First Quarter Takeaways

Fannie Mae and Freddie Mac’s first quarter 2020 earnings were disappointing in one way but extremely promising in another. The disappointment came from the headline numbers, with Freddie reporting net income of only $147 million compared with $1.41 billion in the first quarter of 2019, and Fannie reporting net income of $461 million versus $4.37 billion in last year’s first quarter. Yet upon reading the details it became clear that each company’s results incorporated the effects of having adopted the current expected credit loss (CECL) method of reserving for loan losses, which shifted the basis for these reserves from losses already incurred to all expected future credit losses, and thus incorporated management’s current best estimates of credit losses from the Covid-19 pandemic. For both Fannie and Freddie, those estimates of loss were small by any standard.

In its earnings press release, Freddie said that the change from a $135 million (positive) benefit for credit losses in the first quarter of 2019 to a $1.233 billion (negative) provision for credit losses in this year’s first quarter was “primarily driven by higher expected credit losses on loans as a result of the pandemic, partially offset by the related expected recoveries from credit enhancements,” but it did not give dollar figures for these items nor did it specify the assumptions that produced them. Fannie did both. In its press release it said, “The company increased its allowance for loan losses to reflect the losses it currently expects to incur, including $4.1 billion as a result of the economic disruption caused by the COVID-19 outbreak, which are reflected in its $2.7 billion of credit-related expenses for the quarter.” It also gave two key assumptions behind this estimate in its 10Q filing with the SEC: that single-family loans in Covid-19 related forbearance would rise from their current estimated level of 7 percent of the total to 15 percent, and that 2020 home prices on a national basis would be flat compared with 2019.

During Fannie’s earnings conference call its CFO, Celeste Brown, disclosed more details of the assumptions behind the loss estimates, saying: “Our economists believe that the most plausible scenario is one in which the annualized Q1 GDP decline of 4.8% is followed by a more severe annualized decline of around 25% in the second quarter. Despite a forecasted rebound in the second half of the year, we expect full year 2020 GDP to fall approximately 3% and bounce back in 2021 to approximately 5% growth. We expect the unemployment rate to average 12% in the second quarter of 2020 with the peak of close to 15% before ending 2020 around 7%.” Fannie’s public filings and conference call did include qualifiers. In its 10Q it noted, “Our forecasts and expectations relating to the impact of the COVID-19 outbreak are subject to many uncertainties and may change, perhaps substantially, from our current forecasts and expectations,” while during the call Brown stated, “For the first quarter, the impact to our financials is largely based on management judgment, and by next quarter we will have more data points to consider and we’ll re-evaluate our economic outlook as well as our assumptions regarding forbearance and our loan loss allowance.”

Even with these caveats, both companies’ estimates of pandemic-related credit losses had to come as a welcome surprise and relief to policymakers, investors, analysts or any party interested in or affected by Fannie and Freddie’s financial health and ability to support the mortgage market during the potentially very challenging times ahead. Prior to the earnings reports, the prevailing discussions had been about whether the modest amounts of capital the companies had been permitted to retain since last June would be sufficient to cover their losses from the pandemic without requiring draws from Treasury. We now know from the companies themselves that, using the best estimates they’re able to make at the moment, they’ve reserved for all expected future credit losses without losing money in the quarter in which those reserves were added.

I have to say that my own sense is that Fannie (and by implication Freddie) is being overly optimistic in its assessment of how quickly and fully our country will be able to bounce back from the sudden shut-down of roughly one-third of the economy. Over 30 million people have filed for unemployment benefits in the last six weeks, and that number will grow in the coming weeks. Getting those people back to work won’t be nearly as easy as it was to let them go. But as everyone is saying, we’ll have to wait to see how things play out over the next few months. And in the meantime, we have a baseline for doing sensitivity analyses: the economic scenario Fannie’s management has laid out, and the credit losses the company expects will result from that.

Many commenters, it appears, had leapt to equate the pandemic with the 2008 financial crisis, and therefore based their fears of the magnitude of Fannie and Freddie’s potential credit losses on this prior experience. While that equivalence is false—the circumstances today are different in almost every way from what they were a dozen years ago—we nonetheless can use the 25 percent peak-to-trough home price decline during the crisis to create a worst-case loss scenario for our current situation. The $2.53 trillion book of single-family business Fannie held at December 31, 2007, just before the crisis began, now has twelve years of loss data, and it’s on track to experience a lifetime credit loss rate of 3.75 percent. An identical loss rate on Fannie’s $2.95 trillion single-family book at December 31, 2019 would produce lifetime credit losses of $111 billion, which, if they followed the pattern of the last cycle, would have nearly $80 billion hitting Fannie’s books before the end of 2024.

Could Fannie today be facing worst-case credit loss amounts anywhere near these levels? The answer is “no,” for two reasons. First, Fannie’s 2007 book contained a large number of loans with product types and risk features—such as interest-only adjustable-rate loans, no- and low-documentation fixed-rate mortgages and excessive risk layering—that contributed to roughly half of the credit losses on the 2007 book but no longer are permitted and thus barely are present in the 2019 book. Second, nearly half of the single-family mortgages in the December 2019 book are covered by some form of credit-risk sharing arrangement, over and above private mortgage insurance, which in a severe credit loss scenario will absorb a significant amount of these loans’ losses.

We’ll take these one at a time, starting with the higher credit quality. Fannie publishes periodic presentation packets on its Connecticut Avenue Securities (CAS) risk-transfer securities that include charts and tables adjusting Fannie’s historical credit performance by origination year for the differences in risk profile between the actual book of business then and the pool of loans it’s insuring with a particular CAS issue. While these data vary from packet to packet (because each CAS-insured pool is somewhat different), we can use their averages to reconstruct the losses of Fannie’s year-end 2007 book of single-family business had it been composed of mortgages with risk characteristics and features comparable to those of the mortgage pools Fannie has insured over the past half-dozen years. Doing this, the realized credit losses of the 2007 book fall to about 60 percent of what they actually were, making their lifetime credit losses not $111 billion but $67 billion, or $48 billion over the next five years (not $80 billion), before credit-risk transfers.

I’ve been a persistent critic of Fannie and Freddie’s credit-risk transfer programs, arguing that the companies were greatly overpaying for the right to transfer credit losses they were highly unlikely to incur. Up until late March, when social distancing took effect, that indeed seemed to be the case. For the past three years, the credit loss rate on Fannie’s post-2008 mortgages—which today account for 95 percent of its total book—has averaged a mere 2.0 basis points per year, and in 2019 it was only 1.7 basis points. Last year Fannie paid over $1.6 billion for risk transfers that generally don’t activate until cumulative losses as a percentage of the initial insured pool balance exceed 50 basis points (25 times the 3-year annual average of the post-2008 book), and they cover these pools for more than 400 basis points of cumulative losses (over 200 times the current 2.0 basis point annual loss rate). But now we have the pandemic, and in a worst-case scenario many of these risk transfer arrangements would pay off, to the great shock and dismay of the institutions and investors on the other side of them.

Over the past six and a half years, Fannie has been able to cover 46 percent of the single-family book of business it held at March 31, 2020 either with a CAS risk-transfer security (31 percent), a Credit Insurance Risk Transfer, or CIRT, arrangement with a mortgage insurer (10 percent), or a lender risk-sharing agreement (5 percent). Even in a worst-case scenario, however, not all of these arrangements will pay off, for three reasons. First, some risk-sharing is on older books that now have considerable seasoning and equity build-up, and won’t suffer large losses. Second, even in the highest-loss years some risk transfers will have coverage that exceeds the losses for that particular pool. And third, the most senior CAS tranches (called the M1), which typically cover losses in the range of 3.25 percent to 4.25 percent of the initial pool balance, can pay off very quickly if pool liquidations are high, and thus may not remain outstanding for long enough to absorb their share of losses.

