A Full Short Week

The short week after Labor Day was full of developments of great significance to the fates of Fannie Mae and Freddie Mac. On Tuesday, September 3, we learned that the Senate Banking Committee had scheduled a hearing for the following Tuesday with Treasury Secretary Steven Mnuchin, FHFA Director Mark Calabria, and Department of Housing and Urban Development (HUD) Secretary Ben Carson as witnesses. That immediately sparked speculation that the administration’s long-awaited plan for housing finance reform would be released before this hearing, as indeed it was, on Thursday, September 5.

Treasury’s reform plan, however, was received with disappointment by followers of and stakeholders in  the reform process, because it contained little new information about how Treasury and FHFA were thinking about the process and timing of the recapitalization of Fannie and Freddie and their ultimate release from conservatorship, which Secretary Mnuchin and Director Calabria each repeatedly have said was a top priority. Combined, the two sections of the Treasury report titled Preconditions for Ending the Conservatorships and Recapitalizing the GSEs took up less than two of the document’s 53 pages, and contained only a broad list of known options, gave no indication of Treasury or FHFA’s preferences, and included no estimated timetables. And the section on recapitalization ended with the unhelpful statement: “Each of these options poses a host of complex financial and legal considerations that will merit careful consideration as Treasury and FHFA continue their effort, already underway, to identify these and other strategic options.”

The rest of the Treasury plan gave background on Fannie and Freddie and their history in the secondary mortgage market—much of which repeated the fictions about the companies created by their critics to justify curtailing their operations or replacing them—before detailing the administration’s many recommendations for legislative and administrative reform. And curiously, a number of the administrative recommendations were for “Treasury and FHFA” to take or consider certain actions, which suggested that the plan’s authors may not have been from Treasury but the National Economic Council (NEC), whose director, Larry Kudlow, had been responsible for the March 27 White House memo to Treasury requesting it to prepare the reform plan, and specifying the topics it should cover.

But the disappointment and puzzlement over the tone and lack of specifics of the Treasury plan was short-lived. On Friday, September 6, the Fifth Circuit en banc issued its rulings on plaintiffs’ claims that the net worth sweep was a violation of the Administrative Procedures Act (APA) because it exceeded FHFA’s statutory powers, and was in violation of Article II of the Constitution because it was approved by an FHFA director not removable by the president. Plaintiffs prevailed on both claims. On the APA violation the majority ruled that “the Third Amendment [authorizing the net worth sweep] exceeded statutory authority,” and emphasized that “We ground this holding in statutory interpretation, not business judgment.” On the Constitutional claim the majority said, “HERA’s for-cause removal protection infringes Article II. It limits the President’s removal power and does not fit within the recognized exception for independent agencies.” The en banc panel remanded the APA claim to the lower court for trial based on the fact pattern in the case (which does not favor the government), and on the constitutional claim granted plaintiffs prospective relief (severing the “for cause” restriction on removal of the FHFA director) but not the injury relief of voiding the net worth sweep plaintiffs sought. Plaintiffs’ loss on injury relief, however, was offset by their victory in the APA claim, which will void the net worth sweep if sustained and upheld, as is likely.

I do not believe the sequencing of these two developments—the vague and unsatisfying plan from Treasury for the removal of Fannie and Freddie from conservatorship, followed the next day by the announcement of the en banc Fifth Circuit decisions—was coincidental. In my view the administration almost certainly knew about the court decisions in advance, and believed it would benefit from being silent in its reform plan on the lawsuits and their possible resolution, then being able to cite the Fifth Circuit rulings as a pretext for giving up in an eventual settlement with plaintiffs the lucrative stream of net worth sweep payments it has vigorously defended as legal and valid up to this point. (Appealing one or both rulings to the Supreme Court, as Mnuchin has indicated Treasury may do, still would be consistent with this notion, as Treasury may feel this strengthens its hand in settlement negotiations.)

Those hoping to get clarification on the administration’s next steps in the housing finance reform process at this Tuesday’s Senate Banking Committee hearing came away with relatively little. Mnuchin did leave the impression that Treasury and FHFA would be able to work out some interim arrangement that would allow Fannie and Freddie to retain as capital the earnings scheduled to be remitted to Treasury as net worth sweep payments at the end of this month, in return for some form of compensation to Treasury. But he gave no indication of when, or how, the net worth sweep itself would be terminated. Chairman Crapo, on the other hand, prominently gave the green light to administrative reform in his opening remarks, saying, “Ultimately, only Congress has the tools necessary to provide holistic, comprehensive reform that will be durable through any market cycle. However, it is important for the administration to begin moving forward with incremental steps that move the system in the right direction.”

