Assessing the FHFA Capital Rule

A persistent theme of this blog has been the crucial role that a revised capital standard for Fannie and Freddie will play in determining how effectively and efficiently the companies will be able to carry out their traditional function of profitably providing large volumes of affordable mortgage financing to a wide range of borrower types in a post-conservatorship world.

Since the conservatorships, opponents and critics of the companies have insisted that any future version of them as shareholder-owned companies include the requirement that they hold “bank-like” amounts of capital. This demand has been couched in terms of safety and soundness (“more capital is better”), but in fact the goal of advocates of this approach is to burden Fannie and Freddie with capital requirements that are far out of proportion to the risks of the mortgages they finance, forcing them to raise their guaranty fees to levels that make their secondary market activities overpriced and less competitive, to the benefit of primary market lenders. As I’ve often noted, there is no economic or regulatory reason why Fannie and Freddie’s capital should be equal or anywhere close to that of commercial banks. Fannie and Freddie are not multi-product and multinational lenders; they are mono-line insurance companies, limited to a single asset type—residential mortgages—whose historical credit loss performance has been dramatically better than banks.

Last June, FHFA put a Proposed Rule for Enterprise Capital out for comment. I was among many who submitted one. While I didn’t say this in my comment letter, it was clear to me that in its specification of the risk-based standard mandated by the Housing and Economic Development Act (HERA), FHFA had used a combination of unrealistic structural elements and conservative assumptions to push Fannie and Freddie’s calculated capital requirement substantially higher, to 3.24 percent as of September 30, 2017. My comment addressed the elements and assumptions I thought were unjustified—including not counting guaranty fees as offsets to credit losses—and I suggested ways that FHFA could and should improve the quality and accuracy of its risk-based capital specification to align it much more closely with the risks of the mortgages the companies are guaranteeing and the way their business works. A number of other commenters made similar observations.

FHFA’s revised capital proposal is due to be released shortly, so it was with considerable concern that I read the recent spate of comments by the new FHFA Director, Mark Calabria, repeating the general (and insupportable) assertion that “Fannie and Freddie ought to operate under essentially the same capital rules as other large financial institutions.” These statements raised the possibility that he had chosen to side with the companies’ opponents on the capital issue, but I also thought he might not know the facts about the differences in risk between Fannie and Freddie’s business and that of commercial banks. So last week I wrote a two-page note for the Director and sent it to FHFA General Counsel Alfred Pollard, asking him to submit it both for the record and to Calabria. Here is what the note said:

“A recent interview with Fox Business News quoted you as saying, ‘I think our objective over time is that you have capital levels at Fannie and Freddie that are comparable to other large financial institutions,’ and that 4.5 percent capital was ‘kind of in the neighborhood of where we’re looking at.’

While I agree that Fannie and Freddie’s capital should be comparable to that of other large financial institutions, comparable is not the same as equal. Capital must be related to risk, and if FHFA engineers its risk-based capital standard for Fannie and Freddie’s credit guarantees to produce an average capital percentage equal or even close to banks’ Basel III risk-weighted capital percentage for residential mortgages of 4.5 percent, the companies’ capital standard would be far more stringent than banks’, because: (a) the delinquency and default rates of single-family mortgages owned or guaranteed by Fannie and Freddie have been less than one-third those of residential mortgages held by banks, and (b) bank capital also must cover the interest rate risk of funding mortgages in portfolio, whereas Fannie and Freddie’s capital standards treat credit and interest rate risks separately, and additively.

Historical data on single-family residential mortgage delinquencies and defaults for Fannie and Freddie versus commercial banks are readily available from the companies themselves and from the FDIC and Federal Reserve, and they tell a clear and consistent story.

During the time I was Fannie’s CFO from 1990 through 2004, the company’s rate of single-family serious delinquencies (90 days or more past due) averaged about 55 basis points, while over the same period the average serious delinquency rate for residential mortgages held on the balance sheets of commercial banks was 2.3 percent. Following the financial crisis both delinquency rates spiked, peaking in the first quarter of 2010—Fannie’s at 5.53 percent and banks’ at 11.54 percent. Both have since declined substantially, but banks’ 2.67 percent serious delinquency rate on residential mortgages in the first quarter of this year still was three and a half times Fannie’s 75 basis-point delinquency rate. In addition, Fannie now publishes its serious delinquency rate on the single-family loans it has guaranteed or purchased since the end of 2008, when it tightened its underwriting standards. These loans now make up 93 percent of Fannie’s total book, and their rate of serious delinquency in the first quarter of 2019 was only 33 basis points.

Post-crisis default rates tell a similar story. In the amicus curiae brief I submitted on July 6, 2015 for a court case involving Fannie and Freddie I noted, ‘Solid data now exist, and they show that, from 2008 through 2014, the average loss rate on residential mortgages owned or guaranteed by Fannie and Freddie was 0.45 percent per year. The loss rate for residential mortgages owned by commercial banks during this same period was 1.43 percent per year—more than three times as high.’

Most people are surprised to learn that single-family mortgage delinquency and default rates at commercial banks consistently exceed the comparable rates recorded at Fannie and Freddie, by a factor of three. I believe the primary reason is that banks finance a much greater percentage of home equity loans. But whatever the reason, banks’ much higher delinquency and default rates mean that Fannie and Freddie can provide an equal degree of protection against mortgage credit risk with one-third the capital that banks require.

A second critical consideration for determining what constitutes a level playing field on capital for banks and Fannie and Freddie is the fact that banks’ 4.5 percent Basel III capital requirement for single-family mortgages has to cover not just credit risk but also the risk of financing 30-year fixed-rate and capped adjustable-rate mortgages with consumer deposits and short-term purchased funds. Capital standards for Fannie and Freddie treat these risks separately; currently they have a 45-basis point minimum for guaranteed mortgages (now universally viewed as too little), and a 250-basis point minimum for mortgages financed in portfolio. The companies thus have to hold 205 basis points in interest rate risk-related capital for their on-balance sheet mortgages, even though they can and do match their durations with a combination of long-term debt and derivatives, and constantly ‘rebalance’ to keep those durations matched as interest rates change. Since banks have more interest rate risk in their mortgage portfolios than Fannie and Freddie, the capital required for the interest rate risk they bear should be higher as well.

A true level playing field on capital between banks’ on-balance sheet mortgage holdings and Fannie and Freddie’s single-family credit guaranty business, therefore, is nowhere near 4.5 percent. Banks’ 4.5 percent capital ratio properly applies to the companies’ portfolio holdings, making their credit risk capital no more than 2.5 percent (4.5 percent less at least 2.0 percent for interest rate risk), and the huge differential between banks’ and Fannie and Freddie’s historical credit performance should further reduce the companies’ required capital for their credit guaranty business—to a maximum of 1.5 percent, and arguably less.

For the above reasons, a very good case can be made for FHFA to set 1.5 percent as the minimum capital requirement for Fannie and Freddie’s credit guaranty business, and 3.5 percent as the minimum for their portfolio mortgages. More importantly, it would be a serious mistake for FHFA to employ layered conservative assumptions to push the capital percentage required by its risk-based capital stress test artificially high, in order to make it look more ‘bank-like.’ Doing so is unjustified, and would decouple the capital and pricing for the mortgages the companies guarantee from their true risks, making their services more expensive and less efficient for no good reason, to the disadvantage of the low- and moderate-income homebuyers Fannie and Freddie were chartered to serve.”

Once these facts about relative mortgage risks are known and acknowledged, it becomes obvious that it is incorrect to impose a bank-like capital standard on Fannie and Freddie. On top of that, as Fannie (and I) discovered more than thirty years ago, the correct way to specify a risk-based capital standard is nearly as obvious.

