being successful; there needs to be a transition period where the capital line could be reduced as capital is built up, but it can’t be yanked away completely until the capital target is hit. I believe the Moelis blueprint is in accord. but I would agree with Tim that keeping the capital line as a substitute for raising new capital as earnings are built up to reach the capital target is a political bridge too far.

        @Tim

        this will be a capital raise like no other that I have seen. bankruptcy exits are a piece of cake compared to this. last one treasury did was easy: GM hived all of its assets off into a fresh newco under S. 365 and left old and cold creditors to pound sand. truly cut-throat. this will be far more delicate. one great and underrated financier, meshalum ricklis, once said I will let the seller name his price if I can name my terms. Wall Street will be in that drivers seat given the political risk in this process, notwithstanding the enviable GSE cash flows. I expect there will be a series of deals with serially improving terms along the way. like most things, this will take longer than people expect. but like most things, once the process truly get underway, momentum builds.

        rolg

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  21. Tim

    I have a naive question. while I understand the GSEs need additional capital, what will they do with the money proceeds from that equity capital? the GSEs are already quite profitable without the application of these proceeds. would they enter into new markets (Buffett referenced manufactured housing, self-interestedly), will they be able to increase the velocity of their securitization/guaranty business, would they “expand the credit box” to buy more mortgages or reduce G fees, would they simply pay off debt and become less leveraged, would they simply hold more working capital in the form of deposits (see WSJ: https://www.wsj.com/articles/big-banks-seek-to-liberate-billions-of-dollars-in-funds-11557135001)? How would a significant expansion of capital affect profitability?

    rolg

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    1. The simple answer is that if and when Fannie and Freddie raise new equity capital they will use the proceeds to pay down debt. What they can do beyond that will depend on their capital requirements. There will be a link between the final risk-based capital requirements, the guaranty fees the companies will need to charge to earn their target return on that capital, and the volume and mix of business they will be able to do. As the Center for Responsible Lending pointed out in its comment on the June 2018 FHFA capital standard, that version places a significant penalty on higher LTV-lower credit score business relative to higher-quality business (and the actual risk of the former set of loans). If that is not changed it will be difficult if not impossible for Fannie and Freddie to expand their “credit box” because their guaranty fees on this business will not be affordable for borrowers; to the contrary, the total amount of business the companies could do probably would shrink. Paying down debt with the proceeds of equity issuances will by itself be a modest positive to Fannie and Freddie’s earnings, but this positive could be swamped by the adverse effects of a mis-calibrated capital standard.

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  22. Tim, If the government decided to settle with shareholders and declare the senior pfds fully paid off, do you know if that will hurt the government budget in any way? Will there be a $189b writedown which could add to the deficit? How does this action get treated. Is there appetite for such an action (even if offset w/ warrant monetization). Thank you.

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    1. The most likely way the government would settle the net worth sweep lawsuits would be by declaring Fannie and Freddie’s dividend payments that exceeded 10 percent of their outstanding senior preferred stock as repayments of the principal of that stock. Following that method, as of today the senior preferred of both companies would be completely paid off, and Treasury would owe each one about $10 billion, which it likely would give to them as credits for their future federal income taxes. This would not add to the deficit, and should be relatively noncontroversial.

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  23. Tim

    from the transcript of today’s conference call on 1Q 2019 earnings:

    (CFO): “…In the first quarter our capital requirement under the proposed capital rule declined by 2% from $89 billion at the end of 2018 to approximately $87 billion. The decline in capital is primarily attributable to an increase in home prices and additional capital relief from credit risk transfers, partially offset by growth of our book of business. We use credit risk transfers to reduce the amount of capital we would be required to hold under FHFA’s proposed rule. For single-family, we have reduced our capital requirement for credit risk on recently purchased eligible loans by more than 75% through credit risk transfers… ”

    I find that 75% figure to be surprisingly large. this implies that while Fannie will require equity capital to support its existing book of business (and I assume this is approximately $87B), for so long as CRT transactions can be conducted they can be used as the primary source of new capital necessary to support new MBS generation. am I missing something?

    rolg

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  24. Hi Tim,
    In the Earnings Call today the CFO talked about changes in the account ‘CECL standards’ issued by FASB, which will most likely lead to a draw Q1 2020. Here is the quote:

    “Second, I’d like the touch on the current expected credit loss standard, or CECL. CECL is a new standard issued by FASB which we are required to implement by January 1st, 2020. Upon implementation, we expect to recognize a cumulative adjustment to our retained earnings, which could have a significant financial impact and possibly result in a draw on treasury in the first quarter of 2020 depending on many factors, including our first quarter 2020 earnings, the composition of our book and economic conditions and forecast at the time. Under CECL, we will need to reserve for the lifetime expected credit loss of our entire book of loans. Therefore, once implemented, CECL will likely introduce more volatility to our financial results due to its pro-cyclicality.”