The only way to account for all of the complexities in Fannie’s risk transfers and come up with a net worst-case credit loss number for the company’s December 31, 2019 book is to do projections of gross credit losses by origination year, then match those up with the CAS, CIRT and lender-risk sharing mechanisms associated with those books. I’ve done that using publicly available data. The result of this exercise, which obviously isn’t precise but also shouldn’t be too far off, is that in a repeat environment of a 25 percent nationwide decline in home prices as a result of the pandemic Fannie’s $67 billion in gross credit losses would be reduced by $30 billion because of loss transfers to third parties, leaving Fannie with $37 billion in retained losses, $27 billion of which would be recorded over the next five years.

Credit losses of $27 billion over five years is far from a catastrophic outcome for a worst-case scenario. As of March 31, Fannie had $6.0 billion in loss reserves against its post-2008 book of business, and another $7.2 billion reserved against individual loans from before 2009, most of which will become available to cover post-2008 losses as it gradually gets released. In addition, for the past three years Fannie has averaged $15.6 billion in pre-tax income before its provision for credit losses (which during that period has been an average benefit of $3.1 billion, because of releases of reserves from the pre-2009 book). Fannie’s existing collective loss reserve, likely releases from its pre-2009 reserves, and annual pre-provision income—coupled with the high quality of its post-2008 book of business and the credit risk transfers attached to that book—therefore should enable it to comfortably cover even a worst-case level of pandemic-related credit losses with no further draws from Treasury, as surprising as that may seem.

So, while we hope Fannie’s current estimate of $4.1 billion in pandemic-related losses turns out to be close to the mark, if it’s not it still seems highly likely that the actual outcome for its credit losses will be manageable. This means even in the worst case and during difficult times, Fannie and Freddie should be able to perform their intended roles of supporting the mortgage market, in spite of the fact that their March 31, 2020 core capital, at $13.9 billion and $9.5 billion, respectively, is far below a level anyone would deem adequate.

Which brings us to the impending FHFA capital rule. I wasn’t the only one to be thinking about how Fannie and Freddie’s business might be affected if, instead of the simple and straightforward (albeit outdated) capital standard the companies now have, they were to be subjected to what’s called the “conservatorship capital” standard FHFA promulgated in June of 2018, and is in the process of revising. Both companies addressed this in their 10Qs or conference calls, and made clear that the original FHFA standard has major flaws that if not corrected would have severe adverse impacts on their business in times like these.

In Fannie’s earnings conference call, CFO Brown noted that the inability to issue CRTs would raise Fannie’s required conservatorship capital, and added, “[i]f home prices decline, our capital requirements will increase due to the procyclicality in the current capital framework.” She also pointed out that under the June 2018 FHFA capital rule “loans in forbearance will carry a higher capital charge…credit risk capital increases by over five times with even one missed payment on a single-family loan.” This last feature means that if average capital for Fannie’s single-family loans was 2.0 percent, and 15 percent of these loans went into forbearance as is the company’s expectation, its capital requirement on all $3 trillion of its single-family loans held or guaranteed would jump to over 3.1 percent.

Freddie’s 10Q echoed the concern about CRTs, observing, “there may not be sufficient investor demand for CRT transactions at acceptable prices for the foreseeable future, and it is uncertain if there will be adequate demand for them over the longer term based on the potential impacts of the pandemic on mortgage performance.” And the Freddie 10Q also contained a table that starkly highlighted the interplay between two of the issues Brown raised: an inability to issue CRTs and procyclicality. This table showed that for loans covered by CRTs (at March 31, 51 percent of Freddie’s total), their conservatorship capital was 1.87 percent before CRTs but only 47 basis points after CRT credits. This post-CRT capital number looks too good to be true, and it is. FHFA’s June 2018 standard determines capital using current loan-to-value (LTV) ratios, and for Freddie those averaged 58 percent in March after a decade’s worth of home price appreciation had pushed them down from the original LTVs of 76 percent. I don’t have full historical data for Freddie, but during the financial crisis the current LTVs on Fannie’s loans rose from 55 percent at the end of 2005 to 79 percent six years later. If something similar were to happen to Freddie in a crisis environment, its pre-CRT conservatorship capital requirement would more than double, to over 4.0 percent, and with the CRT market shut down it would have no way to bring that percentage down at all for its new business, let alone to 47 basis points.

We can only hope that FHFA has scrutinized its June 2018 capital rule from the perspective of today’s circumstances as closely as Fannie and Freddie seem to have. Its original proposal was unnecessarily complex, excessively conservative, and had the great flaw of being too generous in good times and highly punitive in bad ones. As I said in my comment letter, FHFA can fix that proposal by making four basic changes to it: greatly simplifying it and removing the excessive conservatism; using original rather than current LTVs in the risk-based capital stress test; clarifying the roles of loss reserves, risk-based capital, minimum capital, excess capital and prompt corrective action, and not giving unwarranted value to credit risk transfers. On this last point, there is a role for CRTs in the revised capital standard, if investors will continue to buy them. But it’s not for FHFA to allow the companies to substitute contingent capital (CRTs) for upfront equity, which, as we now realize, will cause capital requirements and guaranty fees to spike during times of stress, when CRTs cannot be issued. Rather, Fannie and Freddie may wish to issue CRTs, at their discretion and based on the economics, to insure against the loss of equity in a stress environment, which is the role their CRTs are playing now.

So, here are some takeaways from Fannie’s and Freddie’s first quarter 2020 results. Most importantly, both companies believe that the high quality of their current books of business will enable them to make it through the rough times ahead, even with the modest amounts of capital they’ve been permitted to retain. Beyond that, analysis of prior stress experience strongly suggests that given their high-quality books, and the risk-transfer arrangements associated with them, even a 25 percent nationwide decline in home prices will not prevent them from continuing to carry out their missions with the capital and loss reserves they have today. It would, therefore, be the height of irony if what FHFA intends as an improved and more up-to-date capital standard actually impedes the companies’ ability to provide a comparable level of market support during whatever stress situation follows this one. FHFA must get this standard right. The pandemic has greatly increased the appreciation for the roles Fannie and Freddie play in the market—and strengthened the argument for their release from conservatorship—but it also almost certainly has delayed the timing of that release. Thus, if FHFA needs longer than the end of May to remove the idiosyncrasies and excessive conservatism from its June 2018 standard, it has that time, and should take it.

68 thoughts on “First Quarter Takeaways

  1. I have not yet read the Urban Institute analysis of the capital rule. Briefly scrolling through it, though, the paper appears to focus on issues with its technical specifications. There certainly are technical flaws with the work (of which I think the continued refusal to count guaranty fees as offsets to credit losses and the large amount of remaining procyclicality in the rule are the most important). But to me the most surprising aspect of the new risk-based rule is that FHFA chose to add still more arbitrary elements of conservatism to increase the amount of capital it requires, and that it did not fix the capital bias of the last rule as it applies to higher-risk loans.