Prior to the early 1980s Fannie had done all of its business as portfolio purchases, funded with debt. Not long after I joined the company it began issuing mortgage-backed securities (MBS) using pools of newly-originated mortgages for which it bore the risk of loss, rather than having recourse to the originating lender. Fannie’s charter had been tailored for an entity that financed all of its mortgages on-balance sheet, so its new MBS, which for Fannie as well as Freddie were considered contingent liabilities and thus accounted for off-balance sheet, had no required regulatory capital. We had to determine how to capitalize, and then price, these credit guarantees ourselves.

The stress-test based approach we adopted was virtually identical to what FHFA should be doing to specify the risk-based capital requirement for Fannie and Freddie mandated by HERA. First, you use historical data to pick a defined degree of credit stress you want to be able to survive. (We initially picked a credit loss rate we deemed to have less than a one percent chance of occurring, later tightening that to a one-half of one percent chance; under HERA, FHFA gets to pick whatever loss scenario it wishes.) Next, you take your existing book of business with its fee rates, and break it into “buckets” of product types and risk combinations. Assuming no replacement business, you then simulate the performance of each of these buckets using different amounts of initial capital until you determine the exact amount of capital that, when combined with the guaranty fee income from the loans you project to remain outstanding during the stress period and allowing for projected administrative expenses, just allows that bucket of loans to survive the loss scenario you’ve chosen. Finally, you add a reasonable, clearly identified cushion of conservatism, and you have your required capital percentages. It’s that simple.

Unlike banks’ ratio-based standards, Fannie and Freddie’s stress-based capital calculations adjust automatically as the riskiness of their business changes, because they’re done at the risk and the product level. If FHFA wants to be even more conservative, it should pick a higher threshold of stress for the companies to meet (and defend that choice), rather than use unrealistic or unjustified elements to force the capital requirements higher. The latter break the link between capital and risk, and also affect Fannie and Freddie’s ability to attract a broad and profitable a range of business. FHFA’s decision in last year’s proposal not to count guaranty fee income in the stress test illustrates this problem. A properly designed risk-based standard permits the companies to trade off initial capital, guaranty fees and return targets to manage their mix of business, while remaining in capital compliance. For certain loan types it may make sense to charge a lower guaranty fee and compensate with higher initial capital (and thus accept a lower expected return); for other business a higher guaranty fee and lower initial capital may be the right choice. If guaranty fees are not counted in the stress test, however, this flexibility is lost. As a general rule, any significant distortions in the specification of the risk-based capital standard will constrain how the companies can do their business, sometimes in unpredictable ways.

There truly is a right and a wrong way to specify a risk-based capital standard, and the difference between the two is evident. When FHFA releases its revised capital proposal, therefore, there will be little doubt as to whether it has made a straightforward attempt to produce an accurate risk-based standard, engineered the exercise to produce a particular predetermined outcome, or tried to land somewhere in the middle.

Potential investors in a recapitalization of Fannie and Freddie should pay close attention to where FHFA comes out on this proposal, because it will be a window into the agency’s likely regulatory posture with respect to the companies post-conservatorship. At the one extreme, if FHFA makes only minor changes to its June 2018 capital proposal, this would strongly indicate that it intends to favor ideology and politics over economics in its future regulation, which should be a bright red light for any investor with a functioning memory. At the other extreme, a clean risk-based capital standard—which would result in the least amount of unnecessary capital, the lowest average guaranty fees, and the most flexibility to use cross-subsidization to broaden the companies’ product mix and support affordable housing—would be a green light for investment.

A middle-ground outcome on the capital standard, however, seems to be the most likely, and it will be the hardest for investors to evaluate. In this case, they will be well advised to closely examine the details of the proposed standard, assess the potential for any aspects of it to be used to their disadvantage, and insist that anything objectionable be remedied to their satisfaction before they agree to put new capital into the companies. Investors never will have as much influence in determining how the next version of Fannie and Freddie will operate and be regulated as they will prior to a first round of equity raising.

98 thoughts on “Assessing the FHFA Capital Rule

  1. Tim,

    I have seen some speculation that releasing Fannie and Freddie might be difficult because it could cause ratings agencies to downgrade the MBS, potentially shaking up the market ahead of election season. This seems to either ignore the fact that Treasury’s line of credit is limited to around $200B ($400B from the SPSPAs minus the amount already drawn), i.e. that there is not an unlimited government guarantee in place right now, or it makes the assumption that the government will make MBS holders whole no matter what while Fannie and Freddie are in conservatorship but might change their minds if the companies are released.

    As rolg has correctly pointed out in a Twitter response to Christopher Whalen, right now Fannie and Freddie have around $6B in capital ahead of a $200B line of credit with Treasury. If FHFA and Treasury are able to raise their desired level of capital while keeping the line of credit intact (with Fannie and Freddie paying a commitment fee for it, in keeping with the presidential memo), there would be $150B, or whatever number Calabria decides on, of private capital ahead of the same $200B Treasury line of credit. I fail to see how this would warrant a ratings downgrade. If anything, that would be cause for an upgrade! I would appreciate your thoughts on this. To me, it’s just another big bank false narrative with the aim of either slowing down or stopping recap and release.

    Liked by 1 person

    1. If Treasury wants to release Fannie and Freddie from conservatorship there are a number of types of contingent support arrangements it could arrange with them–including a paid-for backstop facility, triggered by a loss of capital to some minimal threshold level–that would maintain the credit ratings on their debt and MBS as well as ensure that these securities remain eligible investments for international investors (as they are now). The “ratings-downgrade-if-released-from-conservatorship” is another hair-on-fire scare story cooked up by those who don’t want the companies released.

      Liked by 1 person

      1. Gee, such a ‘contigent support arrangement’ (otherwise called an ‘explict guarantee’) would require Congressional action. Unless you beleive SecTsy can appropriate funds to the GSEs without Congressional approval.

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        1. Not necessarily. If Treasury were to endorse the new FHFA capital standards as making the risk of the companies losing all of their capital “extremely remote,” I believe a further layer of catastrophic insurance could be arranged with private reinsurance companies for a very reasonable annual premium.

          Liked by 1 person

        2. @egar

          let’s be clear here. read HERA. it says that the current existing treasury backstop is “appropriated”. there is some $200B of remaining congressionally funded backstop for the GSEs THAT IS ALREADY IN PLACE. I do all caps because the MBA group (which may or may not include you) doesn’t seem to get it. congress doesn’t need to do anything!

          read the statue!

          rolg

          Liked by 1 person

  2. Cooper & Kirk Lawyers
    A Professional Limited Liability Company
    David H. Thompson
    (202) 220-9659
    dthompson@cooperkirk.com
    Via ECF 1523
    New Hampshire Avenue,
    N.W. Washington, D.C. 20036
    July 15, 2019

    Lyle W. Cayce
    Clerk of Court United States Court of Appeals for the Fifth Circuit
    600 S. Maestri Place New Orleans, LA 70130-3408
    (202) 220-9600
    Fax (202) 220-9601

    Re: Collins v. Federal Housing Finance Agency,
    No. 17-20364

    Dear Mr. Cayce:

    It is no coincidence that since the current President took office the Department of Justice has had one position on FHFA’s constitutionality and FHFA has had three. FHFA’s latest switch, prompted once again by a change in leadership at the agency, only further underscores how this agency’s novel structure places vast executive power in the hands of a single individual who is wholly unaccountable to the President. Humphrey’s Executor blessed the FTC’s independence because in that case independence—combined with leadership from a commission whose members serve staggered terms—was thought to promote continuity and expertise at the agency. In FHFA’s case, independence achieves the opposite of continuity by leaving critical policy decisions up to the whim of whichever individual happens to sit atop the organizational chart of an agency that answers to no one. FHFA was right the second time, not the first or the third.