    Would you care to state your thoughts on this, and what it may mean for the businesses. Do you know if CECL standards are mandatory? It seems problematic in conservatorship or not.

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      1. For ROLG’s question on the Fannie Mae CFO’s discussion of capital, yes, you are missing something, but more importantly I believe FHFA is as well. In the current post I addressed the need for FHFA to get Fannie and Freddie’s capital standard right prior to any recapitalization initiative, and this is why. The June 2018 version of the standard–which is what Fannie is using currently and is the basis for the CFO’s discussion here–has three features that interact to make it highly problematic, and potentially unworkable in a severe economic environment: it is linked to the current loan-to-value (CLTV) ratios of the company’s loans, it gives excessive capital credit for securitized credit loss transfers, and it is extremely conservative (by not counting guaranty fees as offsets to credit losses, among other things). I’ll briefly touch on each one. Fannie says its first quarter 2019 required capital was $87 billion. That’s 2.54 percent of the company’s total assets, and seems reasonable. BUT…it’s based on Fannie’s CLTV at March 31, 2019, which was just 57 percent compared with the book’s original average LTV of 76 percent, and the $87 billion figure also was reduced by credit for Fannie’s securitized CRTs. Two things will happen during a downturn: (a) Fannie’s CLTVs will rise to approach and perhaps even exceed its original LTV (during the crisis Fannie’s average CLTV got to be 8 percent HIGHER than its OLTV), and (b) the market for its CRTs will dry up. When each of these occurs, Fannie’s capital requirement under the current FHFA capital specification will skyrocket, and be made worse by the fact that FHFA calibrated the current standard to produce a “bank-like” ratio, without CRTs, at a time when the housing environment was very favorable. That conservatism won’t go away in a bad environment. Without a fix from FHFA, the interaction of these features could cause Fannie and Freddie’s capital requirement to double (to 5 percent) in a severe downturn, while the capital requirements of all other financial institutions stay essentially constant. That would be unprecedented, and disastrous; FHFA must fix this in the next version of it standard.

        For Tony’s question about the FASB’s new current expected credit loss (or CECL) standard that is scheduled to be implemented at the beginning of 2020, I don’t have much to add to what Fannie’s CFO said. There will be a large one-time addition to Fannie’s loss reserve in the first quarter of 2020, to reflect a shift from reserving for “incurred losses” as is being done currently to all expected future losses under CECL, which could exceed that quarter’s profits and the company’s $3.0 billion capital cushion, thus triggering a need for a draw. Subsequently, CECL will cause Fannie’s loss provisioning to be more volatile, and pro-cyclical. As the economy slows and home price growth does as well (or prices even fall), Fannie will have to significantly add to its loss reserves because the lifetime expected losses on its loans will rise (probably substantially), and these additions to the reserve will reduce current period income. Conversely, when the economy recovers Fannie will reduce its estimate of future credit losses and take dollars back OUT of its reserve, increasing income. I’m not a fan of this rule; I think it unnecessarily introduces accounting stress at a time that all financial institutions will be experiencing economic stress. But this consideration obviously hasn’t carried much weight with the FASB, because the CECL rule implementation seems to be on track.

        Finally, in answer to SimSla’s question, if Fannie and Freddie’s earnings are made more volatile by CECL, relative to what they had been previously, that should reduce their earnings multiple, and reduce their stock prices. This will add yet a further challenge to the investment bankers who will be working on the companies’ recapitalization (and leave even less room for Treasury and FHFA to add some of the constraints on Fannie and Freddie that the banks will be asking for, and still have the recap be successful).

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        1. How is CECL not akin to being able to predict the future? I don’t understand the world view of accountants that seem to think that everything works in some magical vacuum that adheres to their wants for ‘proper’ accounting.