Nothing I heard at Tuesday’s hearing made me change my opinion that there is very little chance of any type of housing finance reform legislation passing in this Congress. But one episode in the hearing highlighted for me the major difference between an administrative reform process and a legislative one. Whereas in an administrative process hyperbole and misinformation invariably impede results, in a legislative process they frequently are the methods employed to produce them. The episode that brought this point home was the fact-free exhortation from Senator Kennedy (R-LA) for Congress to “put out the dumpster fire” of Fannie and Freddie because “we’ve spent $190 billion of the taxpayer’s money to bail them out, and we’re in worse shape now” because, according to Senator Kennedy, their underwriting standards are worse. Almost as disappointing was Director Calabria saying “I agree” after most of the wildly erroneous statements the senator made. Then, later on in the hearing, HUD Secretary Carson sought to assure his audience that the Federal Housing Administration (FHA), which is under HUD’s authority, had “made substantial progress” in recent years and “was doing well,” seemingly in contrast to Fannie and Freddie.

As Treasury and FHFA pursue the path of administrative reform, they must get a hold on the facts of the issues they will be dealing with, and do so quickly. Given the Fifth Circuit’s ruling on the constitutionality of the FHFA directorship, both Mnuchin and Calabria could have no more than fifteen months to complete the administrative reforms of Fannie and Freddie they’re contemplating. A good place for them to start in their fact-finding would be with the companion housing reform plan put out last Friday by HUD, which received almost no publicity. Reading this plan in conjunction with Treasury’s, it becomes unmistakably clear how far from economic reality the legislative discussions on Fannie and Freddie have strayed, and how useless they are as guideposts for successful administrative reform.

The Treasury report follows the lead of Fannie and Freddie’s opponents and critics in continuing to use commercial banks as the benchmarks for recommendations on Fannie and Freddie’s capital and regulatory oversight, even though banks take both interest rate and credit risk on a multitude of asset types with a wide range of risks, and can (and do) make loans in countries throughout the world, whereas Fannie and Freddie essentially only do credit guarantees on a single and historically safe asset type, residential mortgages, and only in the United States. The HUD report reminds us that there is a direct comparable to Fannie and Freddie, and it’s the FHA, which also does only credit guarantees on residential mortgages, with the same lenders and homebuyers as Fannie and Freddie.

In the Treasury and HUD plans, published on the same day, the same administration makes policy recommendations for three entities—Fannie, Freddie and the FHA—that do the same business with the same customers in the same market. Yet the recommendations of these two plans could hardly be more different, in tone as well as substance.

We learn in the HUD report that, “During the financial crisis, and after due to the policies of the previous Administration, FHA’s and GNMA’s balance sheets swelled, growing by approximately 350 percent and 400 percent, respectively, between FY2007 and FY2018.” Putting aside the political commentary, 350 percent growth for FHA loans outstanding in 11 years is astronomical. The growth percentage for Fannie and Freddie’s combined books of business during the comparable period, between the end of 2007 and the end of 2018, was only 9.6 percent. Stated more starkly, the average annual growth rate in FHA loans outstanding for each of the last 11 years—12.1 percent—exceeds the cumulative growth in business outstanding for Fannie and Freddie during that entire time.

There is only one plausible explanation for such a mammoth growth differential over such a long period: while in conservatorship, Fannie and Freddie have been overcapitalized and overregulated relative to the risks they incur, whereas the opposite has been true for the FHA. And the policy recommendations in the Treasury and HUD plans, if followed, would lead these capital and regulatory differentials to become even greater.

The FHA specializes in low-downpayment lending, so its book of business naturally will be riskier than Fannie’s or Freddie’s. But the gap in serious delinquency rates between the two is larger than one would expect based just on average loan-to-value ratios. In the second quarter of 2019, the FHA’s serious delinquency rate of 343 basis points was more than five times Fannie and Freddie’s average serious delinquency rate of 66 basis points. The HUD report also says, “Despite the current strong economy, the credit risk profile of the average FHA FTHB [first time home buyer] has deteriorated in recent years,” and goes on to note that several key risk factors—average credit scores, debt-to-income ratios, and the percentages of cash-out refinances and down payment assistance—have worsened in the last several years. For Fannie and Freddie, it’s been the opposite. Fannie now publishes its 90-day serious delinquency rate on loans acquired after 2008, and for these loans, which currently comprise 93 percent of its book, the serious delinquency rate in June was only 32 basis points, less than one-tenth the 3.66 percent delinquency rate of the pre-2009 book.

The equivalent to a capital requirement for the FHA is the Mutual Mortgage Insurance Fund (MMIF). Today the MMIF is set at a statutory rate of 2.0 percent. The growth in the FHA’s credit guarantees has been exponentially faster than Fannie’s and Freddie’s (helped by refinancings of conventional loans into FHA-insured loans, one-third of which take cash out), and the FHA has a serious delinquency rate five times that of Fannie and Freddie, a book of business that is getting weaker while Fannie’s and Freddie’s are getting stronger, and only a 2.0 percent MMIF standing between the FHA’s $1.4 trillion in loan guarantees and the taxpayer’s wallet. What, then, is the administration’s proposed response to these circumstances? According to the HUD report, “FHA should adopt a sound risk-based capital regime for the MMIF, well above the statutorily mandated two percent capital ratio, which will manage risk exposure to defined stress scenarios and ensure that FHA does not inappropriately compete with the GSEs or private capital.”