    Respectfully submitted,

    /s/ David H. Thompson

    Liked by 1 person

    1. @Brian

      a particularly effective piece of advocacy, that points out that D’s conduct makes P’s argument for P.

      while I expect it is too late to affect the en banc decision making (though the argument could be tucked into an opinion before publication), Thompson’s point addresses a concern held by at least one 5th circuit judge (Higginbottom) that leans to the govt side. in the All American oral argument he asked P counsel (in context of the CFPB) where to draw line; is single director removable only for cause the constitutional flaw, or do you also need insulation from congressional appropriation etc. he said that if the court were to advise congress on where the constitutional line is to be drawn (which is not the court’s duty in the exercise of its Article III judicial power), what would be the answer.

      by pointing out to the court that the FHFA single director before the court switched positions two times in a full 360 spin during a single argument, Thompson is able to show the judges inclined to follow Higginbottom that the single director insulated from removal doesn’t produce the expertise development and continuity benefits thought to underlie the multi-member commissions in the original SCOTUS case examining insulation of directors from POTUS removal.

      rolg

      Liked by 2 people

  3. Tim

    today we have two news pieces: https://www.bloomberg.com/news/articles/2019-07-12/trump-team-grows-wary-of-fannie-freddie-fix-before-2020-election and https://www.marketwatch.com/story/fannie-freddie-overhaul-could-mean-windfall-for-preferred-stock-analyst-says-2019-07-12?mod=mw_share_twitter

    the first is written by a partisan (anti-GSE) Bloomberg news organization that, I have read, pays more money to its Bloomberg journalists for moving markets. the second is written by a securities analyst who makes more money by making money for his firm’s clients.

    I dont know which article is or will prove more prescient, although I think you can find no better example as to how politics and finance are ill-suited dance partners than this comparison.

    rolg

    Liked by 2 people

    1. I saw the headlines, but haven’t yet been able to read any of the stories. I’ll be traveling back to the U.S. today and won’t have have any informed commentary on anything until sometime tomorrow. In the meantime, I’ll remind readers that mere expressions of opinion (or frustration) about recent developments, without either new information or insightful analysis, will be deleted once I re-engage with the blog, so you may wish to consider saving time by not posting them in the first place.

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        1. Great update to that article 25 mins ago:

          ““The president earlier this year instructed the Department of Treasury to develop a comprehensive plan for bold reform,” White House spokesman Judd Deere said in an email statement. The National Economic Council, Treasury, Federal Housing Finance Agency and others “continue to work together on this presidential priority and anything to suggest otherwise is false,” Deere said.”

          Bloomberg seems to like to print things first from anon sources, only to have the parties involved correct them after the market has moved on their earlier reporting. Bonus achieved.

          Liked by 1 person

          1. This clarification from the White House was helpful in clearing up the confusion created by the original Bloomberg article, but there are two cautionary elements in it. The National Economic Council (NEC), headed by Larry Kudlow who is no friend of Fannie and Freddie, is mentioned first in the list of those who “continue to work together on this presidential priority,” and consistent with that, the group’s efforts are described as developing “a comprehensive plan for bold reform.” The idea that you can’t remove Fannie and Freddie from conservatorship without a bold and comprehensive overhaul of the (“old, flawed”) system has been the pretext for keeping the companies under government control for over a decade. The NEC, at least, seems to be sticking with this playbook. We should know in fairly short order whether their influence prevails within the administration.

            Liked by 2 people

          2. Tim

            “bold” reform caught my eye as well. I concluded that if both admin and congressional reform was achieved (based upon Mnuchin’s desire for bipartisan congressional involvement and Calabria’s suggestions to congress), the result would be bold…including fed mbs guaranty and multiple charters. if just admin reform, less bold.

            rolg

            Liked by 1 person

          3. On legislation, Senate Banking Committee Member Mike Rounds was quoted this past Thursday 7/11 saying regarding congressional GSE Reform efforts, “I wish I could say it was going somewhere. It ain’t.” Per a Thursday 7/11 tweet from ACG Analytics (@ACGAnalytics). A google search indicates Rounds spoke that day at a Venable LLP Event. Interesting to hear this now from a Republican member of the Senate Banking Committee.

            Liked by 1 person

          4. No one expects legislative mortgage reform in the foreseeable future. The question now is: what form will the administrative reform piece take? If Mnuchin and the Treasury are driving the process, I would expect it to be consumer- and investor-friendly, and be designed to result in the removal of Fannie and Freddie from conservatorship in a manner that still could be described as “reasonably fast.” If, on the other hand, the anti-Fannie and Freddie forces within the administration, led by NEC Director Kudlow, have taken control, I would expect the process to be bank-friendly and take much longer, allowing for more opportunity for potential future legislative changes.

            What would pro-bank administrative reform of Fannie and Freddie look like? It would start with few significant changes to the capital standards promulgated by FHFA in June 2018, which were engineered to produce much higher required capital than warranted by the risks of the companies’ business. There then would be an agreement between FHFA and Treasury to cancel the net worth sweep, followed by Treasury’s conversion of its warrants to acquire 79.9 percent of the companies’ common stock. Next, FHFA would direct the companies to come up with plans to achieve their new required capital percentages, which when met would trigger their release from conservatorship. If, given the regulatory and capital requirements FHFA intended to impose upon Fannie and Freddie, investors were willing to put new equity into them, great; if not the companies would remain under FHFA control until they could achieve their target capital percentages through retained earnings, which would take many years but could be done more quickly by “shrinking their footprints.”

            I’m not predicting that this bank-friendly approach to administrative reform will be the one chosen—indeed I dearly hope it’s not. But I do believe there are strong advocates for it.

            Liked by 2 people

          5. Tim

            ex-Freddie ceo Layton just laid out that “baseline” in a WSJ article:

            “Four or five years of retained earnings, then do an IPO of more-likely digestible size that would be contemporaneous with the conservatorship ending and with the shareholders getting their full rights. That’s the baseline. I know a lot of people who would love to accelerate from that, but then they have to deal with all of these trade-offs. That acceleration is one area that’s hard.”

            https://www.wsj.com/articles/former-freddie-mac-ceo-plans-to-keep-hand-in-housing-finance-11562932800?mod=searchresults&page=1&pos=1

            but of course, if the first stage of the recap process can be a re-IPO at the beginning, then the process accelerates and disincentivizes MBA-moral hazard. can the re-IPO occur upfront while GSEs are still in conservatorship? Layton seems to be inclined to think not, but then again, the GSEs have generated >$200B in free cash flow while in conservatorship, so it would seem prudent to give it a shot.

            rolg

            Liked by 1 person

          6. I read the Layton interview. In the spectrum of outcomes I described in the current post for the upcoming revision of the FHFA capital rule–from a “straightforward attempt to produce an accurate risk-based standard,” to one “engineered…to produce a particular predetermined outcome” [favored by the banks], or an attempt to “land somewhere in the middle”–the scenario described by Layton would fall between the middle and the bank-desired alternatives.

            The administration SHOULD do the Fannie/Freddie capital and regulatory reforms in a way that meets rigorous safety and soundness standards comparable (but not equal) to those imposed on other financial institutions, while leaving the companies in the best position to provide the lowest-cost mortgage credit guarantees to the widest possible range of potential homebuyers. That would be best for consumers, the economy, and our financial system. But unfortunately competitive, ideological and political considerations all but rule out the optimum outcome. So now we wait to see how far from the “most homebuyer friendly” towards the “most bank friendly” end of the spectrum Treasury and FHFA elect to go. The point I’ve tried to make with my last few comments is that the amount of new equity supplied by investors will decrease, and the length of time it will take to complete the recap will increase, the further from homebuyer-friendly toward bank-friendly Treasury and FHFA’s “reforms” for Fannie and Freddie end up.