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          1. There is some of that, which is one of the reasons I’m not a big fan of it. But when I was at Fannie we always did make “life of loan” projections for our credit losses, for capital planning purposes. And those projections do change with the cycle. What I object to is the accountants’ view that management must be blind to the business cycle. During my tenure as CFO at Fannie, neither the FASB nor the SEC were happy with companies’ practice of building their loss reserves up during good times and drawing them down on in bad times; they viewed that as improper earnings management. I thought it was common sense. But the SEC and the FASB make the rules; they want companies to do the opposite, and their view holds.

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        2. Tim

          “…it gives excessive capital credit for securitized credit loss transfers” .

          while I get your point from a system design point of view, I am not sure that I would object to this at the moment. There are significant headwinds to raising equity capital in an amount sufficient to take GSEs out of conservatorship, and any capital over-crediting re CRTs only serves, currently, to lower the required equity capital required to be raised over the near term.

          rolg

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          1. I see this problem differently, and for that reason believe it needs to be dealt with before the capital rule is made final and the size of the equity raise is determined.

            I believe that the first pass of the FHFA capital rule was a political compromise designed to have a “headline” number that was close to the banks’ Basel III number for mortgage holdings (but remember, those are holdings in portfolio that have significant interest rate risk because they typically are funded with short-term consumer deposits and purchased funds, and Basel does not require any capital for interest rate risk), but that then could be reduced to a more reasonable number if Fannie and Freddie use the securitized credit risk transfer (CRT) securities Treasury and FHFA have been requiring them to issue since 2013. This way, everybody gets something: the banks get the headline number they’ve asked for, Fannie and Freddie can reduce their capital–and charged guaranty fees–by issuing CRTs, which should please the affordable housing constituency, and Wall Street investors and dealers get to perpetuate two instruments (CAS and STACRs) that are very profitable for both.

            At first blush this might seem reasonable, but it’s a trap. CAS and STACRs will be easy for Fannie and Freddie to issue in good times, but as I’ve noted many times before, as soon as investors begin to fear that they may have to pay out more in principal losses than they can expect to receive in interest payments (i.e, as soon as investors begin to think that Fannie and Freddie’s issuance of these CRTs may actually be beneficial to them), they will pull out of that market. And at that point, two things will happen: (a) Fannie and Freddie will have to sharply raise their guaranty fees to price to their higher required capital without CRTs, and (b) they will have to raise as new equity the capital they thought they would be able to waive through CRT issuance–not just on any growth of their book but also on all the replacement of their prepaying and refinancing loans that occurs (which typically is heavy in downturns, when interest rates tend to be lowered by the Fed in response to the slump).

            The loss of CRT coverage and need to raise new equity will be happening at the worst possible time. In a severe downturn, Fannie and Freddie could have credit losses that exceed their net revenues, producing overall losses (as happened during the 2008-2011 period). The companies will need to tap the equity markets to replace that lost capital in order to remain in compliance with their capital requirements (if they don’t, they will be subject to being put into conservatorship again.) This challenge will be difficult enough without having to raise new equity to make up for the absence of CRT issues on the large volumes of new and replacement business the companies will be doing (and, if FHFA doesn’t fix this, also the rapidly increasing capital requirement triggered by rising current loan-to-value ratios). Investors like to buy equity in companies who raise it in before they need it, much less so in those that HAVE to raise it to avoid calamity.

            I understand that with the FHFA capital standards as they currently are configured the capital raise to get them out of conservatorship seems easier because of the CRT credits. But this just would be pushing a known unsolved problem into the future, which never is a good idea. Better to fix the flaws in the capital standard now, then go out and raise equity that will be adequate for the companies not just when it’s raised, but also in the future, even during times of stress.

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          2. Tim

            Thanks for thoughtful reply.

            for all that calabria has been vocal about recently, one wonders where he would fall in this debate re CRT’s role in the GSE capital regime. after all, calabria has not been a fan of securitization generically in the past (I believe he referred to it as a “false god”), and CRT’s are a type of securitization that finances not the mortgage market but the mortgage guarantors themselves. If anyone might come to the conclusion that CRTs had a role during conservatorship but that equity should be the sole capital source post-conservatorship (and that one should design a capital regime geared to this framework), one might think it would be calabria.