I don’t know what the right level of capital is to safely back the FHA’s credit guarantees. Here I’m citing the FHA’s situation mainly to point out the marked contrast between the casual and vague prescription of the administration for responding to the significant risk to the taxpayer posed by the FHA’s operations—saying only that it “should” (not must) adopt a sound risk-based capital regime, and raise its capital cushion “well above” the current 2.0 percent ratio (with no required percentage, or any guidance as to how to come up with such a percentage)—and the way the administration treats the same issues of taxpayer risk and capital in its discussion of the recapitalization and release of Fannie and Freddie.

The reasons for the vastly different approach to Fannie and Freddie compared with the FHA are, of course, politics, ideology, and the competitive desire of the commercial and investment banks to add unnecessary restrictions and impediments to the companies’ business in the secondary market, to the benefit of lenders in the primary market. Fannie and Freddie’s opponents and critics seek to create the impression that they are so risky, and pose such a danger to the financial system, that removing them from conservatorship must be done with extreme care, akin to handling nitroglycerin, with safeguards wrapped around cushions surrounded by micro-regulation. The reality is that Fannie and Freddie were the best-performing sources of mortgage finance before, during and after the crisis, and that reforms made to national underwriting standards since 2008 have made them even safer. And then there is the FHA, geographically located within 15 miles of Fannie and Freddie, operating in the same market, and being held to a completely different standard.

Secretary Mnuchin seems to be aware of some of this, at least conceptually. In an interview Monday morning with Maria Bartiromo on Fox Business, he said, “This is really housing reform, and we also are working with HUD in looking at reform of FHA. We want to make sure that if we fix Fannie and Freddie, we don’t put taxpayers at risk at FHA.”

Mnuchin’s acknowledgement of the broader scope of the exercise is a definite plus. It’s also a plus that in administrative reform the professionals who will be leading the execution of Fannie and Freddie’s recapitalization—including the investment advisers retained by Treasury—will be able to draw on their own knowledge about and experience with the capital markets and how they, and Fannie and Freddie, actually work, rather than having to rely on agenda-driven housing finance reform plans written by generalist career staffers at the NEC, Treasury, HUD or FHFA. With a fresh start, and a new cast of principals managing the process, fiction should more easily yield to fact, and political biases to economic realities.

During the Senate Banking Committee hearing, ranking member Brown (D-OH) noted that having FHFA boost Fannie and Freddie’s required capital, shrink their business and give away their assets and intellectual property to third parties would make it difficult to raise the amount of new equity required to bring them out of conservatorship. It’s an obvious point, which the investment bankers will understand. They also will understand that when they embark on a roadshow to pitch Fannie or Freddie equity as an investment, they will need to have a convincing answer as to why risk, capital and regulation are being treated the way they are at Fannie and Freddie, not compared with banks, but with the FHA.

 

46 thoughts on “A Full Short Week

  1. Tim or ROLG,
    Since the outstanding warrants obviously add complexity to recapitalization, would you think it is more likely Treasury would sell these back to the companies as opposed to exercising them and selling the shares? What would that look like if they did go that route since the companies don’t currently have funds to buy these back? Possibly an exchange of sorts based on the funds Treasury would owe them based on overpayment from NWS?

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    1. We’re all driving at same point that understandably Collins didn’t address in keeping narrow NWS argument and is ahead of other two cases that just got exponentially brighter. Prior to the Fifth, cases weren’t viewed in aggregate(other than a bunch of losers) but now if one helps in Sweeney discovery and orals, Lamberth etc, then regardless if they join, the Gov’t risk still multiplies so behooves them to settle more than individual suits.

      What would global settlement look like across the three cases? Gov’t keeps all money and GSE’s keep all equity, more or less? Which when you look at seems generous and appropriate for all parties, if overly simplistic. Given only the facts public to date, anything less on behalf of GSE’s seems an operational harm to which SCOTUS might agree. How much is enough for one company to illegally lose yet still maintain viability? Gov’t has yet to show their hand while trying to stop sweep as same time mounting an appeal. Ending Sep sweep seems elemental by comparison. I know we’re dealing with US Gov’t here but do they really want to make a Federal case out of seniors/warrants? Gl, (to them, too)

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      1. there wil be a negotiation between litigating shareholders and fhfa/treasury. if both parties are smart, they will want a global settlement that settles all claims among all parties. each side has a good hand to play, analogizing to poker. treasury has massive financial claims, representing the existing senior preferred and the warrants. the shareholders have potentially massive litigation claims, including Collins, fairholme (2) and Washington Federal (putting aside for the moment Bhattil. notwithstanding these strong opposing hands, there is an alignment of interests since both parties want to recap the GSEs and set them on a path to release from conservatorship. everyone who needs to be at the table will be at the table, understanding that congress has no seat. while financial advisors wont have a seat at the table, their role will be important in advising as to what is achievable in the public markets…no sense for the parties to settle on a plan that is not achievable in the marketplace.

