Now We Know

~ jtimothyhoward

Well, now we know. The Fannie Mae and Freddie Mac capital standards put out for comment last Wednesday by the Federal Housing Finance Agency (FHFA) under Director Mark Calabria openly and unapologetically call for the companies to operate under a capital regime and capital requirements designed for commercial banks—in spite of the fact that the companies are not banks, have no business in common with banks, and have historical mortgage delinquency and credit loss rates one-third those of banks. By imposing these standards, FHFA has made it a condition of Fannie and Freddie’s future emergence from conservatorship that they function at a fraction of their potential efficiency, with severe negative impacts on homebuyers, particularly those with low and moderate incomes.

At one level, this not surprising. Director Calabria has said on numerous occasions that “Fannie and Freddie ought to operate under essentially the same capital rules as other large financial institutions.” That’s clearly what he’s done with this rule. And lest anyone miss the point, throughout the proposal FHFA converts capital percentages into “risk weights,” using the Basel bank convention of 8.00 percent capital being a 100 percent risk weight. So, rather than say that a given loan pool requires 1.2 percent capital, FHFA says it has a “15 percent risk weight,” causing the reader to have to mentally, or literally, multiply that risk weight by 0.08 to get back to the more familiar percent of assets measure. This is a not at all subtle way of saying, “make no mistake, these are bank standards.”

The bank standards of the May 2020 proposal require far more capital than FHFA’s June 2018 capital rule, which was merely “bank-like.” I and others noted in our comments on the earlier rule that it produced results that were unjustifiably and unnecessarily high because of numerous conservative assumptions, the most important being not counting guaranty fee income as an offset to credit losses in the risk-based capital stress test (as the Federal Reserve does in the stress tests it runs on large commercial banks). Not only does the new rule fail to correct this omission, it adds more conservatism, including “capital buffers.” Applied to Fannie and Freddie’s September 30, 2019 books of business, the June 2018 rule would have set their risk-based capital requirements at $136.9 billion, or 2.22 percent of adjusted assets. The new rule increases Fannie and Freddie’s required risk-based capital on the same book of business by over 70 percent, to $233.9 billion, or 3.85 percent of adjusted assets. Moreover, the new rule states that no matter what the risk-based standard requires, the companies must hold a minimum of 4.00 percent in “Tier 1” capital (shareholders’ equity plus retained earnings)—the same as commercial banks for mortgages—to avoid restrictions on their ability to pay dividends to shareholders and bonuses to executives.

I had feared Director Calabria might do something like this. After reading yet another statement by him advocating bank-like capital for Fannie and Freddie, last June I sent him a note, thinking, as I said in a post (Assessing the FHFA Capital Rule) that included the text of this note, that “he might not know the facts about the differences in risk between Fannie and Freddie’s business and that of commercial banks.” I summarized my message this way: “Capital must be related to risk, and if FHFA engineers its risk-based capital standard for Fannie and Freddie’s credit guarantees to produce an average capital percentage equal or even close to banks’ Basel III risk-weighted capital percentage for residential mortgages of 4.5 percent, the companies’ capital standard would be far more stringent than banks’, because: (a) the delinquency and default rates of single-family mortgages owned or guaranteed by Fannie and Freddie have been less than one-third those of residential mortgages held by banks, and (b) bank capital also must cover the interest rate risk of funding mortgages in portfolio, whereas Fannie and Freddie’s capital standards treat credit and interest rate risks separately, and additively.”

Calabria and other senior FHFA officials clearly read this note, and in the new proposal FHFA attempted to refute both the relative credit risk and funding risk arguments. Its responses were unsatisfactory, and in the case of the relative risk point, revealing. Here, FHFA did not address the historical delinquency and loss data, but instead justified its proposed capital requirements by linking them to a concept it called Fannie and Freddie’s “peak cumulative capital losses” during the financial crisis, which it defined as “cumulative losses, net of revenues earned, between 2008 and the respective date at which an Enterprise no longer required draws under the PSPA [the Preferred Stock Purchase Agreement].” For Fannie these totaled $167 billion, and for Freddie $98 billion.