            Liked by 3 people

  4. Tim interesting comment from Paul muoulo
    pmuolo@imfpubs.com, bivey@imfpubs.com

    “If you’re wondering why everyone in the mortgage industry is waiting with bated breath for the new capital standards for Fannie Mae and Freddie Mac, it’s simple: Those standards, once cast in stone, will give the Federal Housing Finance Agency a powerful tool. One GSE observer who used to work on Capitol Hill told IMFnews those standards will give the FHFA legal cover to declare Fannie (or Freddie, take your pick) “critically” undercapitalized. Once that determination is made, the agency can move to terminate the conservatorship and enter into a receivership…

    The next step might be to create a limited liability regulated entity (LLRE) which would succeed the GSE. After that, the LLRE (once capital is raised) becomes a new company and the charter is sold to new owners. From what we understand, the FHFA has the legal power to sell the charter. We also understand that the Treasury Department under former Senior Counselor Craig Phillips was well aware of all of this. More to come in the weeks ahead.”

    Care to comment?

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    1. This is a nothing story. The option for FHFA to put Fannie and Freddie into receivership has existed since it and Treasury decided to use book accounting entries to exhaust all of their capital back in 2008, and it was kept alive when FHFA and Treasury agreed to the net worth sweep in 2012 in order to keep the income from the end or the reversal of those book expenses from becoming retained earnings (i.e., capital) at the companies. FHFA has not put Fannie and Freddie into receivership during all this time for one simple reason–neither it nor Congress has been able to come up with a replacement for them. The pending capital standards don’t change either FHFA’s options or its likely decision with respect to those options in any way. Another scoop from IMF (“Hold the back page.”)

      Liked by 5 people

        1. Michael Bright, now at SFIG and the author of Corker’s legislation that called for receivership, is the only main GSE opponent left who used to work on the Hill.

          Some tigers never change their stripes.

          Like

    1. I am not surprised that Calabria would reverse Acting Director Joseph Otting’s decision in January to withdraw FHFA’s prior assertion that the agency was constitutionally structured, reverting to the original position that FHFA’s single director removable only for cause IS constitutional. (Among other reasons, the current structure gives Calabria more power to do what he wants, for the remainder of his term.) But I AM surprised Calabria also also defended the legitimacy of the net worth sweep (if indeed he did; the Breitbart article says so, but I’ve not seen the actual letter). As a private consultant, Calabria had been consistently and forcefully outspoken about the illegality of the sweep. If true, this would be a striking example of the maxim “where one stands depends upon where one sits.” It also would not be a good sign for FHFA putting itself behind an administrative release of Fannie and Freddie from conservatorship, without a court invalidating the net worth sweep Calabria now says he supports.

      Liked by 3 people

      1. Thank you Tim. I owe you a nice meal if you’re ever in the D.C. metro. You are incredibly insightful on this topic, and you are one of the good ones. Thanks

        Like

      2. Tim,

        Supporting the NWS would mean (a) supporting an interpretation of HERA that allowed for the NWS. It could also mean (b) supporting the NWS decision as a solution, at the time, to end the “circular borrowing.” However, and as strange as it is for Calabria now to support the NWS in those two ways, I don’t think such support would make it inconsistent with (c) supporting putting an end to the NWS so that the GSEs can begin to retain capital.

        (a) is strictly a legal consideration.

        (b) pertains to a (dubious) practical concern during a state of affairs specific to 2012.

        Whereas (c) is justifiable based upon GSE reform giving way to recapitalization concerns.

        Thoughts?

        Liked by 1 person

        1. These are plausible interpretations, but given everything else Calabria has said and done since he became Director of FHFA, it’s hard for me to view his letter to the Fifth Circuit judges as anything other than throwing more sand in the gears of administrative reform.

          Liked by 4 people

      3. This is the correct reading (from Wiggins on COBH):

        It makes sense that Calabria would reverse direction regarding the constitutionality of HERA, given that he helped write it and he keeps an original dog-eared copy of it. In that sense, perhaps he is merely arguing that an unconstitutional structure cannot be a reason for the NWS to be invalid. A key sentence supporting this is: “At all relevant times FHFA argued and continues to argue the issue does not affect the Third Amendment’s validity.”
        I believe his prior arguments against the validity of the NWS were based on the fact that it does not fall within the power of a conservator, i.e. the APA claim. He doesn’t speak to this in this latest letter. Does anyone else see it this way?

        Liked by 4 people

        1. first, this last minute about face by calabria on the separation of powers claim is completely amateurish and makes fhfa look foolish. the en banc 5th C judges have been twisted a full 360 degrees on this and must be laughing in their chambers. my bet is that the majority opinion(s) are written and the dissents are soon to be finished, so this embarrassing letter likely is to be given no weight by the en banc.

          second, calabria did not touch upon the APA claim. fhfa has always argued that no relief should be given for the separation of powers claim, first because removal of single director only for cause was constitutional, second because even though it was unconstitutional no remedy should be provided Ps, and third back to it was constitutional.

          why would Calabria do this? lots of possible reasons: make the deal with mnuchin look more at arms length between co-equal officials, protect himself and the recap/release beyond 2020 in case trump loses election, tell treasury that calabria has final say about capital etc.

          rolg

          Liked by 4 people

          1. Another question, why deny the constitutionality of FHFA in the first place? Would Otting have presumed to make such a decision on his own (especially in his temporary capacity)?

            It’s all so bizarre. I can’t even attribute a calculated scheme to this given all the flip flopping, even accusatory remarks regarding funding Obamacare and other programs. At least the previous two administrations were consistent in their takings.

            Like

          2. I’ve been traveling outside the country this week (returning tomorrow evening) and haven’t been able to follow either the most recent developments in the mortgage finance arena or the postings on this blog in anything close to real time. I finally read the letter Robert Katerberg wrote to the Clerk of the Court of the Fifth Circuit, and see that Breitbart did get the story wrong–Calabria did not reverse his position on the legality of the net worth sweep. That makes this filing less concerning, and for me at any rate merely curious, given that almost six months have passed since the oral argument before the Fifth Circuit and, as ROLG notes, the sixteen judges almost certainly have decided where they stand on the issues before them and why. Katerberg’s letter is unlikely to change any of that.

            Liked by 2 people

          3. @ron

            fhfa and treasury will soon, one hopes if not expects, be negotiating a deal to settle litigation, both against Ps, and to lay out the basis for a recap, fhfa in the capacity as conservator representing the GSEs as debtor and treasury in the capacity as creditor (though re senior preferred stock rather than debt).

            so fhfa and treasury optically should assume an arms’-length relationship, even as their interests are aligned…both want the GSEs out of conservatorship. yet the more treasury keeps the less the fhfa’s conservatorship wards retain, and so there is a diversity of interest as well. fhfa needs to assert independence at this point, so the thinking behind Calabria’s letter assumes, imo.

            Calabria’s letter is kabuki theater in courtroom setting.

            rolg

            Like

  5. Tim

    Hamish Hume’s excellent article regarding how the recap must protect shareholders’ rights: https://www.americanbanker.com/opinion/recap-of-fannie-and-freddie-must-protect-shareholder-rights

    Hume points out that the overpayment beyond the 10% moment, which he calculates to be $18B, should be returned by Treasury to the GSEs, and he refers to how the reasonable expectations of GSE shareholders were violated by the NWS, which is the claim he is prosecuting in front of Judge Lamberth.

    Hume’s article tracks closely along the Moelis Blueprint, though Hume cautions against conversion of the junior preferred into common. On this I quibble with Hume. I expect some form of conversion to be proposed by Treasury and if 2/3rds of each class of junior preferred vote to convert, then there will be “exit consents” forcing the rest of the class to convert (as the consents will be to adverse amendments to the preferred). see section 7(c) of certificate of designation https://www.sec.gov/Archives/edgar/data/310522/000031052213000065/fanniemae201210kex415certo.htm. this coercive “force-along” provision will deprive any junior preferred holes of hostage or hold-up value, with the hurdle of getting 2/3rds consent being the protection for each holder that the conversion rate is fair.

    rolg

    Liked by 2 people

    1. ROLG,the only reason the Moelis’ plan called for Junior preferred shares to be converted to common was because the plan called for no dividends to be paid until recap is achieved. If dividends are stopped the value of the preferred shares is diminished. There is a lot of rhetoric out there saying if commons are worth a penny preferred shares are worth par, but this is in a liquidation scenario. In a going concern scenario preferred shares can be worth more or less than par since their value is based on the dividend percentage that is compared to the Treasuries.