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  2. Don Layton, former Freddie CEO (he’s a very smart man):

    https://www.jchs.harvard.edu/blog/the-new-proposed-capital-rule-for-freddie-mac-fannie-mae-ten-quick-reactions/?fbclid=IwAR23yDH172duDc3yp_lCeynP5jncIXLXbKgbw6Y8nPGM5HbzlvBHDNaZ5A4

    Layton’s “Ten quick and high-level reactions to the [FHFA] proposal”:

    1. The proposal is thorough, thoughtful, and very complicated.
    2. A strange mix of technical specificity and judgmental arbitrariness.
    3. The proposed capital rule and the Federal Reserve stress tests seem incompatible.
    4. A whiff of ideological reverse engineering?
    5. Real world implications on guarantee fees (g-fees) and market share.
    6. The leverage requirement being higher than the risk-based one is highly problematic.
    7. A risk-transfer rose by any other name [CRTs treated more unfavorably than mortgage insurance]
    8. The single security at risk?
    9. A backwards-looking strategic vision.
    10. This is going to hurt the equity-raising needed to exit conservatorship.

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    1. My quick summary of the Layton piece is that he believes the new FHFA capital rule is overly and deliberately complex and arbitrary in where it sets capital levels, and if adopted as proposed would have serious negative “real world” consequences for guaranty fees, Fannie and Freddie’s business volumes and the companies’ prospects for raising the capital required to exit conservatorship. I agree with all of these main points, but people should read Layton’s article themselves and form their own opinions about it.

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      1. Does anyone have insight on what the Dems on the Banking committee think about the proposed capital rule yet? I know it’s pretty soon, but the rule seems contrary to affordable housing goals which will be an important context as the rule goes through the comment period. I’d like to know if there is a Dem champion that will push back on some of the arbitrary and overly complex requirements that drive up capital.

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        1. I haven’t yet spoken with anyone with ties to members of Congress or congressional staffers to gauge what their reaction to the rule is. I would, though, note that because this is an administrative action by the Director Congress has no direct means of influencing it, although members can criticize it publicly and Democrats in the House could hold a hearing on it.

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  3. Tim,

    A few preliminary thoughts I have after reading the fact sheet and some parts of the full capital rule:

    1) The $234B headline number is vastly overblown. Calabria’s risk-based capital requirement for Fannie and Freddie combined is only(!) $135B, or 2.22% of Adjusted Total Assets ($6.072T). The other $99B comes from the Prescribed Capital Conservation Buffer Amount, and from what I can tell this only affects the companies’ ability to make capital distributions like dividends, executive bonuses, and share buybacks. Please let me know if I am misinterpreting this though.
    2) Calabria evidently interpreted HERA the way I had suggested in the past that he might, setting the minimum capital requirement (he calls it the Leverage Capital Requirement) at 2.5% of all balance sheet assets including the MBS, eschewing the 0.45% multiplier on MBS that you said was the spirit of the law (when HERA was written, Fannie and Freddie’s MBS were not on the balance sheet). Oddly, that leads to the minimum capital requirement being greater than the risk-based one.
    3) This last point can cause some oddities: it renders the “Undercapitalized” designation in HERA superfluous because Fannie and Freddie won’t be able to meet the minimum capital requirements without also meeting the risk-based requirements due to the former being greater. Therefore they would jump straight from “Significantly Undercapitalized” (or lower) to “Adequately Capitalized”.
    4) Therefore, if the purpose of the capital raise is to meet the minimum standard, there would be no need for a consent decree afterwards because Fannie and Freddie would be fully and adequately capitalized by HERA. The only purpose of more capital than that would be to gain the ability to make distributions. While this is of great importance to the companies and their investors, it doesn’t seem like FHFA would have a reason to care (i.e. no reason to insist on a consent decree when restrictions on distributions are already in the capital rule).

    If it’s alright with you, I’ll post more as I find it. I’m still trying to digest as much of this as I can.

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    1. Midas–

      I’ve cut this comment down to keep it, and my responses, to a manageable length. By number:

      1. Calabria intends the full capital amount– the base risk-based standard plus the two (and potentially three) buffers, totaling 3.85 percent of adjusted assets (or 4.13 percent of balance sheet assets) and the combined 2.5 percent leverage requirement and 1.5 percent leverage buffer (4.00 percent of adjusted assets, or 4.29 percent of balance sheet assets) to be binding. The proposal says in several places that FHFA will permit the full amounts to be drawn down somewhat during times of stress, but there would be dividend and compensation restrictions when that happens, and that if the companies do not replace that drawn-down capital in a timely manner FHFA can (and will) take regulatory steps against them. And I wouldn’t minimize the potential restrictions on dividends (or executive compensation). I’m concerned that the possibility of having dividends on new preferred shares being reduced or eliminated for some number of quarters during a stress period–even if the companies are very well capitalized–could be a deal-killer for potential investors, because by statute Fannie and Freddie preferred has to be non-cumulative. Potential dividend interruptions for common shareholders could be problematic as well.

      2. FHFA says in the report that for a minimum leverage standard to be credible, it will have to exceed the risk-based standard at some point in the cycle, and September 30, 2019 seemed to be such a point, with current LTVs at a near low point and the economy (pre-Covid 19) very healthy. So that’s actually intentional.

      3. The definitions of “Adequately Capitalized,” “Undercapitalized,” and “Significantly Undercapitalized” have been the same since the 1992 statute was passed. It’s always been true that the condition in which either Fannie or Freddie fall below the minimum but meet the risk-based standard is undefined; that’s not new in this proposed rule. I personally thought that was just bad drafting–falling short of the minimum should make you “Significantly Undercapitalized,” because the minimum is supposed to be the lowest amount of capital you’re allowed to hold and still be in compliance with the standard, but that’s not the way the statute was written (and they missed it again when they reviewed it with HERA).

      4. Again, related to point 1, Fannie and Freddie will need to meet the full capital requirement–base plus buffer, for both minimum and risk-based, to be considered adequately capitalized. And today, that’s more than four percent of on-balance sheet assets.

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      1. Tim,

        Thank you for the responses. In the future I will try to be more brief, and if I feel the need to be more verbose (which is nearly always!) I will post the long version on the CoB&F message board.

        1,4) You’re right: I was underestimating the impact of payout restrictions. While Calabria acknowledges the need for potential exceptions in the short term to raise capital, the specter of such restrictions coming into full force in the future will certainly have an impact on capital raises.

        2,3) Thanks for the explanation. The minimum being higher than the risk-based standard was not an oversight on FHFA’s part but rather on mine for not knowing that they can occasionally invert like this.

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      2. Tim

        I find the proposed rule confusing regarding FHFA’s regulatory authority to take action for failure to maintain the capital buffers.

        First, there is a difference in how the proposed rule frames its regulatory enforcement power relating to the risk/leverage capital standards, on the one hand, and the capital buffers, on the other hand. I note that the proposed rule sets forth an “enforcement” Section VI.C, which sets forth in no uncertain terms regulatory authority to take action to ensure that the risk-based and leverage standards (Sections VIA and B) are met. with respect to the capital buffers, Section VII, I see the Payout Restriction Section VII C, but no regulatory enforcement provision similar to that in Section VI C. there is language that the Director could make a determination that maintaining capital less than the buffer amount would constitute an unsafe and unsound practice (“Nothing in this proposed rule limits the authority of FHFA to take action to address unsafe or unsound practices or violations of law…” p. 102), but this is phrased as regulatory authority to engage in a case by case determination, rather than the bright line enforcement authority regarding the risk/leverage capital standards.

        then to top it off, question 26 asks “Should there be any sanction or consequence other than payout restrictions triggered by an Enterprise not maintaining a capital conservation buffer or leverage buffer in excess of the applicable PCCBA or PLBA?”…which to me simply emphasizes that fhfa expects the GSEs to maintain the capital buffers because of market discipline, so that the supposed fhfa authority, to make a case by case determination that not maintaining capital buffers is an unsafe and unsound practice, is illusory.

        it seems to me that fhfa should provide clarity here…what it seems to me to be saying between the lines is that it expects market discipline to enforce the capital buffers, and that any determination that maintaining the risk/leverage standards but not the capital buffers to be an unsafe and unsound practice to be a rare case…and so it should just come out and say that.

        rolg

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        1. I agree that there is ambiguity about what FHFA would do if Fannie or Freddie do not remediate any shortfalls in their Prescribed Capital Conservation Buffer Amounts (PCCBAs) incurred during a stress environment, and that FHFA should clarify this.