            Liked by 1 person

          3. The more i read your comments Tim, the less optimistic i am about any capital raise. If we do not win in court and reverse previous court opinions which say the conservator can do whatever he/she wishes than i do not see how new investors will be willing to invest. It seems for the capital raise to be successful we need a court victory and updated capital requirements. Both of these tasks seem pretty difficult as of today. And this is just the beginning. Investors will be mindful that in January 2020 the companies may require a new bailout so no equity raise in 2019 will happen otherwise there will be a repeat of the 2008 capital raise where investors put in money just to be told that they are wiped out.

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          4. I wasn’t intending my comments to be negative on the prospect of capital raising for the companies; I’m just trying to clarify some of the issues involved. I think that if Treasury and FHFA are truly committed to removing Fannie and Freddie from their ten-year plus conservatorships, they can get it done. The legislative path is blocked at least through the end of 2020, and if the past is any guide likely well beyond that. So it’s got to be done administratively. These are two very healthy companies, with strong, stable and predictable earnings, so it should be possible to recapitalize them.

            The net worth sweep certainly has to be ended. I think it would be better for Treasury and FHFA to do that voluntarily, but a favorable decision by the Fifth Circuit en banc would do it as well. FHFA also needs to get the companies’ capital standard right, but that’s entirely within their purview and capability. And the implementation of CECL need not be an obstacle. FHFA could suspend the sweep on June 30 (without it and Treasury canceling the Senior Preferred Stock Agreement, if they think it’s premature to do so then) to allow the companies to build enough capital to fund the enlarged reserve. And FHFA should count loss reserves toward meeting Fannie and Freddie’s capital requirements—both loss reserves and equity can be used to absorb credit losses, and are indistinguishable in that regard—so that an increase in loss reserves due to CECL should result in an equal decrease in required equity capital. (Note, though, that CECL still will lead to more earnings volatility for the companies post-implementation.)

            None of these problems are unsolvable. I’m simply trying to point out that they’re there, and shouldn’t be ignored or downplayed. If they’re handled properly, there’s no reason why Fannie and Freddie can’t be recapitalized successfully.

            Liked by 2 people

          5. Is there a reason for Calabria, Mnuchin, investors, or the companies themselves to have a preference for what proportion of the raised capital is in common and preferred shares?

            To me, the variability of the capital requirements points to the capital raise being done either entirely or mostly done with common shares. It is much easier to raise capital in the future, on an as-needed basis as the capital requirements change, with more preferred shares rather than commons, so the common equity will need to be built now.

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          6. That one’s tricky. By charter, in order to count as core capital for either Fannie or Freddie, junior preferred stock has to be noncumulative. Noncumulative preferred would in my view be easier to sell during the recap period than during a time of stress. But I’m happy to leave that call to the investment bankers.

            Liked by 2 people

          7. “And FHFA should count loss reserves toward meeting Fannie and Freddie’s capital requirements—both loss reserves and equity can be used to absorb credit losses, and are indistinguishable in that regard…”

            Tim, this is the first I’ve heard of using loss reserves as potential capital buffer (which will ultimately lower the amount of capital needed to raise in an IPO). Do you know how much loss reserves Fannie and Freddie have between the two?

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          8. As of December 31, 2018 Fannie had $14.2 billion in its total allowance for loan losses, and Freddie had $9.0 billion. Most of these allowances are for what are called “individually impaired loans,” however, and these won’t count as core capital. Of Fannie’s $14.2 billion in total loss allowances at the end of last year, $13.3 billion were for individually impaired loans (down from $46.5 billion at the end of 2011), and only $900 million were for collectively reserved loans. (I don’t have the comparable breakout for Freddie’s year-end 2018 allowance, but I assume it would be similar). The reserves that would be added under FASB’s CECL accounting would all fall into the collectively reserved loan category, and thus should qualify for core capital treatment (although FHFA will need to clarify that).

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  27. Tim et al.,

    What I can’t wrap my mind around is that one and the same administration employs the likes of Kudlow and Calabria, yet also has Mnuchin heading up the Treasury. If the assumptions are all true, namely (a) Kudlow and Calabria don’t get it at all and still oppose the GSEs, and that (b) Mnuchin does get it somewhat (though not fully) but does not have ideological blinders on, then how in the world did all three parties get together in the first place?! I’m dead serious. It’s a complete frenzy. I would’ve at least thought Mnuchin might have been consulted. If so and this is the team that *he* came up with, then maybe things are worse than I thought. Or did Trump and Pence come up with Kudlow and Calabria respectively?