        when there is an alignment of interest there usually is a settlement.

        there may be a collective action problem among investors that fhfa/treasury have to deal with, since the investors may not have a common understanding of what constitutes their best interests and objective…which may prove a barrier to resolution for awhile, so the negotiation may be protracted.

        any prediction as to outcome would be foolhardy.

        rolg

        Liked by 1 person

      2. there is an alternative non-negotiation scenario that occurs to me, after having calabria today say for the second time in an interview that when fhfa/treasury conduct their negotiation, the plaintiff litigation will go away (“Looking to rebuild capital and once NWS ends which is part of our plan then a lot of these suits go away.”)

        in this scenario, fhfa/treasury agree to a plan where Ps get some but not all of what Ps are asking for by way of relief in Collins en banc (ie something less than eliminating the senior pref and putting some $25B back into the GSEs somehow). fhfa/treasury can go into a period of retaining earnings and then implement their something-less-than-what-Ps-want deal, and do a stare down with Ps, asking whether Ps want to hold up the re-Ipo? if Ps dont settle (effectively on fhfa/treasury terms), then GSEs stay stuck in retaining earnings land and dont proceed to the next step of capital raises.

        Ps then would have the choice of proceeding with litigation in order to try to get what they want, or saying good is good enough. hardball.

        rolg

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  2. Just thinking out loud…I wonder how the fact that Fannie and Freddie are cash flow-rich but capital-poor influences recapitalization. Can they use this to their advantage to raise capital on advantageous terms, maybe by offering dividends on common or coupons on a new series of preferred stock? Or is simply retaining the earnings the best option?

    Liked by 1 person

    1. @AC

      GSEs are an outlier on the recapitalization playing field. I have never seen such cash flow rich companies requiring a recap in my >30 years on Wall Street. which is good.

      there are risks to the GSEs, principally political and regulatory risk. no companies dont have any risks. but the biggest risk for companies generally is operational, can the companies create abundant cash flow, and the GSEs frankly dont exhibit this risk. which is very good.

      now, one can expect the capital rule to require a huge amount of capital relative to current status, so execution risk of the capital raise is abundant. but there is a pathway if there is cash flow.

      rolg

      Liked by 2 people

  3. Tim / ROLG,

    In the en banc ruling, it was determined sweep was unconstitutional. Was it determined HERA allowed for the NWS, thereby HERA in that regard was unconstitutional, or did they determine HERA didn’t allow for the sweep. (The Epstein rule.)

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    1. The Fifth Circuit en banc determined that the provision in HERA that made the Director of FHFA removable by the president only for cause was unconstitutional, but ruled that the remedy should be changing that provision prospectively, rather than granting plaintiffs the injury relief (voiding the net worth sweep) that they sought. The en banc panel also ruled that HERA did not authorize FHFA to enter into the net worth sweep, and that doing so was a violation of the Administrative Procedures Act (a statutory violation) rather than simply bad business judgment by FHFA. The panel did not find that HERA, as a statute, was unconstitutional.

      Liked by 1 person

  4. Thanks Tim. This is the best, objective and most informed blog covering this issue.

    I am wondering if anyone knows what the timeline for the Sweeney and Lamberth courts would be. I know specifics are hard but are we talking about months or years before we get any kind of ruling in those cases?

    Cheers

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    1. I’m following the Sweeney and Lamberth cases fairly closely, and think I have a pretty good idea of where they are. Other readers should correct me if I’m in error, however.

      Sweeney has scheduled a single session of oral argument on all of the related cases before her court (including Washington Federal) in mid-November, to decide the issue of whether her Court of Federal Claims has jurisdiction over these matters. I believe she will rule that the CFC DOES have jurisdiction (although I don’t know when that ruling will be made). Assuming that’s the case, discovery then will proceed on plaintiffs’ motion for summary judgment on the claim that the net worth sweep was a regulatory taking, for which they are entitled to damages. No timetable exists that I’m aware of for how long it might take for Sweeney to decide this claim. Then, assuming the Washington Federal case has not been settled or dropped–and that its legal team wishes to continue to proceed with it–that case would begin discovery, and its own lengthy process of wending its way towards a decision.

      In the Lamberth remand, all parties agreed this summer on a four-month extension to complete discovery, which should be done in mid-November. What then will follow will be a sequence of expert witness reports, the potential filing of amended complaints, further discovery based on the expert witness reports, and briefing on summary judgment motions. A ruling on the summary judgment motions would likely come in the summer of next year, and assuming that neither the plaintiffs’ nor the defendants’ summary judgment motion is granted, trial is tentatively scheduled to begin on October 19, 2020.

