How We Got to Where We Are

It is difficult to evaluate the wide range of opinion about how best to end Fannie Mae and Freddie Mac’s conservatorships, or the alternatives Treasury and FHFA now have for doing so, without an understanding of the political battles that have engulfed the companies over the past two decades, which I call “the mortgage wars.”

Following two thrift crises in the late 1970s and late 1980s, Fannie and Freddie’s access to the international debt and mortgage-backed securities markets enabled the U.S. mortgage finance system to undergo a smooth transformation from having been heavily deposit-based in the mid 1970s (when nearly three-quarters of all single-family mortgages were held by thrifts or banks) to being much more evenly balanced between deposit-based and capital markets-based sources of funding in the late 1990s, with Fannie and Freddie either owning or guaranteeing two of every five residential mortgages in the country.

The increased competition with deposit-based mortgage lenders by capital markets investors, facilitated by Fannie and Freddie, benefited homebuyers by adding greater standardization and increased liquidity to the 30-year fixed-rate mortgage. But it also reduced deposit-based mortgage lender profitability, because capital markets investors could price 30-year mortgages more efficiently than depositories, who had to compensate for the risk of funding them with short-term deposits and purchased funds. This better pricing lowered mortgage rates in general, led to a relative shift in volumes away from depositories, and reduced the net interest margin on the mortgages depositories did hold. In addition, Fannie and Freddie’s influence over secondary market underwriting limited the ability of primary market lenders to customize or “brand” their mortgages, because they wanted  them to remain eligible for sale as Fannie or Freddie mortgage-backed securities.

Large commercial banks and bank-owned lenders chafed at the constraints imposed on the pricing, underwriting and profitability of their mortgage operations by the secondary market activities of Fannie and Freddie. In reaction, in June of 1999 three large banks, two mortgage insurers and one subprime lender formed a lobbying group called FM Watch, whose goal was to attempt to undermine the strong bipartisan support the companies had in Congress, and ultimately obtain legislation favorable to themselves. From its inception, the message of FM Watch to Congress, and the public, was that Fannie and Freddie’s unique federal charter needed to be amended or repealed because the companies were using it to take enormous financial risks at taxpayer expense (pre-crisis, this was always said about interest rate risk, and never credit risk), and to channel its benefits to shareholders and management rather than homebuyers. These claims were demonstrably false, and while I was at Fannie we easily could counter them in Congress with verifiable fact. Yet over time the constant barrage of FM Watch-based misinformation had a profound negative effect on Fannie and Freddie’s public image, and this paved the way for what Treasury was able to do to the companies during the financial crisis and afterwards.

Treasury had been advocating publicly for changes to the companies’ charters since 2000, without success. But in the summer of 2008 Secretary Henry Paulson saw an opening to achieve all of Treasury’s historical objectives for Fannie and Freddie, and then some. A series of negative articles about them (citing rumors from an unknown source) had caused severe weakness in their stock prices, and in response to one such episode Paulson made a public pledge on July 11 to support Fannie and Freddie “in their current form.” Paulson could not provide this support without the reform legislation Treasury was sponsoring—the Housing and Economic Recovery Act (HERA)—and as he writes in his book, On the Brink, “Fannie and Freddie needed to be brought on board, quickly. Without their support, legislation would go nowhere. On Saturday I called Dan Mudd and Dick Syron to get their cooperation.” Taking Paulson at his word that HERA would be helpful to their firms, both CEOs agreed not to oppose it, and the legislation passed easily.

Mudd and Syron had little reason to suspect that what Paulson really wanted was not to help the companies out but to take them over. At the time Fannie and Freddie were fully in compliance with their statutory capital requirements, and were the only healthy sources of residential mortgage financing in the market. The private-label securities market had imploded, and banks were suffering from mortgage delinquency rates three times those of Fannie and Freddie. Under the circumstances, Mudd and Syron can be excused for not having paid more attention to a clause in HERA not found in any other regulatory statute: “The members of the board of directors of a regulated entity shall not be liable to the shareholders or creditors of the regulated entity for acquiescing in or consenting in good faith to the appointment of the Agency [FHFA] as conservator or receiver for the regulated agency.” Paulson knew he would be able use this clause, together with what he termed “the awesome power of the government,” to force the boards of directors of Fannie and Freddie to accept conservatorship notwithstanding that neither company met any of the criteria for conservatorship listed in the HERA legislation they just had been tricked into supporting.