          And there is a further issue that adds a complication here. As discussed in section VII.4, FHFA didn’t really eliminate the procyclical capital effect of using market value LTVs in the risk-based capital stress test–they’ve just muted it. Page 121 has a chart that illustrates what FHFA’s proposed “countercyclical adjustment” does and doesn’t do. It’s designed to cap changes in mark-to-market LTVs when home prices get outside a channel that runs from 5 percent below to 5 percent above their estimated long-term trend, but that still means that market value LTVs could rise by up to 10 percent in a severe stress environment, pushing risk-based capital requirements up along with it. I haven’t done the math on this yet, but this mark-to-market LTV-driven increase in capital requirement could eliminate the PCCBA by pushing the risk-based capital requirement up (that is, if a company’s risk-based capital is 2.5% and its PCCBA is 1.5%, a drop in home prices would raise the risk-based requirement, eating into and potentially eliminating the PCCBA before any credit losses have been incurred). Depending on the sensitivity of the mark-to-market LTVs to home price changes, therefore, the companies may have to hold excess capital–above their current base risk-based requirement plus PCCBA–to protect against this.

          I’m still making my way through the proposed rule–reading it slowly and taking notes–and I won’t really have a comprehensive reaction to it until I’ve finished it and done some analyses on a number of issues associated with it. So far, though, there is no question that to me this rule is worse for Fannie and Freddie as going concerns than was the 2018 rule. The questions I won’t be able to answer until I’ve finished the rule and my analyses are what changes might FHFA be willing to make to it in a final proposal, and which aspects of the rule are “lines in the sand” that FHFA seems not to be willing to give on and that we will have to live with, at least as long as Calabria is FHFA Director.

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          1. If I were to comment,

            1. GSEs are in specialized insurance business, not banking business.

            2. Loan quality is much better than those before 2008. People, including GSEs, buyers, originators, and FHFA, have learned a lesson. Don’t apply a solution to non-existent problem.

            3. Unnecessary capital costs home buyers money and negatively affects economy.

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          2. Tim

            thanks for reply. it IS hard to say whether the capital buffers will be “lines in the sand”. on the way towards build up of capital, FHFA is asking whether there should be a phase-in of the capital buffer requirements…I imagine the GSEs’ bankers wouldn’t mind 5 years. frankly, FHFA should want 5 years as well, to give the bankers “regulatory room” to execute some very large capital raises. and question 26 seems to indicate that FHFA itself doesnt consider the proposed rule to have any regulatory teeth to the enforcement of the capital buffers other than market discipline…so it should make this clear.

            rolg

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  4. looks like the capital number is higher – FHFA Says Fannie, Freddie Should Have $240 Billion in Capital After Returning to Private Hands.

    thoughts?

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      1. The proposed capital regulation is 424 pages long and will take quite some time to go through, but the 16-page fact sheet is not promising. The new rule appears to be more, not less, complex than the first one, and adds more, not fewer, buffers to total required capital (including one that relates to each company’s total share of the overall market, penalizing Fannie for being larger). The headline capital percentages for both the risk-based and minimum numbers are close to 4 percent, although it appears that more categories of “capital,” including subordinated debt, can be included in this percentage (presumably up to some limit).

        As I say, it will take considerable time to go through this proposal, but my initial reaction is that it is highly punitive to Fannie and Freddie’s business. Just as a reminder, the Dodd-Frank stress test FHFA ran against the companies last year showed stress credit losses of $7.2 billion for Fannie and $5.6 billion for Freddie. The new proposed capital requirements are almost forty times those average amounts.

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        1. Tim,

          Am I missing something here? It looks like the regulatory minimum is $135B as opposed to $180B in the 2018 proposal. The additional $99B is for capital buffers that are not required, but if not met then there are restrictions:

          Capital Buffers – The proposed rule’s risk-based and leverage capital buffer amounts can be drawn down in a period of financial stress and then rebuilt over time as economic conditions improve. Similar to capital buffers under the Basel and U.S. banking frameworks, when an Enterprise does fall below the prescribed buffer amounts, it must restrict capital distributions, such as stock repurchases and dividends, as well as discretionary bonus payments until the buffer amounts are restored. Of note, the proposed rule would deviate from the Basel and U.S. banking frameworks by establishing capital buffers that supplement the risk-based capital requirements as a percentage of an Enterprise’s adjusted total assets as opposed to a percentage of risk-weighted assets. This deviation promotes greater stability in the Enterprises’ aggregate risk-based capital requirements throughout the economic cycle.

          Why wouldn’t Fannie/Freddie retain earnings for the remainder of 2020 and 2021, add that to current capital, then raise equity to meet the regulatory minimum. Then they could build the buffers via a combination of smaller secondary offering and a few additional years of retained earnings? It could take 5 years to get to the total capital requirement, but that’s consistent with Calabria’s comments about this taking years to build capital, but getting them to a position to exit conservatorship in a much shorter period of time.

          Thanks.

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          1. Again, I’m going to want to read and analyze the proposal in its entirety before I make any definitive comments on it, but what struck me about the fact sheet is how detached Fannie and Freddie’s required capital, including buffers, is from the actual risk of the business they’re engaged in. This had been my concern from the beginning, and I fear it’s where we’ve ended up. Even before getting into the details, I can say that without significant changes FHFA’s new capital standard would make Fannie and Freddie much less efficient as businesses, and thus much less attractive to potential investors, than they could or should be. And this seems to have been a deliberate choice on Calabria’s part. The layering of a countercyclical buffer on top of already tough basic capital requirements is consistent with his articulated view of what Fannie and Freddie’s role in the market should be: as a supplement to “private capital” (however that’s defined) during normal times, but ready to be activated during times of stress, when private capital moves to the sidelines. That’s a very different role from what Fannie and Freddie have had for their previous 82 and 50 years of existence, and it remains to be seen whether it’s one investors will find sufficiently enticing to put in the capital required to get them out of conservatorship and out from under a consent decree within the next half-dozen years.

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          2. Tim

            when reviewing this release, I will be interested to read your take as to what kind of “bite” the limitations on distributions and exec bonuses will have for failure to meet the capital buffers. see. table 8, p. 101. my initial take is that the risk-based and leverage capital requirements of the new release are about what was proposed in 2018 (see table 2, p.22), so that while the new release adds buffers, these buffers only prohibit distributions if less than 25% of the buffer amount is satisfied…and I wonder whether a 20% payout limitation when the buffer is 25%-50% satisfied would be viewed as a harsh distribution limit by investors. eg. for a GSE that earns $10B in annual net income, a $2B dividend payout limit doesnt seem to me at first blush to “bite”…2% dividend rate on $100B of common equity.

            rolg

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          3. I’ll definitely take a look at the restrictions associated with the capital buffers, but this is probably a good time to mention that because I’m doing this blog for policy reasons and as a pro bono sidelight–and not as an investor with “first to the post” urgency for insights or conclusions–my reactions and responses to the FHFA proposal may come a little more slowly than some may wish.