      Liked by 1 person

    2. The only reason to convert the preferred shares to common will be to simplify the capital structure if the plan calls for recap issuing new preferred shares.

      Like

    3. I agreed with almost all of what Hume said in his American Banker article. On the issue of how to reverse the sweep, Hume’s method of re-characterizing quarterly sweep payments in excess of a 10 percent annualized dividend on the then-outstanding senior preferred stock as paydowns of the senior preferred balance is what plaintiffs are asking for as a remedy for the imposition of the sweep, and I think it’s the correct way to do it. The “ten percent moment” is an internal rate of return calculation popularized by Alex Pollock, and it would result in substantially less than an $18 billion refund going to the companies, essentially rewarding Treasury for having entered into the sweep. If the sweep was illegal it should be unwound, full stop. And I don’t have a view about whether or how the junior preferred stock should be converted to common; I’ve said from the beginning that I’m content to leave that decision to the investment bankers and the major institutional investors who have more expertise and more of a stake in that decision than I do.

      Liked by 1 person

      1. Along with his previous convictions?! “Where one stands depends upon where one sits” is a new proverb to me. I think I’ll keep it (along with Geritol).

        Like

  6. Tim,
    If at some point in this process the senior preferred are deemed paid and the parties are unable to convert the junior preferred to common shares under a recap and release, would the junior preferred be considered part of the companies’ core capital?

    Like

    1. Fannie and Freddie’s junior preferred is part of the companies’ core capital today. Fannie, for example, has shown $19.1 billion in junior preferred stock on its balance sheet since the end of 2011. (For the trivia buffs among the readership, Fannie had $21.7 billion in junior preferred outstanding when it was put into conservatorship in September 2008, but some of that was convertible. With the dividends shut off on all preferred stock–and it all being non-cumulative–holders of convertible preferred converted most their shares to common over the following three-plus years: $503 million over the balance of 2008, $874 million in 2009, only $144 million in 2010, and then $1.074 billion in 2011, before the conversion window closed. Some who converted may now wish they had not done so.)

      The reason you don’t see Fannie’s or Freddie’s junior preferred in the companies’ equity totals is that it’s offset by a combination of losses accumulated between 2008 and 2011 (which wiped out all of the companies’ capital, and more) and Treasury stock (common shares repurchased in pre-conservatorship years to boost earnings per share–which seemed like a good idea at the time, but in retrospect was not). Any who wish to know what Fannie’s equity account looks like–and how it changes from period to period–can go onto the company’s website and download any of its earnings press releases. At the very end all of them have a schedule titled “Condensed Consolidated Statements of Changes in Equity (Deficit).”

      Getting back to your question, if the senior preferred for each company were cancelled, their equity accounts would be unaffected: the component of their equity called “Senior Preferred Stock” would be reduced by the dollar amount of the cancelled senior preferred shares, and the “Accumulated Deficit” component would be increased (that is, made less negative) by the same amount. But then the companies could begin retaining earnings and raising new capital without fear of it being shipped to Treasury.

      Liked by 1 person

      1. Tim – many believe that the fear would still be there as there has been no court ruling saying what was done over the course of the conservatorship was illegal or even ultra vires from the conservators standpoint. I still fail to see how fears of capital recapture would be abetted given that there seemed to be no legal recourse for the investors the first time around.

        Yes they sued, but their pleas all feel on deaf ears even when the facts were loaded in the plaintiffs favor along the way.

        Further, the secrecy with which the gov’t attempted to, and at least partly successfully, operated with would also make it neigh impossible to discern what actually occurred and make a judgement on whether or not it would be able to defend its invested dollars here going forward. My view is that they would have 0 chance given comments from plaintiffs attorneys in public forums “because of what that would mean.”

        Further still, the media was very obviously in on the take along they way – with the likes of wsj, fox biz, brietbart, cnbc, all abdicating any responsible role the 4th estate is ostensibly supposed to fill but has clearly failed.

        I fail to see how any rational investor managing billions is going to look at the history and say hit the bid given the reality of what happened and the ever shifting sands in DC.

        How does one get comfortable here?

        Like

        1. @anon

          if I may, while I am sympathetic with this line of thinking, and indeed it formed the basis of the Perry amicus brief authored by Vartanian, also remember that the NWS was a conservator’s act, which (assuming it is not ruled authoritatively to be illegal) can only be repeated in conservatorship under HERA. once fhfa lifts conservatorship in connection with the capital raise, there would be no authority for fhfa or anyone else to repeat the NWS saga unless the GSEs were first put back into conservatorship. this may may be scant solace if there is no ruling by the 5th circuit invalidating the NWS…and even if there is, it is not likely that collins will be ruled upon by scotus prior to a release from conservatorship. a settlement is likely to be reached before that point.

          rolg

          Liked by 1 person

          1. Thanks for your reply rolg.

            I appreciate that something similar to the NWS MAY only happen again under HERA if the GSEs (are ever released and then) re-enter conservatorship.

            However this brings up another question about bridges.

            Many say that at this point in the saga that it is a bridge too far to completely reverse the conservatorship. However, we now know that the impetus for the conservatorship was based on ‘creative accounting’ (read: fraud) and assumptions of catastrophic losses at one point in time that were used to justify the takeover and of course those losses never came to fruition. No, in fact the profits were so enormous that the same people who were publicly saying it was going to be a death spiral were privately discussing a golden age of profitability just a couple short years later after massive amounts of gov’t stimulus was required to shore up the housing market and save the banks from their own malfeasance of PLMBS issuance and cubed CDOs.

            I think it is a bridge too far to expect, with the publicly available history that now exits here, that money is going to come in given the systemic problem the gov’t itself has shown to be.

            Now as Tim points out, many of the competing firms are continuing to desperately try to hamstring them any way they can so they can swoop in and take over the market, killing the 30 year and making SFR biz model rule the land and we’re supposed to think that they are going to be released by a former alum of the same firm that whose prior alum had peoples heads hitting the floor. I find this all very convenient and suspect and I would wager that many others do as well, so much so that barring an adverse ruling on this entire fiasco cutting all the way back to the actions in 08, there will be few takers today.

            Would love to get thoughts on why that line of thinking is incorrect as well. Truly I would. I’ve not seen any to date.

            Like

          2. ROLG, the companies were put in conservatorship while meeting all capital requirements imposed on them by their regulator. What guarantee do investors have the Treasury will not do the same takeover in the future and impose a new NWS? The plan in 2008 was to liquidate both companies and nobody was thinking how the Treasury actions would be interpreted by invesotrs, since nobody was thinking of recapitalizing the GSEs. Now it is catch 22.

            Like

          3. @anon

            one observation and a suggestion for Calabria (who could use a little help from his friends).

            Greece within recent memory was on life support, and is now selling sovereign debt at rates comparable to the US. memories can be short in finance.

            Calabria should make clear as fhfa director, in connection with the settlement of litigation, that the NWS was not valid under HERA. a 3rd A that accelerated repayment of interest and principal to treasury with a sweep mechanism would have been, for example, so long as the sweep was extinguished when the sr. pref was paid off…something along those lines. he can do that in connection with a settlement and full releases all around…and he can do that because as far as I can tell he believes that. that might go a long way to addressing the market concern.

            rolg

            Liked by 2 people

          4. I don’t have much to add to this discussion (which I’m seeing late, since I’ve been traveling). I only would emphasize that in the discussions between senior officials at Treasury and FHFA, investment bankers and major institutional investors that will have to take place before any serious recapitalization plan can be formulated, the past actions of Treasury and FHFA with respect to Fannie and Freddie will be one of the top concerns raised by investors, and it will be up to Treasury and FHFA to come up with a way to address those concerns to investors’ satisfaction. I don’t know how that will be done, only that it will need to be for a recapitalization of the companies to go forward.