      Liked by 1 person

      1. @franz

        Tim has this exactly right, and I would add only one thing that I find curious about Washington Federal. this is the only case that was filed before lapse of statute of limitations that attacks the conservatorship itself. claim is that HERA required board of directors consent for conservatorship (absent other findings) and that consent while given was coerced by Treasury Secretary Paulson. this is a triable claim in the sense that imo no court could grant the government summary judgment on coercion; rather a trial would be needed to find facts. so while this case likely wont get to trial, it isn’t going away anytime soon, and will have to be a part of a negotiated settlement (which I think will be a global negotiation covering the Collins litigation, any exchange of junior preferred for common etc…it is always better to negotiate everything once at the same time). in theory, if the govt put GSEs into conservatorship improperly, the validity of many things (ie warrants) could be called into question. so while I dont think this case ever sees a courtroom, it will be another pesky item on the negotiation agenda. it has holdup value, when viewed uncharitably from the govt’s point of view, but candidly likely not that much value.

        rolg

        Liked by 1 person

        1. @rolg

          Since I’m not a lawyer, I would like to ask for legal opinion on this question. Fifth Circuit en banc has ruled that FHFA was not authorized to enter into NWS under HERA. Does this mean then Third Amendment of SPSA is illegal? And as stated in section 6.12 of SPSA on non-severability, wouldn’t this also mean that senior preferred and warrants are illegal as well?

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          1. Jim—I’m not a lawyer either, but I can answer your question. The ruling by the Fifth Circuit en banc that the agreement with Treasury to impose the net worth sweep was beyond the powers conveyed to FHFA by HERA did not invalidate the entirety of the Third Amendment (just its net worth sweep provision), and it has no direct implications for the legality of either the senior preferred or the warrants.

            Liked by 1 person

          2. I just want to clarify that when Tim says “it has no direct implications for the legality of either the senior preferred or the warrants.” i would agree that the the holding has no implications on the legality of the senior preferred, but the holding has “indirect” practical implications on the senior preferred insofar as all of the historical sweep payments of dividends stand to be recharacterized as part dividend at 10%/part retirement of preference amount of the senior preferred, leading to a retirement of senior preferred, if all of the NWS payments are to be recharacterized by the district court as relief pursuant to the en banc opinion, and no implications whatsoever, legal or practical, on the warrants.

            rolg

            Liked by 1 person

      2. just one more thing on Washington Federal and coercion. some of Ps factual allegations of Paulson coercing the GSE boards of directors come straight from Paulson’s book, written after the event and in which he rather boasted about holding and pointing figurative bazookas and knocking heads. this hubris reminds me of Parrott’s zealous crowing about the NWS in emails that found its way to a prominent place in Judge Willett’s bravura majority Collins APA opinion. that happens when power is exercised without measure and wisdom.

        rolg

        Liked by 2 people

      3. Tim, ROLG,
        Excellent. Thank you for clarity on this.
        Given David Thompson’s post ruling comments about Calabria being on a 15 month shot clock, what is the likelihood of The cases in both Sweeney and Lamberth’s courts being expeditiously settled. It seems that the legal pipeline, especially with ongoing discovery, will tilt strongly toward shareholder relief. Assuming that is the case, what do you believe settlement would look like for the remaining cases that pose the most threat to the government?

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      4. Tim/ROLG-

        During the Investors Unite conference call with David Thompson last week, he made a comment (not sure whether he was referring to either Fairholme or Perry remand, or both) that in the DC courts if plaintiffs won on breach of implied covenant of good faith and were awarded damages, those damages were liabilities of the companies, not the government. I’m still trying to understand this. How can the shareholders of the companies be liable for the actions of the government (FHFA), who acted ultra virus, and failed to uphold their fiduciary duty to “conserve and preserve?” Did I hear Thompson right? This throws me for a loop. I understand the difference between direct and derivative claims. Shouldn’t the government be on the hook for the direct claims? They are the primary named party in the lawsuits. If what Thompson says is true, one shareholder will extract legal claims from the rest of the shareholders by successfully suing the government, a third party, for its malfeasance.

        Liked by 1 person

        1. @bw

          forget the legal analysis, the big takeaway from David’s point is that there can be no public offering if the issuer GSEs have a contingent liability represented by this litigation…so it needs to be settled in order to recap.

          Liked by 1 person

    1. I’ve not followed Fannie’s multifamily business that closely since I left (mainly because it’s not been subject to nearly as much outside opposition as Fannie’s single-family business), but from what I’ve been able to ascertain the industry is not upset about it, so I would take FHFA’s revised multifamily cap as a neutral to a positive development.