Claiming that peak cumulative capital losses were a valid measure of Fannie and Freddie’s riskiness was a giveaway: it was an unmistakable indication that FHFA had rejected the reality-based realm of economics and finance for the fabulist realm of ideology and politics. Prior to the day the new capital proposal was released, I had been unsure how FHFA would square the fact-based approach required to devise and implement a balanced capital rule with the fictional versions of the financial crisis and the Fannie and Freddie takeovers it and Treasury had adopted in defending the lawsuits against the net worth sweep. Again, now we know: the current FHFA leadership has aligned itself with the fiction. Rather than acknowledge the demonstrable reality that Fannie and Freddie were by far the strongest providers of mortgage finance leading up to the crisis—which, as FHFA ignores, was caused by the collapse of underwriting standards following the rise to dominance in 2005 of undisciplined and unregulated private-label securities financing—FHFA in the text of its capital rule repeats the fable that the companies were not victims but causes of the crisis, claiming, “The Enterprises’ imprudent risk-taking and inadequate capitalization led to their near collapse and were among the proximate causes of the 2008 financial crisis.”

Discovery in the lawsuits has helped bring the facts about Fannie and Freddie’s pre- and post-crisis financial condition into focus. As I discussed in the July 2015 amicus curiae brief I wrote for the Perry Capital case, Fannie and Freddie’s placement into conservatorship by FHFA (at Treasury’s direction) was not a rescue, it was a takeover, and the reason the companies incurred such a large capital deficit between 2008 and 2012 was that “well over $300 billion in non-cash charges [were] booked to their income statements after they were put in conservatorship and placed into the hands of FHFA.” The large majority of these non-cash book entries were discretionary or based on inflated estimates of future losses, and were made to force the companies to take nonrepayable draws of senior preferred stock from Treasury they neither needed nor wanted, whose purpose, as I’ve noted elsewhere, was “to transform massive, temporary and artificial book expenses created for them into massive, perpetual and real cash revenues for [Treasury].” Had there been any doubt that these losses were artificial, it should have been dispelled when in just 18 months, from the fourth quarter of 2012 through the first quarter of 2014, the two companies somehow came up with enough income to make net worth sweep payments to Treasury of $158 billion—half again what they had earned in their entire existence as private companies.

FHFA leadership, however, is pretending that Fannie and Freddie’s “peak cumulative capital losses” were real, and that they are a better basis for calibrating the companies’ capital standards than are several dozen years of incontrovertible relative credit loss and delinquency data. FHFA also isn’t admitting that funding risk argues for a higher capital requirement for the banks who take this risk than for Fannie and Freddie who don’t. FHFA does concede that “the Basel and U.S. banking frameworks generally do not contemplate an explicit capital requirement for interest rate risk on banking book exposures” [except not “generally;” they don’t at all], but argues that “differences in the interest rate and funding risk profiles…should not preclude comparisons to the U.S. banking framework’s leverage ratio requirements” [not “comparisons to;” equivalence of.] The two reasons it gives are at best weak: that “the monoline nature of the Enterprises’ mortgage-focused businesses suggests that the concentration risk of an Enterprise is greater than that of a diversified banking organization with a similar amount of mortgage credit risk,” and that bank capital standards leave “interest rate risk capital requirements to bank-specific tailoring through the supervisory process” [while citing no instance of any such “tailoring” ever taking place].

Here too, FHFA forsakes economics and finance for ideology and politics. Fannie and Freddie would be able to deploy their proposed 4 percent minimum capital only to make credit guarantees on residential mortgages, for which in 2019 they earned an average fee of a little over 40 basis points. A bank can take its 4 percent minimum capital and buy mortgages with the same credit risk as Fannie and Freddie are taking, but then fund them with short-term, maturity-mismatched consumer deposits and purchased funds and earn a spread of over 300 basis points. It is axiomatic in finance that return is related to risk. A business that supports a margin of 300 basis points is in the judgment of the market far riskier than one that supports a margin of 40 basis points. Yet FHFA would have us believe that the capital for these two businesses should be identical.