From the moment the companies came under government control, the official narrative about them differed markedly from economic and financial reality, and closely tracked the mantra created by FM Watch almost a decade earlier of “flawed charter, excessive risk to taxpayers, and questionable benefits to homebuyers.” In conservatorship Fannie and Freddie no longer were free to counter this narrative, and the media did not question it, in spite of the many contradictions between what Treasury and FHFA said was happening with the companies and what was readily observable about them. One early example was Treasury’s claim that Fannie and Freddie urgently were in need of financial help, and then having its first requirement of them be that they shrink their mortgage portfolios by ten percent per year, even though the net interest income from those portfolios was helping to absorb the losses from their credit guaranty businesses. That didn’t matter to Treasury: shrinking or eliminating Fannie and Freddie’s portfolios had long been on its “hit list,” and it now had the power to require that.

The companies’ critics also got away with completely switching the focus of their claims of excessive risk-taking. Prior to the crisis they uniformly asserted that the threat posed by Fannie and Freddie to taxpayers came from the interest rate risk in their portfolios (which were tightly duration matched, rebalanced continually, and performed superbly during the downturn), and that they weren’t taking enough credit risk with their affordable housing initiatives (and instead were “gaming the system” and making only safe, profitable loans) because their credit losses were so low. But post-conservatorship these same critics instantly, and shamelessly, began saying the opposite: that Fannie and Freddie’s “flawed business model” had caused them to take so much credit risk as to trigger the mortgage crisis. Of course, both before and after the crisis contemporaneous data on mortgage credit performance were freely available to anyone who cared to look at them, and they consistently showed Fannie and Freddie’s delinquency and default rates to be about one-third those of banks and one-tenth those of subprime lenders and the loans in private-label securities. But that didn’t matter either; the media ignored the facts and printed the fiction, while Fannie and Freddie remained within their enforced cones of silence.

I won’t retell in detail the story of how Treasury and FHFA engineered massive amounts of discretionary book losses for Fannie and Freddie between the third quarter of 2008 and the fourth quarter of 2011 to force them to take $187 billion in senior preferred stock from Treasury, at a 10 percent annual dividend, that they didn’t need and Treasury wouldn’t let them repay, nor of how Treasury and FHFA agreed to the net worth sweep in August of 2012 when they realized that a huge amount of these book losses were about to reverse and become income and then capital, which they desperately did not want the companies to be able to retain. The net worth sweep, however, proved to be “a bridge too far,” and it resulted in a flurry of related lawsuits against the two agencies. Suits filed in the U.S. Court of Federal Claims were granted fact discovery, and documents produced from it left no doubt that Treasury and FHFA had entered into the sweep not for the reason they gave at the time (to prevent a “death spiral” of borrowing to pay senior preferred stock dividends) but to prevent the companies from rebuilding their capital.

Paulson and others at Treasury never expected things to get to that point. The prevailing view among members of the Financial Establishment when Fannie and Freddie were taken over was that Congress would replace them relatively quickly with a secondary market mechanism more to their liking. Consistent with this expectation, Treasury and FHFA had openly managed the companies not to prepare them for release from conservatorship but to ultimately wind them down, with FHFA requiring that they collaborate in building a common securitization platform that could be used by their eventual successors, and mandating them to “de-risk” themselves by issuing non-economic credit risk-transfer securities. Yet even with no opposition from Fannie, Freddie or their past supporters, opponents of the companies never were able to come up with a viable replacement for them. The reason should have been obvious long ago: contrary to the now two-decades old label from FM Watch of Fannie and Freddie as a flawed business model, the two companies did and do work effectively and efficiently, while the ideas devised by the Financial Establishment for replacing them with something different did and do not.

When Treasury Secretary-designate Steven Mnuchin said in November of 2016, “we gotta get [Fannie and Freddie] out of government control….and in our administration it’s right up there in the list of the top ten things we’re going to get done, and we’ll get it done reasonably fast,” he undoubtedly believed that the path for releasing the companies would run through Congress. Today, he and FHFA director Mark Calabria both understand that the only way to make good on Mnuchin’s pledge is through administrative reform. But neither, I believe, has fully come to grips with the crucial fact that in switching between these two tracks, the fictions about Fannie and Freddie that were essential elements of the attempt to replace the companies in a legislative process become impediments when the goal is to successfully recapitalize and release them in an administrative process.