      Like

  5. Tim

    interesting leak if true:

    @KatyODonnell_
    Calabria talked next steps in an all-staff mtg today — raising capital buffer in a limited way and having GSEs operate under a consent agreement at point where they have enough $ to leave conservatorship but not enough to fully comply w/ new capital rules

    I think it would be constructive to have GSEs leave conservatorship before meeting (what we can assume to be a rather stringent) capital rule

    It is possible that when FHFA/treasury tested the investor waters (assuming they have) the feedback they got was that, yes we would very much be interested in investing into companies with these cash flows, but not in companies controlled by a conservator having HERA conservator powers (the extent of which is still under litigation).

    rolg

    Liked by 2 people

    1. Allowing the companies to leave conservatorship before they fully meet their new capital standards would be sensible and welcome, but how sensible and welcome will depend on the details–what is the ultimate capital percentage, at what level prior to that is the release point, and what will FHFA count as capital–which we don’t know yet.

      Some numbers here might help, and I’ll use Fannie’s, since that’s the company I know.

      For the last few years, Fannie has been earning around $19 billion per year, pre-tax. But what most don’t realize is that since 2012, the company has been booking an average of $3.0 billion a year (pre-tax) in benefits for credit losses, through slowly drawing down the ridiculously high loan loss reserves FHFA forced them to build between 2008 and 2011. In the last 7 1/2 years, Fannie has booked $24 billion in these benefits. But that boost to annual earnings soon will run out. Fannie’s total allowance for credit losses, which was $72.2 billion at the end of 2011, was down to $11.5 billion in June of this year. The company should still be able to pull some of that out, but we’re close to the end. And once that happens, Fannie’s annual pre-tax earnings will drop down to around $16-17 billion per year (and less, if FHFA makes a serious effort to shrink their footprint, and as their total interest payments on CRTs continue to build).

      And next year, Fannie probably will have to add about $10 billion to its loss reserve because of the Current Expected Credit Loss (CECL) accounting rule. That will come out of earnings. So as a rough approximation, between now and the end of 2021, Fannie will likely earn a little less than $30 billion after-tax. If you add to that the $6.4 billion in retained earnings they have now (which it looks like they’ll be able to keep), that will bring their capital to around $35 billion at the end of 2021, or about 1 percent of Fannie’s total assets today. I doubt that FHFA would release them for less capital than that, and they probably will insist on a good deal more–at least half the fully effective new regulatory capital percentage. (Winning a reversal of the net worth sweep will add a little more capital to the equation through the application of the overages in sweep payments to cover Federal taxes, but it won’t help that quickly, because of the lower marginal Federal tax rates). So, without a public capital raise, we’re still talking about a fairly lengthy period of time for Fannie to get a “get out of jail free” card through retained earnings alone.

      Liked by 2 people

      1. Tim

        after reading the Treasury Plan, I have been trying to understand what Treasury counselor Phillips had been doing the past two years. that Plan could have been written in two days. it had been my understanding that Phillips conducted wide ranging interviews with many parties interested in the GSEs, including within the investment community many of which, given his background, he knows well. I have been trying to get a sense whether there is a “plan not for public consumption” regarding the steps towards recap and release which is the product of his two year inquiry. this tweeted leak, if true, is the first glimmer that I have seen that there is a more substantial plan than that which calabria and mnuchin have been willing to publicize to date. I may be giving the administration too much credit though. what I don’t think calabria and mnuchin are willing to admit is that the Collins en banc APA opinion is a big plus towards raising public capital, reducing the risk factor presented by the stewardship of a conservator claiming to have unfettered power.

        rolg

        Liked by 2 people

      2. Tim

        so obviously this is speculation, but a smart investment banker like phillips might recommend (and a smart investment banker like mnuchin might agree) that the plan would have the following steps (roughly):

        i) initial period of earnings retention, during which fhfa and GSEs would reach an agreement that would amend the SPSA (also presumably settling litigation and eliminating senior preferred) and provide for terms under which the GSEs are to operate post-release from conservatorship; ii) a re-ipo of sufficient funds such that at the closing of the the re-ipo, the conservatorship would end and the agreement would activate (so that new investors would not subject their money to conservatorship whim, but to agreement terms which would be disclosed in the re-ipo); iii) a further period of earnings retention and capital raises raising GSE capital to the level set forth in the final fhfa rule; iv) a plan end state where presumably many transitional items in the agreement would terminate (once the capital rule has been satisfied) and the remaining agreement items would constitute the going-forward “reform” of the GSEs.

        rolg

        Liked by 1 person

        1. I have a different take. I’m not sure why most everyone is convinced there will be a “capital raise”. For me, this gradual generic capital build over the next couple of years signals there will not be a capital raise. The situation has competing desires. On one hand, the treasury has the warrants, and why would they want their investment to be diluted by a capital raise. On the other side, you have prospective investors that I’m sure would not want their investment diluted by the warrants.
          So, I believe it’s one or the other, but not both. Either the warrants get converted in a couple years slowly, or warrants get cancelled and institutional investors step in and provide capital. I tried, but I can’t wrap my head around the possibility of warrants being converted AND a large capital raise. there is just too much dilution for any takers.
          Rather, I see a generic capital build over the next few years that approaches the number that the most recent stress test provided (I think it was 43 Billion).