            Liked by 4 people

          4. Tim

            well, as something of a sidetnote, but you can now lay to rest the Calabria “competition charters” theme…no financial institution will want to set up a third GSE under this capital framework. Calabria would be the “soup nazi” to them…no dividends for you!

            rolg

            Liked by 3 people

          5. The same disincentive may well apply to the new investors required to fully meet these new standards for Fannie and Freddie. I’ve now reviewed the fact sheet, and it’s astounding how much more capital Calabria is going to insist on the companies having in order to meet his definition of “safe and sound” operation. I thought the old proposal was way too conservative, relative to the risks of the loans Fannie and Freddie are guaranteeing and the credit losses they had following the 2008 crisis. In the current proposal the risk-based standard has gone from 2.25% of “adjusted” assets in the June 2008 proposal to 3.85%, and the new minimum standard not only is higher than that–at 4.00% of adjusted assets (which translates to 4.29% of the companies’ reported on-balance sheet assets)–but, unlike with the risk-based standard which can be met with up to 1.5% of loss reserves and subordinated debt, the minimum leverage standard has to be met entirely with “Tier 1” capital, which for Fannie and Freddie is just common and preferred stock. So this is basically a bank-like 4.00-percent plus Tier 1 capital requirement for two companies limited to the mortgage credit guaranty business whose loss rates on their post-Dodd Frank book of business are running at about 2 basis points per year. But Calabria is the current Director, and this is what he says he wants.

            Liked by 2 people

          6. Tim

            if this is an indication of real flexibility, then it may be easier to build up the capital buffers in the first instance than it will be to rebuild them: https://twitter.com/HoldenWalker99/status/1263325016030162944?s=20

            I think given the size of the initial capital raises and their importance to get the risk/leverage standards achieved, I believe the market is going to need to see some real flexibility of the type that is indicated on pps. 102-103.

            rolg

            Like

          7. I haven’t gotten to page 102 yet, but it’s indicative of the tone of the entire proposal that FHFA is asking for comment as to whether new issues of preferred stock should be exempted from the restriction on payment of dividends prior to the company’s attainment of their proposed (binding) capital requirement of 4.29 percent of balance sheet assets. Ya think? Otherwise you’d be asking people to buy a new issue of preferred stock that may not pay a dividend for quite some time. But it will be harder to make a dividend exception for new issues of common shares; unless you turn on dividends for all existing shares you’d have to issue a new class of shares that are specifically exempted from the dividend restriction for some period of time (which would trade at a higher price than other common shares).

            Liked by 1 person

          8. Tim

            another question for you to answer based upon your experience and knowledge base: what % level of dividend payout do you think the GSEs need to achieve as a terminal objective? I assume that the GSEs will never “need” to be able to pay out 100% of annual net income, though that would be an enviable status. if you think I am right, then aren’t the higher tranches of capital buffer illusory as a requirement that is realistically needed to be achieved? though nice optics politically…

            rolg

            Like

          9. I’m not sure how current management is thinking about dividend policy (since it’s been moot for the past twelve years). I can tell you that in the last half-dozen years I was CFO at Fannie we targeted a dividend payout rate of about 30 percent of our EPS, which was in the middle of the range of a peer group of companies we compared ourselves with. According to Table 8 of the capital proposal and Preamble Table 1 of the fact sheet, Fannie would have to have built its Tier I capital to almost 3.50% of its on-balance sheet assets before its dividend rate could exceed 20 percent. But I also wouldn’t discount the impact the restriction on executive bonuses might have. Congress already passed a law limiting Fannie and Freddie executives’ base salaries to $600,000 per year, and there is only so much restriction of total compensation you can have before it becomes impossible to attract and retain qualified people to work at the companies.

            Liked by 1 person

          10. Tim,

            Speaking of payout restrictions, Calabria is asking for comments on whether, and for how long, to make an exception to the payout restrictions for the purposes of raising capital.

            There is definitely such a thing as too short of a period, because new investors wouldn’t like the risk of their dividends being cut off so soon after buying, and too long, because it would render the restrictions toothless. In your opinion, what is the sweet spot?

            I’m thinking 3 years is a happy medium, which should be enough time for the companies to at least get to the threshold of being able to pay out up to 40% of net income.

            Liked by 1 person

          11. I’m still sorting through my thoughts about the proposed capital rule. While I’m disappointed with it, I can’t say I’m surprised by it. Director Calabria has never supported Fannie and Freddie–either conceptually or in practice–and his capital rule is aggressively anti-Fannie and Freddie, which means it’s also anti-these companies’ stakeholders, the homebuyers they serve and the investors who have invested in them and soon will be asked to invest considerably more in them. My policy interest is aligned with the potential homebuyers who will be penalized by this rule, while yours is aligned with those who have a current investment in the companies and wish to maximize its value. At this point, however, neither of our views matter; it’s going to be up to the group of potential new investors to tell the financial advisors for FHFA, Fannie and Freddie what terms and conditions they will require to invest in two companies whose regulator does not believe they should exist, and who will continue to at exert at least some degree of control over them for as long as he remains in his position. At this point I don’t have any advice to give these potential investors; perhaps at some time in the future I will.

            Liked by 1 person

        2. Hi, Tim.

          I was wondering if the buffer above min requirements is to induce CRT selling or some other risk transfer when it’s viable. Am I reading it correctly, and can you comment on how CRTs will play into this?

          Liked by 1 person

          1. No; the proposed capital buffers are unrelated to CRTs, and not affected by them. Also, relative to its June 2018 proposal FHFA seems to have cut the capital credit for CRTs by well over half. You can see both of these effects if you look at Table 2 on page 11 of the fact sheet. The “net credit risk” of Fannie and Freddie as of September 2019 was measured at $109.1 billion in the June 2018 rule, and reduced by $41.3 billion (39.5%) by CRTs. In the May 2020 proposal, net credit risk on the same date is $134.9 billion, and reduced by only $22.1 billion (16.4%) by CRTs. The capital buffers ($98.8 billion) are then added below the risk-based subtotals in the new proposal–to produce total required capital of $233.9 billion (compared with $136.9 billion in the June 2018 proposal)–and because they’re additive they can’t be reduced by CRT issuance.

            Liked by 1 person

  5. Tim –

    Yesterday both Fannie and Freddie issued a request to hire a financial advisor to exit the conservatorship. Does it seem strange that both acted in sync? What do you make of this?

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    1. No, it’s not strange that Fannie and Freddie would announce their requests for proposals to hire financial advisors on the same day; they both will be working closely with their conservator and regulator, the Federal Housing Finance Agency, on their release from conservatorship, so it makes sense that they act in synch on this. The hiring of investment advisors is an essential step on the path to the companies’ eventual release, and it’s good that both have now taken it. Next we’ll see which firm each hires.

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      1. Tim

        one question I have is whether some effort to synch the actual offerings will be attempted by FHFA (assuming still a conservator then). first to market may be an advantage in some ways (some buyers in first offering may have no appetite for second offering), and disadvantage in other ways (it is always good to learn from the first offering’s mistakes). I doubt synching would make sense, as there may be material differences in preparedness to go to market and capital structure. but I have never seen this type of capital markets dual re-IPO scenario before.

        rolg

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        1. I would be surprised if Calabria attempts to set the timing of the companies’ secondary offerings, for a variety of reasons. One is that it’s not FHFA’s role to make that decision, even as conservator. FHFA as regulator will set the companies’ capital requirements, but then it should be left to each company’s management and board of directors to determine how best to meet those requirements. They may have different strategies, and one of them may be ready, or willing, to do a capital raise earlier than the other. We’ll see what the advisors recommend (although we very likely won’t know that until after the fact), but I doubt that any will recommend that both companies do large secondary equity raises simultaneously.