            Liked by 1 person

  7. Tim

    as we await the treasury plan and the Collins en banc decision, I have tried to simplify the situation in my mind, and perhaps this might interest you and your readers. you can certainly weed out much detail when you simplify, and as well run the risk of dropping important details from the process. any feedback is appreciated.

    in my view, number one rule in finance (and business generally) is to try to engage in a course of action in which all parties to a transaction prosper. even better if that course of action is really the only feasible course of action.

    rule number two is that you almost never find transactions that satisfy rule number one.

    but consider this: the only way to raise $100B of GSE capital is to nuke the senior prefs. the only way to settle the lawsuits is to nuke the senior prefs. not saying this is sufficient, but it is necessary in each case.

    wow. it looks like we are pretty close to satisfying rule number one…nuking the senior prefs is the core course of action.

    now there are obviously a lot of details around this core course of action that need to be worked through, and i) fhfa will have its say (principally, capital), ii) treasury will have its say (how much more than the 10% return does it need from this saga…which affects whether the $20B+ it has received beyond the 10% moment will be put back into companies…remember that if treasury does this, it stands to gain 80% benefit from doing this through the warrants…and how much of the 80% warrants does it want to monetize…understanding that the more it monetizes the harder the capital raise), iii) the market will have its say because the market always has its say, iv) congress will have its say (but query if it will be more substantive than the usual grumbling, amounting to nothing), and v) the large junior prefs will have their say, given their prominent economic position (and the need to get 2/3rds of each class of junior preferred to convert into common as, I suspect, will be an aspect of the plan).

    so this will shake out slower than one might want, and since this is a dynamic non-linear process (one player’s move affecting the decision processes and moves of the other players), it will also shake out likely in a more unpredictable way than one might want. by simplifying one cannot make it more determinate.

    while this process is without precedent (no release from conservatorship/receivership of this magnitude before), which one might think adds to the uncertainty, I actually think this benefits the process insofar as decision makers will need to gravitate to the best solution on offer in the absence of precedent, and clearly the Moelis Blueprint is that roadmap. no other course of action that has been discussed over the past 7 years comes remotely close.

    now one culled detail that I want to reintroduce to the analysis is the tbtf bank effect on decision makers calabria and mnuchin. given the demise of SBC plans over the past few years that were neither well thought out nor feasible, it seems clear that Calabria’s suggestion to congress to pass a limited fed guaranty and charter competition is an accommodation to the tbtf banks. I feel certain this will not pass congress during the timeframe that calabria has discussed for the commencement of the administrative reform process. at some point once the administrative reform does commence, I believe the prospect of the tbtf banks being able to earn outsized underwriting/advisory fees will capture the attention of tbtf banks. nowhere but on wall street does money more focus the mind.

    rolg

    Liked by 1 person

    1. I’m not as sanguine as you are on the potential for the banks and their supporters to back away from their opposition to having Fannie and Freddie return as shareholder-owned guarantors in anything close to their pre-conservatorship form. Put differently, I don’t think they’ll renounce a lifetime of opposition to the companies for a one-time (or maybe two-time) underwriting fee, no matter how large. In my view the bank lobby will continue to ask the impossible of Treasury and FHFA in administrative reform: smother Fannie and Freddie with structural constraints, including excessive capital, and intrusive oversight, then go out and convince investors to put $100 billion or so in new money into two companies that will have to struggle to achieve middling financial performance. I believe Treasury and FHFA will have to make a choice between what the pro-bank crowd wants and what will work in the market. I don’t know what they’ll do, so I’m just going to wait to see what the administration’s mortgage reform plan and FHFA’s revised capital plan look like. Then I’ll know, as will everyone else, and we can take our analyses from there.

      Liked by 3 people

  8. Tim,

    Charlie Gasparino at Fox Business News reported today that JP Morgan held a meeting that included banks as well as FNMA FMCC top stock holders and Moelis today. I don’t fully trust his reporting, but he occasionally gets a truth nugget and this feels like one. Any thoughts on how such a meeting might have gone?

    Also, my sense is that rules of cooperative effects will soon start to take hold upon release of the administrations plan. At least one big bank will want the underwriting business of the largest public offering ever. That bank will need to support the recap and release against the will of the other banks. If this is imminent, wouldn’t they all start wrangling to be the chosen underwriter and thereby all start singing a new tune in support of recap and release? Or do you think that IPO is not enough business to warrant such a change in tone?

    Like

    1. @juice

      if I may, this capital raise will be large enough to require all investment banks’ participation, and the fees will be large enough to guarantee this widespread participation. while there are tbtf banks, all of which have capital markets investment banking divisions, which may oppose the GSEs at the C suite level and have contributed to the MBA lobbying effort against the GSEs, there is no way any of these tbtf banks are going to make their investment banking divisions sit this one out once it gets started. all big investment banks will want to participate in the underwriting syndicate.

      rolg

      Liked by 2 people

      1. I have no reason to doubt that the meeting Gasparino described did in fact take place. I would have liked to have been a fly on the wall there. (And, yes, I do know some of the people who were alleged to have attended, but I would not ask them about it, and if I did I’m sure they wouldn’t give me any details.) Breaking it into groups, you have the authors of the only public plan for recapitalizing Fannie and Freddie (the Moelis team), major institutional investors who will need to supply the capital that would make the recap a reality, and underwriters who will be responsible for structuring, marketing and pricing the deal. I doubt that any of these groups yet has a solid idea of what Fannie and Freddie are going to look like and how they will operate post-conservatorship, so my guess is that one key purpose of the meeting would have been to elicit the views of each party on the prerequisites for a successful capital raise, including the terms and context of a settlement of outstanding shareholder lawsuits, and what will be required from FHFA in the way of the capital rules and regulatory regime for the new companies to be able to successfully attract the volume of new equity needed to return them to shareholder ownership.

        Liked by 4 people

        1. Tim

          my question is why did JPM hold this informational meeting? or put another way, if the Moelis folks were the main presenters, why didn’t Moelis hold the meeting?

          one answer is that JPM has many institutional investor clients who JPM thinks may have an interest in an upcoming offering, and JPM was just doing right by its customers. moelis wouldn’t have pulled in an equivalent audience. in my experience, however, someone in JPM’s position would usually also have some relationship with the prospective issuer, so that the investment bank is sniffing a forthcoming fee. without that relationship, the investment bank is just prospecting without a client. why help out an issuer if the investment bank isn’t retained? it’s the expectation of a fee that usually sets activity in motion.

          which leads me to believe that JPM has some obtained a mandate in connection with this deal…which is my speculation based upon my experience.

          rolg

          Liked by 1 person

          1. I think there may be a simpler explanation for JP Morgan’s role in the meeting: JPM convened it at the request of one or more of the non-litigating shareholders who hired Moelis as their investment advisor, with the goal of trying to agree on how to structure and market a deal that will appeal to the much broader range of investors that will be necessary for a successful equity raise, but who are not nearly as familiar with what’s recently been happening with Fannie and Freddie as are the core group of litigating and non-litigating shareholders.

            The notion that JP Morgan already has been given the mandate to lead one or both companies’ capital raises at this early stage strikes me as a stretch. That mandate would have to have come from FHFA, acting for the companies it controls in conservatorship. Since FHFA has no experience in evaluating investment banks’ suitability for this role–and I doubt it would allow Fannie and Freddie’s management to make the choices–it will end up deferring to Treasury. That should indeed be what happens at some point, but I doubt it’s been done already. FHFA Director Calabria still is trying to exert influence over what the post-conservatorship Fannie and Freddie will look like, and in this regard seems at the moment to be more at odds than in alignment with Treasury on the recapitalization process. You don’t pick your horse (a lead investment bank) until you’re agreed on the size and type of the cart you’re going to ask it to pull, and FHFA and Treasury don’t appear to be at that point yet.