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          1. For ROLG: The scenario you outline above–in which a consent decree governs key aspects of Fannie and Freddie’s operations until they can meet their new capital targets, which they would have an incentive to do quickly through capital raises–would allow Mnuchin and Calabria to accomplish their reform objectives for the companies in the 15-month period they know they have, and they may well find something like that attractive.

            For Daniel: The $43 billion “stress test capital” you cite isn’t anywhere close to the capital figure the companies will have to hit. As I’ve noted before, the Dodd-Frank stress test that produced this loss figure for Fannie and Freddie (which would only have been $18 billion without assuming a reserve for the companies’ deferred tax assets, or DTAs, and which for commercial banks subject to the same test was $114.9 billion without DTA reserves) is simplified and stylized, and not a good approximation for what actually would happen if home prices did fall 25 percent. Even with the DTA reserve, the Dodd-Frank stress loss number is only 78 basis points of the companies’ total assets, and also barely half of the $84.1 billion in core capital the companies had when they were taken over by Treasury in September 2008, for the ( fabricated) reason that they were undercapitalized. If I had to guess, I would say FHFA and Treasury will be shooting for something close to double Fannie and Freddie’s June 30, 2007 capital, which would be around $170 billion, or 3.0 percent of their current assets. Fannie’s piece of that would be around $105 billion. With retained earnings alone–and assuming no asset growth–it’s unlikely the company would reach that figure before 2027. That’s an awfully long way off.

            As to the warrants, Treasury will (and has to) make that decision well before any capital raise could take place, so it’s not an “either-or”. I have no insights as to how Treasury is thinking about that, however.

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          2. @Daniel

            calabria has been talking about a capital raise to reporters enough for me to believe that there will be a capital raise; my problem has always been that I couldn’t understand how it could be executed if, as I believe it is true, new investors would be reticent to invest money into companies that would remain in conservatorship for some period after the capital raise (because it will require more than one capital raise to meet the capital rule).

            this transitional idea where the GSEs go from current state with NWS switched off to retain earnings, to a capital raising state where the companies have been released from conservatorship but operate under an agreement, to a final state where the companies meet the capital rule but continue to operate under some provisions of the agreement (thereby accomplishing “lasting reform” administratively) is brilliant from an execution and logistics point of view.

            of course, I may be misreading the leaked tweet.

            rolg

            Liked by 1 person

        1. The $10 billion figure is my estimate (based on Fannie’s guidance) of the first quarter 2020 addition to the loss reserve Fannie will book as it adopts the Current Estimated Credit Loss (CECL) method for its loss reserving. As the name implies, CECL requires a company to hold in its loss reserve an amount it deems sufficient to cover the lifetime credit losses it anticipates for its current book of business. As I’m sure everyone will recognize, $11 billion in lifetime credit losses–the $1.0 billion in the general (i.e., not specifically identified) loss reserve Fannie has now, plus the estimated $10 billion addition next year–on $2.9 trillion in single-family credit guarantees and $300 million in multifamily guarantees is an extraordinarily low amount: only 34 basis points of combined outstanding single- and multifamily loans. (By way of comparison, Fannie books more in annual guaranty fees than this estimate of its lifetime credit losses.) Going forward, Fannie will make quarterly additions to, or subtractions from, its loss reserves as its estimate of the lifetime expected credit losses on its total book of business changes. These future quarterly entries, however, should be much smaller than the roughly $10 billion I expect the company to book in the first quarter of next year.

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          1. Tim,

            Thanks for that info. Can you explain why the statutory capital requirement is at 3% when the expected CECL is only $10 billions? 3% seems rather large which would result in about $100B in reserve.

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          2. Well, the $10 billion is an expected loss number, not a stress loss number, and a capital requirement needs to cover the stress loss with a margin of safety. But a paraphrasing of your basic point–that a 3 percent capital requirement for a company whose 34 basis point expected lifetime credit losses can be covered by less than one year’s worth of guaranty fee income seems far too high–I agree with you on, and it’s a point I’ve made previously. And you can say the same thing about the Dodd-Frank stress losses: in this year’s test Fannie and Freddie’s combined stress losses were $12.8 billion, or 23 basis points of their average loan balance, while the large commercial banks subjected to the same stress environment had credit losses of $296 billion, or 5.7 percent of THEIR average loan balances. When FHFA finally comes out with its required capital for Fannie and Freddie, we will be able to compare the relationship of the companies’ capital requirement to their Dodd-Frank stress losses and CECL expected losses with the same relationship (required capital to Dodd-Frank and CECL losses) for the large commercial banks. When we do this I suspect we will find that Fannie and Freddie are being asked to hold a much larger multiple of these two loss measures than are banks, which I (and I’m sure others) will not be hesitant to point out, and to ask, “why”? At the same time, we also will be able to compare Fannie and Freddie’s capital-to-loss ratios with the FHA, relative it ITS credit losses and delinquencies (it doesn’t do a Dodd-Frank stress test), where I’m fairly certain we’ll find the same thing.