    Given the crapshoot of how two of the three wise men were selected, it’s a bit unsettling that the roadshow might begin a learning curve on raising capital.

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    1. @ron

      there can and will be no learning curve on raising capital. this >$100B capital raise is for pros only, and there is no room for newbie baggage. at some point, once the treasury/hud plans have been submitted and capital targets have been specified, the capital markets bankers and lawyers will take over, although I admit I am rather concerned that each GSE has a new ceo. they will experience a trial by fire (thankfully, the GSEs are world class business organizations). I expect people like Kudlow who provide no value added will drop from the process once the bankers are retained, and while Calabria will certainly remain involved, fhfa’s lawyer (and here’s hoping for Calabria’s buddy Krimminger at Cleary Gottlieb) should tell him that the capital raising “quiet period” requires Calabria to adopt a “cone of silence.”

      rolg

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    2. Ron–My honest answer, before you look for synergy, forethought in appointments, some common ground, and–God forbid–“logic,” look who is making/approving these appointments and think if there is any precedent of past personnel successes???

      Short term the good GSE news is Mnuchin; hope he’s not forced out for marginal reasons.

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      1. Ron–

        If Mnuchin were involved in the selection of Kudlow for the head of the National Economic Council—and he may not have been—there would have many policy issues other than Fannie and Freddie that would have influenced how he weighed in on it. I do think Mnuchin would have been consulted on Calabria, and may even have had something close to veto power. I wasn’t puzzled at the time by the choice. I thought Calabria’s stance against the net worth sweep would have been a huge plus in Mnuchin’s eyes: it gives Treasury a considerable degree of cover should it end up reversing the sweep without a court telling him to do it—and the sweep will need to be reversed to recapitalize the companies. Even Calabria’s past pro-bank writings might have been viewed as a positive, because having him on the team makes it easier for Treasury and FHFA to go against what the banks want them to do, if that’s what it takes for the recap to be successful (and as I say in this post, I think it will be).

        I also draw a distinction between Calabria’s views on the sweep—which are based on a deep knowledge of the subject matter, as one of the principal drafters of HERA—and his views on Fannie and Freddie, which are NOT based on any detailed knowledge; they’re what you might expect from anyone who’s gotten their information on the companies from conservative think tanks and the media, rather than first-hand. Calabria is smart, and if presented with verifiable facts about Fannie and Freddie (which do exist), I think his views on them will change. Also, he’s going to be the junior partner in the recapitalization process, and once he learns that comments from the regulator about changing the companies’ charters are highly damaging to the capital-raising process he’ll conduct himself in a manner that’s supportive of the success of his and Mnuchin’s joint priority task.

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  28. Tim

    What are your thoughts about the POTUS memo request to assess both an explicit and implicit federal guarantee?

    at first I thought an implicit guarantee was stupid (how do you price a non-contractual guarantee); and then I considered for a second and thought it was brilliant. (not an uncommon occurrence for me). assuming that no explicit guarantee is passed by congress, an implicit paid-for guarantee as part of administrative reform should be an effective signal to the institutional market that the federal government stands behind the GSEs (and this signal should be credible because the GSEs are paying for the privilege of their charters, in effect). this should reduce GSE borrowing costs and serve to quiet some of the political risk chatter. agree?

    rolg

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    1. The White House memo doesn’t ask Treasury to “assess” an explicit and implicit federal guarantee; it sets as one of the conditions of releasing Fannie and Freddie from conservatorship that, “The Federal government is fully compensated for the explicit and implicit guarantees provided by it to the GSEs or any successor entities in the form of an ongoing payment to the United States.”