            Liked by 2 people

  9. Tim

    you and your readers might find this curious. this is a tweet by chris whalen to the effect that there can be no congressional passage of Calabria’s suggestions (charter competition and fed guaranty), based upon his attendance at a HFSC staff meeting, https://twitter.com/pgray41/status/1144608240501698560

    that tweet was then deleted. given that whalen holds himself out as a bank consultant, one wonders whether he was encouraged to delete the tweet by those who are eager to turn Calabria’s suggestions into roadblocks to delay admin reform.

    rolg

    Liked by 1 person

    1. Your theory about the deletion of the tweet certainly is plausible. Whalen’s statement that legislative mortgage reform is “[n]ever gonna happen” is hardly news–any objective observer knows this–but as you point out the pro-bank crowd has to pretend to believe it could happen in order to justify slow-walking, or opposing outright, administrative reform. Whalen’s slip-of-the-tweet apostasy leaves the pro-bank forces with no argument for opposing what Treasury is trying to do other than self-serving obstructionism, so, poof, the tweet is gone.

      Like

  10. Tim

    I watched the SBC hearing on SIFI designation for GSEs this morning. as far as I could tell only 6 senators showed up for it.

    why does Calabria continue to suggest that congress pass “GSE reform” when it is clear that the senate committee charged with GSE oversight has no interest in taking up the issue? the more calabria raises the issue of need for congressional action, the harder it is for him to supervise a successful capital raise.

    It is hard to imagine a regulator creating more harm (market perception of political risk) for less benefit (likelihood of actual congressional action). what started in my view as an intramural showing of respect by the executive branch for congress has now in my view morphed into a comedy of the absurd.

    rolg

    Liked by 3 people

    1. there was one interesting comment by senator brown during this SBC hearing. he stated that he and the other members of the committee were surprised at the number of speakers invited to address the committee who argued for “utility ” regulation of the GSEs. see for example https://www.creditslips.org/files/levitin-senate-banking-testimony-3-26-19.pdf.

      this is a rather explicit rebuke of Calabria’s call for GSE charter competition. one speaker in this hearing, Prof Wachter made the further point that competition doesn’t become effective, assuming it could be effective in the case of mortgage guarantors, until there are some 30-100 competitors. but she believes that mortgage guarantor competition in any event would have negative effects on the housing finance industry.

      here is the video of the hearing: https://www.banking.senate.gov/hearings/should-fannie-mae-and-freddie-mac-be-designated-as-systemically-important-financial-institutions

      rolg

      Liked by 2 people

      1. ROLG: I haven’t seen the SBC hearing video (and may have more to say if and when I do), but even without seeing it I’ll say that your two comments are related.

        The multiple guarantors idea is the latest in a long series of reasons invented by supporters of the large banks as a pretext for arguing that legislation “reforming” Fannie and Freddie is essential, and that anything less–including imposing sensible capital requirements and regulation on the companies–would be an unacceptable return to the “failed model of the past.” I won’t go over all the reasons why multiple credit guarantors is not a good idea–others have done that–but as you point out Congress simply isn’t going to give the banks what they want on this.

        Which brings me to Calabria. I had said from the time his appointment was announced that reconciling his ideological (and in my view uninformed) views about Fannie and Freddie with the facts and market realities of releasing them from conservatorship was a prerequisite to achieving the latter. I thought the way that most likely would play out would be for Treasury Secretary Mnuchin, his staff and financial team (including investment bankers) to essentially say to Calabria, “Your ideas about Fannie and Freddie may sound good in theory, but we won’t be able to get Congress to put them into practice, and even if we did they won’t work the way you think they would.” Calabria then would say, “Okay, so what should we do,” and the recapitalization process would begin.

        I don’t know what’s happened to change that, but my guess is it’s been the influence of the banks and their supporters within the administration. I strongly suspect they’ve been telling Calabria that his ideas on bank-like capital and multiple guarantors are absolutely on the money, and that he needs to see them through and not give in to what the greedy hedge funds want Treasury to do. And with Calabria digging in on these points, Mnuchin hasn’t yet come up with a way to overrule him without causing friction with the banks, who are Treasury’s historical allies.

        This is not a particularly optimistic reading of the current situation, but I fear it’s the correct one: Calabria is setting himself up as an obstacle to something that should and could happen (sensible recapitalization of Fannie and Freddie and their release from conservatorship) by becoming an outspoken advocate for something that shouldn’t and won’t happen (bank-centric legislative reform). Mnuchin has Treasury’s considerable institutional clout to draw upon in breaking this impasse, but so far he hasn’t seemed willing to do so. Perhaps a ruling from the Fifth Circuit in favor of the plaintiffs will give him the impetus he thinks he needs.

        Liked by 2 people

        1. I don’t think that Mnuchin feels all that differently from Calabria. The public comments that Mnuchin has made indicate that he supports multi-guarantor model. His former top advisor Craig Phillips has also made similar comments:

          “The administration advocates ending the conservatorship of Fannie Mae and Freddie Mac and returning them to private ownership,” Phillips said. “Their charters should be removed from statute and their operations should be overseen by the primary regulator that has the authority to approve additional guarantors to introduce competition into the secondary mortgage market.”

          No high ranking official in Trump administration has publicly advocated for simple Recap & Release plan.

          Like

          1. Mnuchin has always said he would prefer a legislative path to removing Fannie and Freddie from conservatorship, but the midterm elections effectively closed that off, leaving administrative reform as his only practical option. And we know from the leaked remarks made by Acting Director Otting to the FHFA staff in mid-January that there was an administrative proposal set be announced “in two to four weeks” that “really sets a direction for what the future of housing will be in the U.S.,” and that would require raising “probably somewhere, based upon their business models today, [in the range of] $150 to $200 billion.” Something happened to derail that plan, and I believe it was a swift and fierce show of opposition by the banks and their supporters. Perhaps we’ll learn the full story at some point.

            Liked by 1 person

          2. @homebound

            this is a statement of aspiration by Phillips. I agree that this is the preferred end result for the administration. my question is how long will the administration dither with resect to implementing administratively that which it can implement, leaving congress to its devices. the administration could plausibly think that no large capital raise can be executed with the political risk posed by a congress that “might” do something…except that Calabria has stated that there is a roadmap and milestones to a release from conservatorship (including a capital raise), and congressional action (fed guaranty and charter competition) can be layered on top of that.

            there does not appear to be any interest in the SBC to move on Calabria’s suggested congressional action (if you watch the last SBC hearing, it seems that Sen. Brown is addressing both Sen. Crapo and Calabria with respect to his comment regarding the surprising support for utility regulation), and the HFSC is extremely unlikely to do so (and that is an understatement). my own view is that Mnuchin is preoccupied by trade at the moment with Phillips’ work product likely sitting on Mnuchin’s desk. this is a very thinly staffed administration and it appears to me that the only official who can green light the delivery of the Treasury plan to POTUS is Mnuchin himself. and so we wait for Mnuchin (and perhaps for the HUD memo to be finished as well).

            rolg

            Liked by 2 people

  11. Tim,
    Thanks for your coherent and cogent analysis. It’s absolutely refreshing to read commentary not designed for a 5th grader, using words greater than 2 syllables and with a terrific attention to detail. I am a “Mom and Pop” investor who is greatly interested in the outcome of the GSEs.

    Liked by 1 person

      1. @BM

        no relevance to fairholme. elsewhere on the scotus front, scotus just granted cert on Aurelius, an appointments clause case that has some relevance to separation of powers claim in collins en banc (whether de facto officer doctrine/apparent authority bars P’s relief). will be argued in October. collins en banc enters its sixth month post oral argument, which is about the median time period for 5th circuit en banc rehearing rulings.

        rolg

        Liked by 1 person

  12. Tim. Thank you for all you do. Do you think they would set a capital standard so high (such as bank like), that they know the GSEs will never be able to raise, for an ulterior motive? Set them up to fail?