          Like

          1. Tim

            as I think about it, my last thought on this. if there is a global litigation settlement (as I expect there will be prior to a public offering), I expect both GSEs will participate at the same time. they are joint defendants in the Ps’ litigation. I also expect an amendment to the PSPA eliminating the NWS (as I expect there will be prior to a public offering) will deal with both GSEs at the same time. so there will a contemporaneous legal preparation for each company’s offerings. just wondering if there will be a race to the public offering line, or whether some sort of coordination (whether from FHFA or between the GSEs) will occur. I cant recall a situation quite like this, in terms of anticipated size of offerings and contemporaneity at which they will be set up to be conducted. the bankers “may” wish to coordinate the offerings (time wise, not in terms of any closing conditions) if they think that by doing so they will be more successful.

            rolg

            Like

          2. I agree with you that both Fannie and Freddie will participate in any legal settlement, and that the net worth sweep will need to be cancelled before either company can raise new equity. And I suspect there also will be consultation between the companies–or their financial advisors–on the timing or sequencing of their equity issues. I’m just skeptical that they would do their issues at the same time.

            Here is how I see the potential capital-raising process playing out. At the moment we have four unknowns: (1) What will the companies’ new minimum and risk-based capital requirements be; (2) at what stage of attainment of the minimum requirement will Calabria deem them ready to be released from conservatorship under a consent decree; (3) how quickly can the companies reach this capital milestone through retained earnings, given the uncertainty about their credit losses occasioned by the Covid-19 pandemic, and (4) when will the lawsuits be settled and the net worth sweep be cancelled? We should know (1) soon. It’s Calabria’s call (perhaps with Mnuchin’s concurrence) as to what the answer to (2) is, and when to make that known publicly. I believe it will take several months at least for the companies, and everyone else, to get a handle on (3). The interaction of (2) and (3) will determine the earliest each company could do a secondary equity raise, assuming that Calabria requires both of them to meet the same percentage of minimum capital target before they could be released from conservatorship (which I think is a reasonable assumption). Finally, that projected release date–based on (1), (2) and (3)– will set a deadline for Treasury for accomplishing (4), assuming it does not suffer a definitive loss in one of the court cases before that time. And if Treasury still isn’t ready to settle the lawsuits by the time one or both of the companies are ready to raise new equity, the capital raises will be put on hold until the suits are settled.

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  6. Tim

    I offer to my dismay a horrific opinion piece by the Urban Institute, with Mr. Parrott among other authors, recommending among other things GSE repurchases of CRTs: https://www.urban.org/sites/default/files/publication/102225/the-mortgage-market-has-caught-the-virus.pdf

    “the GSEs should purchase some modest amount of CRT securities on the open market to create price transparency and help breathe life back into the market for these securities. Issuers often do this to stabilize the market for their issuance, and that is precisely what is needed here.” p.8

    price transparency is a laughable term for a security no one wants to buy. rather than admit that CRTs are a security that cant perform its intended function, the Urban Institute wants the issuer to be the sole bidder for these securities in order to hide their horrific performance.

    I rest my case.

    rolg

    Liked by 1 person

    1. I read the Urban Institute article you’ve linked, and viewed it as being two pieces by two authors: the bulk of the article—almost seven pages, and I’m sure written by Laurie Goodman—is an informative and useful analysis of the impact the Covid-19 pandemic has had on various aspects of the mortgage market, which I would recommend to readers. The last page and a half, however—starting with the heading “What Should be Done”—contain observations and opinions unconnected to the exposition and analysis in the first part of the paper, and almost certainly are the work of Jim Parrott. I won’t argue with your description of this part as “horrific.”

      Parrott begins his discussion of CRTs with a loaded sentence: “There is broad consensus that CRT is a critical means of dispersing credit risk away from the GSEs and whatever guarantor entities might succeed them, so its long-term collapse would strike a blow to both the reforms we have managed coming out of the Great Recession and to the prospect of more structural reforms in the years to come.” The phrase “whatever guarantor entities might succeed [Fannie and Freddie]” shows that Parrott is one of the few people still clinging to the fantasy that the net worth sweep he helped engineer had “closed off possibility that they ever go (pretend) private again,” while the notion that the collapse of the CRT market would be “a blow to…the reforms we have managed coming out of the Great Recession” is equally fixated on his own narrow, and wrong-headed, view of what the secondary mortgage of the future should look like. The large majority of the participants in the reform debate have moved on from there.

      Parrot makes two recommendations for Fannie, Freddie and FHFA to “shore up confidence in the CRT market.” The first is to “clarify that loans in forbearance during the COVID-19 crisis will not count as delinquent under the terms of the early CRT deals.” Parrot doesn’t explain why he recommends this, but it’s because a rising delinquency rate on a pool of CRT-insured loans will, after about six months, cut off prepayments to the CRT tranches, leaving them outstanding until their contractual maturity. Both Fannie and Freddie have said they will classify forborne Covid-19 related loans as delinquent (as they did for loans forborne during Hurricane Harvey in 2017). Changing that policy to consider these loans current would result in many CRT investors getting their tranches repaid before the credit losses could hit them, leaving those losses to be absorbed by Fannie and Freddie. Parrott is right that not transferring losses to CRT investors would be good for that market, but it would defeat the purpose of the companies’ having issued these securities in the first place.

      Purchasing “some modest amount of CRT securities on the open market” also runs counter to the reason for the securities’ existence. Three months ago, the vast majority of Fannie and Freddie’s outstanding CRTs stood very little chance of ever paying off. With the pandemic this chance of an eventual payoff has risen—to what extent we don’t yet know—and given the companies valuable insurance against a worst-case credit loss scenario. The only reason to have issued the CRTs was as protection against just this sort of environment. Buying back the CRTs now is akin to a southern California homeowner requesting a refund on their home insurance policy as flames are cresting a neighboring hill.

      Towards the end of the Urban Institute article, Parrot seems compelled to make a final recommendation, a propos of nothing: “The one thing policymakers should not do, however, is release Fannie Mae and Freddie Mac from conservatorship, at least not without an explicitly defined government backstop and a much clearer mandate to support the market.” He must know that the ideas currently being considered for releasing Fannie and Freddie include retention of the Treasury PSPA support arrangement, for which the companies would pay a fee. Moreover, none of the alternatives to Fannie and Freddie he has advocated or supported in the past have had any “mandate to support the market,” let alone a “much clearer one” than the companies are operating under currently. Parrot’s reasons for his continued opposition to retaining Fannie and Freddie in anything close to their traditional form ring hollow, yet he continues to advance them because they’re all he has.

      Liked by 2 people

    1. @j barnes

      no big deal, even though I disagree with it. the Arrowood takings/improper conservator action claims were asserted as a direct claim, which J. Sweeney found shareholders did not have standing to assert in Fairholme. Fairholme continues as a derivative claim, now up on interlocutory appeal to the federal circuit appeals court. J. Sweeney found that only the GSEs had standing to assert any takings claim, which J. Sweeney also found could be derivatively asserted by shareholders since fhfa had a conflict in asserting this claim against itself.