Personally, I think the arguments FHFA makes to justify its imposition of bank capital standards on Fannie and Freddie are pretextual, and even its leadership doesn’t believe them. Rather, Director Calabria has determined, against any objection, to use the most powerful tool he has—the authority to set capital requirements—to reshape Fannie and Freddie’s business according to his view of how they should operate in the mortgage market. I first learned of this view in an essay Calabria did in July 2016 for the Urban Institute’s “Housing Finance Reform Incubator” (for which I also wrote an essay). There he claimed, “Securitization is often defended as an important provider of ‘liquidity’… [but] securitization’s ‘liquidity effect’ is procyclical, providing too much liquidity in good times and not enough in bad times.”

The new FHFA proposed capital rule seems structured precisely to remedy this perceived problem. Fannie and Freddie have base capital requirements of 2.5 percent—either exactly (minimum) or approximately (risk-based)—but also must hold capital buffers of another 1.5 percent—exactly (minimum) or approximately (risk-based)—to avoid restrictions on their dividends and bonuses. The combined base and buffer capital of roughly 4.0 percent is designed to restrain or reduce the companies’ business in “good times” by making the pricing of their credit guarantees uncompetitive. Then, in “bad times”—when banks and other providers of mortgage credit move to the sidelines because of worsening credit conditions—Fannie and Freddie’s envisioned role is to finance the mortgages the banks and others won’t. And if losses from those loans cause their capital to fall below the level required by the capital buffers, FHFA will not put them into conservatorship, but instead “only” require them to forego shareholder dividends and executive bonuses, until in good times they can restore their capital to the fully compliant percentages.

If this interpretation of what Calabria is doing with the capital rule is correct, as I believe it is, FHFA will resist making any significant changes to it following the comment period. It will try to keep minimum capital at a 50 percent risk weight of the base 8.00 percent Basel bank capital requirement, no matter what the commenters say. And because the risk-based standard has been engineered to produce a result very close to the minimum requirement, FHFA also will resist removing any of the new elements of conservatism it has added to the June 2018 rule, including the minimum 15 percent risk weight (or 1.2 percent capital requirement) on any loan no matter how low its risk, the nearly doubled capital charge for operations risk, or the so-called “stability buffer.”

The stability buffer is nothing more than a capital incentive for Fannie and Freddie to reduce their volume of business. FHFA sets this buffer to kick in whenever either company exceeds a 5 percent market share, as defined by FHFA. But by its definition, a mortgage guaranteed by Fannie or Freddie and held in a bank portfolio is deemed to be financed by the companies, not the bank. That’s a gross inaccuracy. The mortgage business consists of several linked activities, the main ones being origination, servicing, credit risk-taking, and funding. Fannie and Freddie have a market share of zero in origination, zero in servicing, a share of less than the stated 44 percent in credit risk-taking—because private mortgage insurers do supplemental risk-taking and their share isn’t counted anywhere—and as of the end of 2019 about a 3 percent market share in funding (which is dominated by banks). Weighting these mortgage-market activities by the revenues available to be earned in them, Fannie and Freddie’s true combined share of the mortgage market is only about 2 percent—well below the 5 percent threshold for FHFA’s punitive capital surcharge. FHFA, however, undoubtedly would dismiss this analysis were it presented in a comment letter.

The only potentially successful opposition to FHFA’s strategy of using excessive capital requirements to reshape Fannie and Freddie’s role in the market to the liking of its Director will need to come from the investment community, whose support FHFA is counting on for a successful recapitalization of the companies. With 4 percent minimum capital, Fannie and Freddie’s normalized earnings (that is, earnings without the recent benefits for credit losses, which are about to end) would produce returns on equity (ROEs) for each of around 8 percent, far below the 12 percent average ROE in the banking industry last year and even further below the ROE of a typical Standard & Poor’s 500 company. Both companies could potentially increase their ROEs by raising guaranty fees, but this would reduce the amount of business they can do in normal times—which indeed is what FHFA intends.