If the best economic result were the overriding objective, getting Fannie and Freddie out of conservatorship would be no more difficult than it was to get them in: Treasury would settle the lawsuits by unwinding the net worth sweep and canceling its liquidation preference; FHFA would specify a true risk-based capital standard without excessive conservatism—making the companies attractive to new equity investors—and based on their updated capital requirements Fannie and Freddie each would prepare capital restoration plans for FHFA’s approval. In these plans they would use retained earnings to reach the critical capital requirement in the new standard, at which point they would be released from conservatorship under a consent decree and be free to raise new equity in whatever amount and at whatever pace they chose. Then, once they fully met both their minimum and risk-based capital requirements, they would be released from their consent decrees to return to their former status of independently managed shareholder-owned entities, under FHFA’s supervision and regulation.

But that’s not how the process will work, because of two carryovers from the failed legislative efforts of the past. The first is that the Financial Establishment and its supporters remain committed to their twenty-plus year goal of hamstringing Fannie and Freddie’s competitive position, and are hoping to accomplish this in administrative reform by convincing FHFA to subject the companies to excessive and unnecessary required capital and burdensome regulation by using the arguments of promoting safety and soundness and a “level playing field” for new competitors. The second is that Treasury as of yet has shown no signs of moving away from the false claims it’s been making about Fannie and Freddie since before the conservatorships, which it must do if it wishes them to be able to raise new capital. Investors will not put tens of billions of dollars into companies Treasury describes as having a “flawed business model.”

It seems that FHFA will be the first of the two agencies to reveal where it has come out in the choice between fiction- and fact-based alternatives, if as most observers expect it issues its revised Fannie and Freddie capital proposal for comment sometime this quarter. If FHFA removes some or most of the cushions and conservatism it built into its June 2018 proposal—which were designed to produce an artificially high but “bank-like” risk-based capital number of 3.5 percent—it would be a strong positive signal that it and Treasury are willing to go at least some distance towards allowing Fannie and Freddie to function efficiently as private entities. The consequence should be a relatively rapid recapitalization, fueled by significant access to private capital. A revised FHFA capital proposal with few changes to the 2018 version would send the opposite signal, foreshadowing a much slower recapitalization, accomplished largely if not exclusively through retained earnings, before the companies could free themselves of FHFA-imposed operating restrictions.

For its part, Treasury seems inclined to wait until the revised FHFA capital proposal is out and the timing of a potential Fannie or Freddie capital raise is more clear before giving any indication of its thinking about ending the net worth sweep and canceling its liquidation preference (which are essential steps before Fannie or Freddie could raise new capital). The key unknown is the critical capital requirement, which will be half the new statutory minimum. In my view it is likely that for minimum capital FHFA will select “Alternative 2” from its June 2018 proposal: 1.5 percent of trust assets (mortgage credit guarantees) and 4.0 percent of non-trust assets. Applied to the companies’ current balance sheets, these percentages would produce required minimum capital of around $60 billion for Fannie and around $40 billion for Freddie, and required critical capital—which could trigger release from conservatorship under a consent decree—of about $30 billion and $20 billion, respectively. Both companies are very likely to use retained earnings to meet their critical capital targets, which would push any potential capital raise by Fannie well into 2021 and by Freddie probably into 2022.

Based on this timeline, Treasury should have plenty of discretion to pick what it thinks is the best approach to and timing for a settlement of the lawsuits. I have long believed that Treasury will want some political cover for any settlement it negotiates, to avoid the charge (leveled loudly and often by Fannie and Freddie’s opponents) that it is “giving away the taxpayers’ money to hedge funds.” Treasury is closely monitoring the three suits that are moving towards trial on the facts—Collins under Judge Atlas, Perry Capital under Judge Lamberth, and Fairholme under Judge Sweeney—and I’m sure it realizes, because of the documents produced in discovery in Sweeney’s court, that it won’t prevail in any of them. My analysis is that Treasury will initiate serious settlement talks with plaintiffs when the first of those three suits (now most likely Collins) is getting close to the trial date, with the goal of of reaching settlement before that trial occurs in order to avoid a public airing of facts unfavorable to the government, as well a high-dollar settlement award to plaintiffs.

It is regrettable, though, that the sequencing isn’t reversed, with Treasury first settling the lawsuits and FHFA issuing its capital proposal subsequently. In that order, I believe there would be a much better chance for the investment community to convince Treasury that it has to structure Fannie and Freddie to succeed in order for their recapitalization to be a success as well, and for Treasury to be able to maximize the value of the warrants it holds for 79.9 percent of the companies’ common shares. Treasury then could convey this reality-based message to FHFA as it re-engineers its capital rule. But the sequencing die has been cast, and we now are left to wait to see whether the proposed future versions of Fannie and Freddie that emerge from Treasury and FHFA’s administrative reform process are based on historical fact or fiction. It will not be difficult to tell which it is.