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  6. Ditto to fanfred1 and thank you Tim. It’s frustrating to see the main players – treasury. FHFA, congress both sides – seemingly out in left field on this whole fiasco, lacking reality and common sense. And the SBC hearing shows the administration doesn’t seem to get it either. So grateful for the en-banc court to push things back toward sanity, reality, and common sense as well as constitutionality and justice.

    Liked by 1 person

  7. Having re-read this more closely (too rushed for time earlier this morning) I find your comments empowering. I like to comment frequently on GSE articles in NYT, WaPo and WSJ, because no one else seems to be doing so very forcefully. I truly enjoy giving the ideologues there grief in a pleasant and joyful manner. You have given me lots of additional ammo. Thanks.
    Jeff Wood
    Springdale, AR

    Liked by 2 people

    1. Jeff: You’re welcome, and have at it! The dramatically different treatment of and prescriptions for Fannie/Freddie and the FHA in the Treasury and HUD reports, respectively, would have been an easy, and a great, story for an informed, inquisitive and objective journalist to pursue. If only we had such journalists covering this beat.

      Liked by 4 people

    1. @Q

      one of the interesting things Thompson mentioned on IU conference call was that the Collins APA holding is not a final judgment, just a reversal and remand so that the district court judge can assess relief and then order a final judgment.

      any filing for SCOTUS cert now by treasury would be an interlocutory appeal, which SCOTUS is usually disinclined to grant. for instance, there is a big difference between a collins holding which results at the district court in a retirement of the senior preferred and some $25B credit for future taxes, as opposed to no relief granted by the district court (for reasons that I cannot imagine, but until the district court rules, one never knows). SCOTUS typically wants to review not just a legal holding in the abstract but a final judgment that has the relief attached to it. Thompson also mentioned that the solicitor general, knowing this, often doesn’t even file for cert under this circumstance, which could lead to a conversation between Treasury Mnuchin and DOJ Barr.

      so the appeal to SCOTUS is uncertain, and the timeline if there is an appeal is even more uncertain.

      rolg

      Liked by 1 person

  8. Tim

    there was some discussion at SBC re GSE’s increasing amount of mortgages to high DTI borrowers, as well as cash out mortgages and even multi-family lending, and there is the scheduled background the 2021 expiry of the QM “patch”, with uncertainty as to any replacement. My own expectation is that congress will address none of this, so that fhfa will be the party responsible for addressing, or not, this “deterioration” of underwriting standards. while I agree with your commentary regarding the stark differences between HUD and the GSEs regarding credit quality, my fear is that Calabria will restrict GSEs activity under the guise of reducing their “footprint” and may even require higher capital levels in view of this supposed credit deterioration (even though as you note the far greater urgent is to be found at HUD). my suspicion is also that Calabria won’t address most of this until the QM patch replacement, if any, is resolved, leaving this to be at least one year off, but that suspicion is based more on my view of human nature (facing and addressing difficult things take longer than one might think) than anything else.

    what I am not clear on is what kind of process must fhfa go through in making any underwriting changes. as opposed to the capital rule which is subject to publication and commentary, I am not aware that in trying to become a “world class regulator” calabria needs to apply a similar publication and commentary process for any underwriting changes. I would be interested to know what you think Calabria’s process will (or must) be in this area.

    rolg

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    1. I did note the discussion about higher debt-to-income (DTI) borrowers during the Senate Banking Committee hearing, and also Calabria’s focus on it. When I was in charge of the credit risk analytics at Fannie, there was some correlation between DTI and delinquency and default, but it was relatively weak, and the modestly higher risk of higher DTI loans could easily be covered by slightly more capital or modestly higher guaranty fees. I doubt that’s changed much since I left. And in any event, this sort of thing is a normal part of the credit guaranty business, and in fact the risk-based capital requirement FHFA is now working on is designed to accommodate changes in DTI automatically. They’re certainly not anything the Director of FHFA needs to take regulatory action on.

      I understand that Fannie and Freddie don’t have a binding risk-based capital requirement yet, aren’t yet allowed to retain capital, and are still in conservatorship, so the FHFA director has a larger role to play in their governance. But I (and others) sense in Mark Calabria a tendency to want to impose his own, sometimes not-too-well-informed, views on what the companies should or shouldn’t be doing. I believe that as conservator he has very broad powers to direct underwriting or even product changes at the companies, but once they come out of conservatorship he will not. My main concern is that before Fannie or Freddie can get themselves recapitalized he will make ill-advised or ideologically driven changes in their business, to the detriment of the capital-raising effort. The only way to stop that, I’m afraid, is through some form of political pressure, or if Treasury and its investment advisers tell him that he’s being harmful rather than helpful.

      Liked by 2 people

  9. Thanks Tim. I read your blog more closely, and more completely, than any other one out there. And all the comments too! I don’t have the financial or legal background to comment much, but this has been a great education!!
    Jeff Wood

    Liked by 4 people

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