      Washington Federal is the last of the J. Sweeney cases, which also asserts a direct claim, but it differs materially from Arrowood (and Fairholme). WF states that GSE shareholders suffered direct harm (to their property interests in their shares) from the improper imposition of conservatorship, and they have standing to assert this claim. Arrowood/Fairholme allege improper exercise of conservator authority after the conservatorship was in place. so all of J. Sweeney’s analysis about what the conservator’s authority was and who could assert a violation of this authority is besides the point. One would think that if there was a violation of HERA in the imposition of the conservatorship, which caused damages to shareholders, then shareholders have standing to assert this statutory violation.

      I am cautiously optimistic that J. Sweeney permits the WF direct claim to proceed. Shareholders have a greater interest in WF than they had in Arrowood.

      rolg

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      1. I’ve now read the Arrowood decision, and found it consistent with Sweeney’s ruling in the Fairholme case as regards direct and indirect claims. As she says in her opinion, “Under Delaware Law, the test for whether a shareholder claim is derivative or direct depends on the answers to two questions: ‘(1) who suffered the alleged harm (the corporation or the suing stockholders, individually); and (2) who would receive the benefit of any recovery or other remedy (the corporation or the stockholders, individually)?'” Sweeney consistently has found that the harm done by the net worth sweep was to the corporation, and not individual shareholders. Thus, she has allowed derivative claims to proceed and denied direct ones, as here in Arrowood.

        Given that point of view, I don’t see as much daylight for a favorable ruling on the direct claims made by Washington Federal as ROLG does, although there must be something there that Sweeney still is wrestling with, because she hasn’t yet entered a judgment in this case.

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        1. Tim

          the problem with the direct/derivative standard is that for many corporate actions, both shareholders and the companies suffer harm and stand to benefit, depending on how the relief is formulated. there are easy cases…if you take a question of corporate waste, say where the ceo has spent many millions of dollars outfitting his home office (in the Bahamas), here the company has lost money and the claim if brought by a shareholder would have to be derivative. but where a government actor has breached a federal statute (as WF alleges) that causes financial harm to shareholders (quantitative=share price dives; qualitative=shareholders have lost the board of directors that they elected to govern their corporation), I think it “should” be easier to see the shareholders as having the best pathway to seek judicial review and remedy.

          rolg

          Liked by 1 person

          1. I agree that there is ambiguity in the “who has been harmed” determination. In the net worth sweep cases, Sweeney clearly has come down on the side of the corporation being the harmed party. Opinions on this can differ, but I for one agree with her: Treasury didn’t propose the net worth sweep to harm Fannie and Freddie’s shareholders; it proposed it to harm the companies, and thereby make it easier for Treasury to replace them with a favored alternative. But I think you can make a good case that the conservatorships themselves (which are what Washington Federal is contesting) caused the most harm to shareholders. They came when the companies were fully in compliance with their regulatory standards, took away shareholders’ voting rights, and replaced the directors they elected. Contemporaneous reports indicate that “the corporations,” as represented by their managements and boards, viewed the imposition of conservatorship as the lesser of two evils–compared with a public fight with Treasury over its desire to have FHFA take control of them–and also believed that, based on their understanding of the language in HERA and the statements made by Treasury and FHFA of how the conservatorships would work, they eventually would be released from them. The question for Washington Fed, though, is whether Sweeney sees these issues the same way I do.

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          2. Sweeney cited Hometown Fin Inc v United States on page 40 of her Fairholme opinion and page 32 of her Arrowood opinion:

            (“[C]ourts have consistently held that shareholders lack standing to bring cases on their own behalf where their losses from the alleged injury to the corporation amount to nothing more than a diminution in stock value or a loss of dividends.”).

            From this standard, I think Washington Federal’s direct claims on a quantitative basis (loss in share price/lack of dividends) are toast. I don’t see any difference between the quantitative claims for Washington Federal and those for Fairholme/Arrowood.

            However, the qualitative part is a big difference between Washington Federal and the rest of the cases. As in, the qualitative harm only exists in the WF case. With WF, as you said, the shareholders got their elected boards of directors cut out from under them. Perhaps that is what she is stuck on: how to deal with this.

            One thing I would be afraid of with WF is Sweeney going to great lengths to avoid hypotheticals and dismissing the whole case, saying that we have no way of knowing if things would have been better for FnF shareholders if the companies had never been put into conservatorship. That would seem like a copout to me, but i find the scenario rather plausible.

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          3. @midas

            I think the courts of federal claims have difficulty assessing takings/illegal exaction claims in a corporate context…cf AIG (Starr). what gives me some cause to think J. Sweeney might deny motion to dismiss in WF is the degree to which she characterized Treasury Secretary Paulson’s actions as “mafia like”, in bad faith etc during oral argument in the combined cases. now as to the merits, this should not be determinative, but taking a realist view of the case and putting aside a purely academic analysis of the merits, a case involving this type of activity (as expressed by the Judge herself) is the kind of case that judges have difficulty dismissing without giving Ps “their day in court”.

            rolg

            Liked by 1 person

    1. I’m not sure what to make of this news release by FHFA.

      Payment deferral is not a “new” repayment option for borrowers whose loans are in forbearance because of Covid-19; Fannie has been offering it as one of its options for at least a month (the options are: full repayment; short-term repayment plan; payment deferral; loan modification and deed-in-lieu-of foreclosure). It’s possible that FHFA thought that servicers–who are a borrower’s direct contact on a Fannie- or Freddie-financed loan–had not made the existence of the payment deferral alternative clear enough to borrowers, and thus felt today’s press releases (not just by FHFA, but also Fannie and Freddie) were warranted,

      One aspect of the payment deferral option that remains to be clarified (or, if it has been, I’ve missed it) is when servicers get repaid for their first four months of P&I advances on a loan that subsequently is granted a payment deferral–surely it can’t be up to 30 years (for a new loan that went into forbearance and remains outstanding for its contractual life).

      Liked by 1 person

  7. Tim

    on p.14 of Fannie’s Q1 10Q, fannie recognized a fair value gain of $637MM on its CAS debt. Does this represent the amount of losses that would be absorbed by holders of the CAS if the reference assets corresponding to this debt was liquidated? I assume this is a non cash gain, but I am trying to understand the utility of these securities.

    also on p.14, fannie explains that its fair value losses were “…partially offset by fair value gains in the first quarter of 2020 on trading securities and CAS debt, primarily driven by declines in U.S. Treasury yields and widened spreads between debt yields and U.S. Treasury yields, which resulted in gains on fixed-rate securities held in our other investments portfolio and our CAS debt held at fair value.”

    this leads me to believe that the CAS fair value gain is not a representation of losses that would be incurred by holders, but rather is simply an accounting adjustment resulting from a decline in interest rates.

    so color me confused.

    rolg

    Like

    1. The CAS fair value gain on page 14 of Fannie’s first quarter 10Q does not reflect an estimate of the losses that might be absorbed by the holders of these securities; rather it’s the change in their market value caused by the sharp widening in the spread between the reference issue rate (1-month LIBOR) and current CAS yields. One could, of course, characterize this spread widening as the market’s attempt to capture the increased exposure these securities have to potential loss transfers, but that’s still different from what Fannie’s estimate of these loss transfers might be.