    Liked by 1 person

    1. I suspect there are some opponents of administrative reform within the executive branch who would like to see it fail, and requiring capital for Fannie and Freddie so excessive as to severely harm their business, and thereby scare off investors and make it impossible to raise that capital in the equity market, would be a way to produce that failure. I don’t think they’ll convince Treasury to sign on to that, though, because Treasury doesn’t have a “Plan B”. It knows Congressional reform is unlikely for the indefinite future, and it also knows the status quo of an indefinite conservatorship is not sustainable: the plaintiffs are likely to prevail in at least one of the upcoming court challenges to the net worth sweep, and the current director of FHFA believes the sweep is illegal, and I doubt he’ll support it much longer. And of course there is the value to Treasury of the proceeds from conversion of the warrants if it supports a successful recap.

      Liked by 5 people

  13. Tim, Many thanks to you for the great public service as a private citizen when public servants are trying to rob the public for the benefit of their cronies.

    Like

  14. Mr Howard

    Anyone reading this can’t help but come away knowing that you have left MC plenty of wiggle room politically and economically to implement what you propose. All concerned will never be able to repay you for your tireless efforts but universal gratitude I hope will have to do for now.

    Liked by 2 people

  15. Continued endless thanks for all you, and other major contributors, do to shed light on the corruption, greed and outright theft we have witnessed. Also, between a possible favorable en banc decision, the specter of a debt ceiling fight and early 2020 maneuvering, I could see the gov’t feeling some pressure to lock in their $100B windfall. But main message is one of gratitude – Thanks!!

    Like

  16. Potential new investors and investment bankers hired by the GSEs will eventually ask the same questions to make sure the GSEs are neither under-capitalized nor over-capitalized. GSEs and FHFA have to answer them.

    Liked by 3 people

  17. Thank you Tim. Your ability to provide clarity on complex issues such as this is truly invaluable to us mom ‘n pop investors. I believe Bill Ackman is arguing for the same thing as you regarding capital standards. I’m not sure if you and he are in touch with each other but I sincerely hope you are.

    Liked by 1 person

  18. “Finally, you add a reasonable, clearly identified cushion of conservatism, and you have your required capital percentages. It’s that simple.”

    If that is simply putting an extra X% cushion on top of a minimum risk-based capital calculation, what do you think would be a sensible range for the cushion?

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    1. No, the “cushion of conservatism” is applied to the calculated risk-based capital percentage, not the minimum– to account for model risk, among other things. The proper range for the cushion depends on whether conservatism has been built into some of the other assumptions that are needed for the parameters of the test; the more of that sort of conservatism exists, the smaller the cushion needs to be. The minimum leverage ratio also should be set at a level where one would expect the risk-based constraint to be binding most of the time.

      Liked by 2 people

  19. Thanks for that. How about cc’ing Ken Moelis, too. Why only flavour the milk when you can also flavour the feed? Exclusively pitching FHFA is like erecting a fence around your burger so the cattle doesn’t wander off.

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      1. We surely hope so. Just as MSM loves to tout benefits of ex intel officers maintaining clearance to aid in those efforts, ignoring your advice should be viewed as needlessly reckless while shaping housing. Excuse my ignorant cynicism as the only voices that seem to have the mic are opponents. Nice to know your efforts are wisely being consulted and considered. Even Zuck consulted the twins when launching FB’s crypto. Expertise is just that and avoiding it is akin to inviting one’s own peril. Adding your experience to FHFA Dir’s intelligence should make FHFA a formidable ally to US Homeowners bar none.

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  20. Tim

    thanks for sending this letter to Calabria. as a professional economist, Calabria should be most interested in the data you have presented, and should either be persuaded by it, or be in a position to offer a rational, data-backed response to it.

    I would offer from my own experience an addendum to your thought at the end of the post that investors “insist that anything objectionable be remedied to their satisfaction before they agree to put new capital into the companies.” the investors’ cudgel is pricing, and if the capital proposal is set unrealistically high, the common stock will be priced correspondingly low, in order to consummate the capital raise.

    it is my expectation that fhfa and treasury are having (or should soon have) a conversation about capital levels, as the higher the fhfa sets the capital level the lower will be treasury proceeds from its warrant position. fhfa has no skin in this recapitalization game, while treasury has all of the skin in this game.

    so it would be my expectation (assuming treasury is pursuing its interest in the recapitalization) that treasury, more so than re-IPO investors, will bear the biggest burden, and therefore be in a position to make the most effective argument, with respect to an overly conservative, politics-driven capital level.

    rolg

    Liked by 3 people

    1. As I tried to point out in the post, it’s not just the level of capital that’s important, it’s also the way the risk-based test is constructed. Specifications that divorce capital from risk at a disaggregated level can hamstring the business in ways that aren’t immediately apparent to the layperson, but can be significant.

      Liked by 2 people

      1. Tim

        assuming that congress passes additional fhfa chartering authorization, would any of this capital analysis change for a new entrant? for example, do the sizes and operating histories of Fannie and Freddie affect them for purposes of capital in a way that is advantageous or disadvantageous when compared to how a capital analysis would be applied to a new and much smaller entrant without a past operating history?

        rolg

        Liked by 1 person

        1. It would be up to FHFA as to whether there would be any different capital standards or charges for new entrants. The core risk-based capital numbers shouldn’t change, since those are keyed to the product types and risk characteristics of the mortgages financed, not the guarantor. One could make a case for some type of management and operations risk capital surcharge for a new entity with no track record of being able to do its business with operational or technical competence or reliability, but since FHFA is the one pushing for new entrants I suspect it would view such a surcharge as a barrier to entry and not impose it.

          Liked by 1 person

          1. Tim

            my thought exactly, which in mind points to what I believe amounts to a conflict of interest on the part of fhfa/calabria. in my view, a new entrant without an operating history that is substantially smaller than Fannie and Freddie should have a more conservative capital analysis than Fannie and Freddie. whether Calabria’s ideological interest in seeking new entrants clouds this capital analysis for new entrants is something I hope we never have the opportunity to witness.

            rolg

            Liked by 2 people

          2. Tim and ROLG,

            Assuming that any capital standard applied to Fannie and Freddie would also apply to any new entrant, I would think FHFA would really want to get the standard right. If it hamstrings F&F, why would anyone else want to get into that business?

            Liked by 2 people

          3. I think this is a matter of theory and practice. Bank-like capital and multiple guarantors are ideological (and also pro-bank competitive) objectives, and most of those who advocate them don’t have the practical knowledge of the credit guaranty business to understand that they’re not compatible. FHFA got a lot of constructive feedback on their June 2018 capital proposal; we’ll see how much of it they incorporate into their revised proposal.

            Liked by 2 people

      1. I don’t see these as being in conflict. FHFA currently performs two roles: conservator and regulator. As regulator, Calabria believes that multiple guarantors would be better for the mortgage finance system. I disagree with him, but I don’t think his position on this conflicts with his duties as a conservator.

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        1. Tim “Happy Holiday,” very much appreciate your work and insight. Would you care to comment on the news of Bob Ryan, senior Policy Advisor, leaving FHFA? Could this possibly signal a major change in the regulation of the GSEs’ financial standards?

          Liked by 1 person

          1. No. Bob joined FHFA to work with its then-new Director, Mel Watt, so it’s neither surprising nor significant that he’s leaving with Calabria having taken Watt’s place. (If anything, the surprise is that it took this long; Ryan’s fellow senior policy advisor to Watt, Eric Stein, left several months ago.)

            Liked by 2 people

  21. Thank you for your tireless work Tim! I check your blog every day to read any new comments (thank you for responding to everyone’s questions/comments) and responses from you. You are a vital advocate for the GSE’s and I thank you for that!

    Liked by 2 people

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