22 thoughts on “How We Got to Where We Are

  1. Tim,

    I would love to be able to post this to Linked In (I already posted it to Facebook.) Is there any way to to that? I would love to enlighten the public more and your history of this situation should be cast far and wide, in my humble opinion. Thank you for the work you are doing. It is much appreciated.

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  2. Tim

    Thanks for this. I found in private practice that inertia was the strongest force in the universe, especially with respect to litigated matters, where lawyers go into litigation mode (war analogies come to mind) and wish to show no signs of “weakness” such as to contemplate settlement, and the principal absents itself from decision making because the legal process is arcane, opaque and “best left to the lawyers”. This is the situation with the GSEs, where DOJ is running the show and Mnuchin is more than busy attending to such other matters as tariffs, sanctions and pesky congressional oversight.

    This litigation inertia is enabled by motion practice relating to the proper statutory interpretation of HERA and the constitutionality of FHFA’s structure, all very complicated legal matters “best left to the lawyers”. What is required to break through this litigation inertia and force Mnuchin as principal to use his banker’s judgment even in this highly political setting is precisely something far less conceptual, opaque and esoteric…such as the prospect of a >$100B judgment entered against the United States, forcing Mnuchin to bear the burden of Hank Paulson’s misadventures. I am not aware of a larger financial judgment ever having been entered against the United States in its history and, based upon Judge Willet’s opinion and the facts as they have emerged in the Fairholme discovery, this judgment is exactly what will ensue. Yes, this judgment would still be subject to eventual scotus review, but a massive financial judgment dropped in Mnucin’s lap should have the effect of forcing the principal to realize that the process is no longer “best left to the lawyers”.

    rolg

    Liked by 1 person

    1. I agree with you, and it’s one reason I said in the piece that it would have been preferable for the legal settlement process to have occurred before FHFA came out with its proposed capital rule. Based on Director Calabria’s public statements, I’m concerned that his revised capital rule will be guided more by ideology and politics than finance and economics, and that this will make the path to a successful recapitalization of the companies more difficult. Of course, there will be a comment period before a final rule is adopted (I will be one of the commenters, and I know the affordable housing groups will weigh in as well), but it would have been better had the reality-based exercise of a settlement of the lawsuits happened first.

      Liked by 2 people

    2. Why would the Plaintiffs settle now? I think a settlement should have occurred a year or two ago. If the winds of Victory are blowing in the direction of the Plaintiffs after many years of wrangling- isn’t it best to play this out in the Courts?

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      1. If the plaintiffs can get what they’re asking for as a judgment given to them in a settlement, they save time, legal fees, and the potential (however small) for a favorable lower court verdict to be overturned or the judgment reduced on appeal or by the Supreme Court. But the plaintiffs will make that call.

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      2. David/Tim

        my own view is that any litigation settlement should be done in connection with an amendment to the Senior Preferred Stock Agreement and an exchange offer made to the junior preferred holders. one large comprehensive deal.

        for example, lets assume that treasury might be willing to cancel its senior preferred in connection with a litigation settlement but is not as willing to provide a credit against future taxes in respect of the some $25B in dividends made to treasury in respect of the senior preferred beyond the “10% moment” (point in time when the senior preferred would have ben retired in accordance with its original terms). this forgone $25B in future tax collections is what I call “hard money”. a negotiator would try to find if there can be substituted for this hard money something resembling “soft money”.

        one source of soft money is treasury’s warrant position, what it might be able to monetize down the road at the end of the privatization of GSEs and full withdrawal of the government’s investment. Treasury is likely to be more willing to forgo $25B in (speculative) future value of the warrants as opposed to forgoing receipt of more certain GSE tax payments…so for example that if the treasury warrant position is valued by mutual agreement at $75B, it would cancel one third of its warrant position.

        GSE common shareholders would favor this, but junior preferred holders would derive no value from an enhancement of the common stock value…unless junior preferred holders are made an exchange offer for common at the valuation of the common prior to any cancellation of treasury warrants.

        it has been my experience that if you are trying to settle a complex situation it is best to put all of the issues on the table and solve them all at the same time…you will be able to find more items that can serve as possible trading chips if you find more issues to solve at the same time. things actually become easier rather than more difficult.

        rolg

        Liked by 1 person

  3. This is an excellent historical summary. Thank you. I do think, in light of the discovery documents that have been released, that the warrants are suspect along with all the other manipulations Paulson and Geithner imposed. I don’t think Treasury is going to get nearly as good a settlement today as it could have gotten two years ago. We’ll see.