      I’m not sure how one would define an “implicit federal guarantee,” but I agree with you that some type of formal arrangement between Treasury and Fannie and Freddie would highly desirable, if not essential, for the companies to be able to keep their MBS (and debt) as eligible investments for those categories of investors who would not be able to purchase them otherwise. Moelis, as you know, has the companies paying the government to transform the existing PSPA backstop into “an explicit, limited, second-loss catastrophic loss guarantee that would be called upon only when robust private capital reserves were fully exhausted.” I proposed a similar arrangement in my reform essay for the Urban Institute, “Fixing What Works.” There should be a link between the cost of any implicit or explicit government guaranty and the degree of credit losses the companies could withstand based on the severity of the stress test FHFA imposes on them–with the greater severity of that stress corresponding with a lower cost of the federal support that would kick in subsequently. Through this link, the cost of the guaranty should be partially (or even largely) recouped through lower option-adjusted spreads to Treasuries of the companies’ MBS and debt.

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  29. Tim,

    This post feels very much like the introduction to the climactic chapter of a story. Let’s hope the dramatic conclusion comes soon and is Moelis.

    Cheers,
    Justin

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  30. This accurate and articulate historical and investment summary needs to be absorbed and disseminated thru all news and information channels – but the opposing fraudulent but powerful groups mentioned will blindly fight it. Courts – justice – sound lawmakers – we need you! Thank you Tim.

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  31. So far, the investors are staying on the sidelines which is evidence of their caution when it comes to the Government’s handling of the Conservatorships and the pathway out, for good reason.

    Thanks to Tim for the post!

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  32. Tim,
    Thank you for your insight and clarity….few questions….please remember, newbie here and still learning.
    Do you feel the “powers that be” will be less or more inclined to resign to the fact a Moelis-style reform is the path to a more likely success, as all these obstacles you mention start to become obvious?
    If not how do they close the gap here enough to bring this to the finish line and still appease the parties involved?
    Lastly, If the banks don’t get what they want what’s to stop the administration from just throwing their hands in the air and saying “oh, well we tried” and rather keep them in this state of limbo instead of letting the twins back on the field….

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    1. As I said in the post, “It won’t be an easy process.” And it’s not so much that “a Moelis style reform is the path to a more likely success;” I believe it’s the ONLY path to successfully removing Fannie and Freddie from conservatorship. Bank-supported legislative plans have failed because they all have had the intent of creating weak and ineffective secondary market credit guarantors, and that’s just too risky a proposition to get Congress to endorse, given the importance of housing to our economy. It’s possible that Treasury may dither on agreeing to reconstitute Fannie and Freddie in a way that will permit them to raise the amount of capital required for their release, but that’s where a favorable decision from the Fifth Circuit would make a difference. If the net worth sweep is reversed and these very profitable companies begin retaining their earnings as capital, it will be very difficult for Treasury and FHFA to claim that they haven’t been “conserved” and therefore must be returned to private ownership.

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  35. “For investors to put new capital into Fannie and Freddie, the companies must be set up to succeed, not struggle.”

    The GSEs are not going to be able to raise >$100B of new capital with risk factors in their offering documents highlighting the political risk posed by calls for charter elimination, bank competition and footprint shrinking.

    As you suggest, the process will begin to take shape and the capital-raising bus will be leaving the depot, and the requirements posed by that process will place institutional investors at the table rather then bank lobbyists, and somewhere along that process either the focus will turn to selling GSE stock based upon a framework of GSE strength and viability, or the process will grind to a halt. Raising money has a way of exposing reality.

    Treasury Secretary Mnuchin understands this, and I expect Mnuchin does not want to be associated with a very large and public failed capital raising process. herewith, a prayer that once the capital-raising process begins, it is conducted in a fashion that promotes, rather than detracts from, successful execution.

    Tim, great review of this decade long saga of failure at the behest of “policy expert” bureaucrats pursuing their own “false gods”, and one hopes that once the enormity and strictures of the capital raising process begins, these finance know-nothings realize they have nothing of value to add and potential to do great harm. You are either on the bus or you are off the bus.

    rolg

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    1. Thanks Tim!!! Hope when Treasury and FHFA team (Munichin / Calabria) meet again they would start their meeting dissecting and discussing this well written narrative of what administrative reform they must agree to recommend to the POTUS.

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    1. Nice summary and close to go with title. I pray Trump and Mnuchin stick to their appeared original thinking or prior to election beliefs these are private companies who did not cause the financial crisis, and should be recapped and released. Very disappointing to hear Kudlow talks out both sides of his mouth and only cares about self interests or TBTF. I think you are right Mr. Howard! In the end, they will have no choice.

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