      The rest of the language in the fair value segment IS confusing, because it lumps together several different effects. One is the impact that changes in interest rates have on Fannie’s book of interest rate swaps, while a second is the effect of interest rates on the value of the mortgages Fannie has committed to sell through its conduit program (where it buys mortgages from small lenders, then aggregates and pools them as MBS for sale to third-party investors). Fannie had losses on both the swaps and the forward-sale commitments, although these losses were partly offset by gains on trading securities—which are held as hedges (albeit imperfect) for the former two types of fair value exposure. Hopefully this is a little less confusing.

      Like

      1. So just to simplify the CAS portion – the hedge is working in their favor so they’re able to book a non-cash gain because their sold liability is now worth less in the marketplace based on the spread widening in that product type – this does not imply they repurchased those positions and booked a gain on the extinguishment of that position at a discount? If not, this must be a temporary blip if there is a recovery in the MV of those securities they will have to write this back down?

        Like

        1. The CAS issues are not hedges, and Fannie has not repurchased any of them. The mark-to-market gain Fannie took on them during the first quarter will only be a “blip” if the CAS spreads tighten in the future. That’s how fair value accounting (which I’ve never been a fan of) works.

          Like

    1. I’m not sure what you mean by “in the past few days,” but Fannie disclosed in its first quarter 10Q that it had greatly increased its holdings of cash and cash equivalents between December 31, 2019 and March 31, 2020, from $21.2 billion to $80.5 billion. Freddie also increased its cash holdings in the first quarter, although by considerably less than Fannie—to $24.3 billion from $5.2 billion.

      Fannie said in its 10Q that the increase in its cash and cash equivalents was “driven by proceeds from increased debt issuances to support higher refinance activity in the whole loan conduit and potential future liquidity needs…as well as proceeds from loan payoffs.” Fannie described its “potential future liquidity needs” this way: “We expect our debt funding needs to increase in future periods, as significantly higher rates of loan delinquencies and an increase in forbearances and other loss mitigation activity driven by the COVID-19 outbreak require us to fund greater amounts of principal, interest, tax and insurance payments on delinquent loans and to purchase a larger volume of delinquent loans from MBS trusts. We also may continue to fund a high volume of whole loan conduit activity.”

      Liked by 1 person

  8. Always a great source of valued information. Both Fannie Mae and Freddie Mac are doing what they were created to do. While they will always be the topic of debate, it remains clear that they are an important part of the U.S. housing market. I look forward to your continued commentary and perspective!

    Like

  9. Tim

    Thanks much for the hard work that underlies this insightful analysis.

    I must say, while I am not an unabashed supporter of Director Calabria, I think he is an unsung hero in this developing story. when he started at fhfa, the GSEs had zero capital, and the financial melodrama that we would be going through today, if the NWS had continued, is thankfully avoided precisely because, as conservator, he rightly understood that it was his duty (not just preference) to build GSE capital to a more sound position.

    and for this, Director Calabria has endured nothing but the slings and arrows of Messrs. Stevens, Whalen and other GSE antagonists. hopefully Director Calabria reads this post for the excellent analysis and recommendations, but hopefully he also reads it and appreciates that the advantageous financial positions that the GSEs are in relative to 2007 are an important accomplishment of his conservator tenure. Much more for Director Calabria to accomplish certainly, but now is a good time to appreciate what has been done.

    rolg

    Liked by 4 people

    1. +1 to calabria as the unsung hero. he is not perfect but his integrity has been tested and so far he’s done quite all right. as TH repeatedly reminds us however, “we shall see”. capital rule will confirm whether he has the pragmatism and good, balanced judgment we need in the head of fhfa or not.

      does anyone have a way to forward this post to calabria btw?

      Liked by 1 person

    2. I often say stupid things and Tim deletes me but why doesn’t the Gov’t eliminate the NWS, retire the senior prefs, exercise warrants, and provide a explicit back stop until the capital cushion from retained earnings is large enough to make it a limited backstop? The answer I often get is well that would take too long. Well, this is taking too long as it is so let’s just take the easy route…and PLUS the governement would make a lot of money off of the common shares to pay for the trillions of debt …Thank you in advance for not deleting me

      Liked by 1 person

      1. @BIGe

        assuming Tim doesnt delete both of us, this is precisely what will happen…at the right time. as my mother told my daughter about marriage, “the right man at the right time.” after treasury/fhfa won so many cases, we needed a win, and we got it in collins, and now we need a little something more. I think it might be Seila, but these tea leaves are hard to read.

        rolg

        Liked by 2 people

        1. My answer is a variation of ROLG’s: Treasury has no reason to take any of those steps now. It WILL need to take them before Fannie and Freddie can be released and allowed to raise new equity, but we’re not yet close to that point, particularly given the pandemic. Treasury has spent almost seven years defending the legality of the net worth sweep (and telling a false story about why and how it did it) in several dozen cases in close to a dozen venues, and it would be very hard for it to turn around and say, “You know, we really didn’t mean any of that; let’s just drop the whole thing.” That’s why I’ve consistently said it’s going to wait as long as it can for the political cover of a definitive loss in one of the court cases before seriously negotiating with plaintiffs on a settlement. If we get to a point where Fannie and Freddie have met the capital benchmarks FHFA has set for them and there still hasn’t been a clear victory for plaintiffs–which I hope won’t be the case–then I think Treasury will come up with the best face-saving story it can for the shift in position and move forward with the release and full recap. But that won’t happen any time soon, in my opinion.

          Liked by 1 person

          1. But why raise new equity? Just retain earnings with an explicit backdrop until retained earnings is enough to build a larger enough capital cushion and then make it a limited backing

            Liked by 1 person

          2. Whether to raise equity, and if so how much, should be up to the companies, although there is a provision in HERA that allows FHFA to “Require the regulated entity to acquire new capital in a form and in an amount determined by the Director” if it is “Significantly Undercapitalized”–meaning it meets neither its risk-based nor minimum standard, which very likely will be true for both companies at the time they are released under a consent decree. While I doubt FHFA would do this right away, it may effectively force a capital raise by requiring them to meet at least the minimum capital standard (and become “Undercapitalized,” since they won’t yet have met the risk-based standard) in a time period shorter than they could accomplish through retained earnings alone. And absent that, Fannie and/or Freddie also may wish to raise equity on their own initiative, to get out from under whatever regulatory restrictions have been imposed upon them in the consent decree.

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          3. Tim,

            First time question, but long time reader. Thank you for the hours you have poured into this. You are one of the few sources on this matter with true expertise. My question comes in reaction to your last comment. I admit this question goes toward the speculative side of your commentary (which it seems you like to expand upon the least, understandably), but I am interested in how you might buttress your position in light of my push back. You say we should expect Treasury to “wait as long as it can” and if no court action conveniently forces it hand, recap/release “won’t happen any time soon”. I assume by “anytime soon” you mean not in the late 2020/early 2021 time period? I guess I find that difficult to believe. Assuming Mnuchin and Calabria want their preferences (release) to ultimately prevail, is it not a reasonable expectation to assume they will take irreversible action to set their preferred outcome in motion (via consent decree) ahead of elections that could easily make one a lame duck and the other a relative pariah (wearing the wrong partisan colors in a new DC)? Or are you saying: “sure, expect a consent decree which locks in their preference, but don’t be surprised if the conditions in that decree means it takes X years to achieve release”?

            Thanks!

            Brian

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          4. No; my “won’t happen any time soon” was tied to the timing of Fannie and Freddie reaching whatever capital retention threshold FHFA and Treasury set for their release under a consent decree, without considering the election. I know some are speculating that Mnuchin may intend to try to negotiate a settlement with plaintiffs prior to the election, as a hedge against losing it, but I’m officially agnostic (and privately skeptical) about that.

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