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    1. I’m still waiting to see Judge Sweeney’s ruling as to whether her court has jurisdiction for hearing the suit brought by Washington Federal. If she denies the government’s motion to dismiss that case, the warrants may be play in settlement talks, since Washington Fed is the only suit that challenges the conservatorships. Note, however, that Washington Fed does not ask for the warrants to be cancelled; it asks for monetary damages ($41 billion) for all of the financial harm from the conservatorships. Still, that would be a “handhold” for getting some concessions on the warrants in a settlement.

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      1. Mr. Howard, i often wonder if the reason the warrants have not been challenged is due to not being exercised thus not being ripe. “a claim is not ripe for adjudication if it rests upon contingent future events that may not occur as anticipated, or indeed may not occur at all.” Though the statute of limitations appears to have expired for new suits I am wondering you thought if exercised would there be a legal argument that the legal clock starts when exercised, because this matter is now ripe?

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        1. I’ve seen comments on other forums–and also get comments on this blog (which I delete)–expressing puzzlement about why I’m a fan of the warrants. I’m not. I believe Treasury improperly and probably illegally granted them to itself as part of an overall set of confiscatory actions intended to keep what had been two healthy companies, Fannie and Freddie, in conservatorship indefinitely (which so far has worked), and I wish the granting of the warrants had been challenged legally before the statute of limitations had expired. But as an analyst I also have to be realistic: I do not believe there is a direct path now to invalidate the warrants (although as I note above the Washington Fed case, if accepted by Judge Sweeney, may give plaintiffs leverage to get them modified in a settlement).

          The point you make about ripeness has come up before, and I haven’t changed my view on it. The warrants conveyed economic value to Treasury on the day they were granted, a fact Fannie and Freddie both reflect in their quarterly financial statements, because they calculate their earnings per share using the number of shares that will be outstanding after warrant conversion. The warrants are so far in the money (with a strike price of one one-thousandth of a cent per share) that I do not believe the “ripeness” argument will apply.

          Liked by 1 person

          1. Tim,

            Regarding your last paragraph, I’m not addressing the ripeness question directly but rather the value you cited with respect to the Treasury and the referenced EPS relative to traded shares plus warrants.

            If the warrants, with respect to original intent and fair play, are akin to the value of a term life insurance policy (a hedge against the death of the GSEs), then the warrants always have value as long as death of the GSEs looms. As long as the GSEs are on life support, then yes, the insurance policy has value (and EPS are further diluted). The value can be considered a potential value – – but a potential value that would be predicated upon the death of the GSEs. Yet once the patient is restored to full health, the insurance policy hedge against death would no longer be needed.

            My point is, how is it unreasonable to value the warrants *only* in light of the potential chance of death (for no such policy can be exercised unless the patient dies)? If the patient exits the hospital (of the Hotel California), then wouldn’t the need for the insurance policy have expired? The reason being, the Treasury would no longer be at risk.

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          2. Ron: As you probably know, in this blog I have a policy not to engage in discussions about the warrants. It is a very emotional topic for investors who have a lot at stake in their holdings of Fannie and Freddie common stock—Treasury obtained the warrants improperly or illegally (I concur), so how can I possibly not agree with their argument for why they should be cancelled, or if exercised be subject to a legal action? My analysis is that Fannie and Freddie investors did not challenge Treasury’s warrants within the statute of limitations, and that as a consequence Treasury now is able to do with these warrants as it wishes, although if the Court of Federal Claims takes jurisdiction over the Washington Federal case investors will have some ability, in a negotiated settlement, to affect the terms of that exercise. I wish it were otherwise, but that’s how I see it. (And, consistent with my policy, this will be the last comment I’ll accept in this string about the warrants.)

            Liked by 1 person

          3. One would hope all these snippets of snippy Libs on MSM going full-on, panic mode over the “hidden documents” potentially concealing POTUS malfeasance do not age well and in the near term. I was getting tired of typing the word “documents” for the past three years but today’s hearings give me renewed vim & vigour to redouble my efforts because my misery is happy that company brought whine. Refreshing that our pain is shared. History does love a good sequel. I dare anyone to play the “documents” drinking game tonight for ten minutes of Maddow(which you would need to do to watch, imo). hic Gl,

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