The large institutional investment firms know Fannie and Freddie quite well, understand they don’t need anywhere near 4 percent capital to operate safely and soundly, and also know that requiring so much unneeded capital will make them considerably less valuable to homebuyers and thus considerably less valuable as investments. The question is, will Calabria be willing to give on this, or will he say, essentially, “This is what the companies will have to look like to exit conservatorship, so tell me what they’re worth?” There almost certainly will be discussions about the impact of excessive capital on business value, but we won’t learn about them from the comment letters; the discussions will take place privately, between the investment firms and FHFA’s, Fannie’s and Freddie’s financial advisors.

I haven’t yet determined whether to make a formal comment on the proposal, but I’m leaning against it. For the 2018 capital rule my comments were intended to help FHFA find the right balance between safety and soundness and allowing Fannie and Freddie to do business in a way that provided the maximum support to the widest array of borrower types, throughout the business cycle. The current FHFA leadership has made clear that this is neither their goal nor their interest. Yet I do believe it’s important for affordable housing groups and others interested in economics-based housing policy to comment on the FHFA proposal, if for no other reason than to get their views on the record. At some point there will be a FHFA Director who will look at his or her capital-setting authority not from Calabria’s ideological perspective but as a means of safely restoring Fannie and Freddie to their traditional roles of channeling large amounts of low-cost funds from the international capital markets to U.S. mortgages, to help a wider segment of the American population afford a home. This final step, which Director Calabria so adamantly refuses to take with the current proposed capital rule, will complete the companies’ full release from their 2008 conservatorships.

 

 

125 thoughts on “Now We Know”

    1. I agree with your conclusion that it is in Director Calabria’s best interest to settle the net worth sweep cases (to keep Collins from being decided by SCOTUS), but Mnuchin and Treasury are the ones who can be accused of giving up the government’s rights to the net worth sweep proceeds–which the companies now are being allowed to retain, up to limits of $22 billion for Fannie and $17 billion for Freddie–and also relinquishing its liquidation preferences in them, “for nothing.” I wonder how much of a stumbling block that’s going to be, as we get closer to the election.

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      1. Who would be the settling parties?This has been going on for so long, why settle when the tide seems to be favoring Plaintiffs or are the shareholders not a part of the settlement.

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    2. Another way to think about the lawsuits, I believe, is if the shareholders lose in the suits then absolutely no way will anyone invest in the recapitalized companies..

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      1. @BIGe

        agreed. fhfa, and treasury if former acting fhfa director otting is to be believed, are “on board” to recap the companies, so i) the senior pref must go, and ii) no way any common can be raised with the treasury warrant overhang if, in addition, treasury insists on getting something for giving up the senior pref. I believe this statement is irrefutable. now, is it possible that calabria and mnuchin are out of their element and are proceeding upon a massive fool’s errand? yes. but hopefully not likely.

        rolg

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  2. Tim

    scotus granted cert on both Collins claims. will be argued next fall. I will post to SA a longish piece and copy link here, but my quick reaction is that this increases risk substantially for FHFA. There was no “ratification” of NWS by fhfa in Collins as there was “ratification” of CID in Seila. also no severability “boilerplate” in HERA as was in DoddFrank. and Roberts said in Seila that boilerplate severability provision was important, not to be dismissed as “mere” boilerplate. while its absence wont be outcome determinative, the risk for goes up for fhfa big time. very hard to distinguish fhfa/cfpb removal provisions. also while CID was signed off by some inferior officer, NWS signed by acting director himself. will this increase incentive for FHFA to settle? it certainly avoids any argument that a Biden potus can immediately remove Calabria with the whole question under scotus review…may provide more time for Calabria to proceed with administrative plan.

    rolg

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    1. I would think that having SCOTUS grant cert on both petitions WOULD give FHFA as well as Treasury an incentive to settle. They have very weak hands on both the APA and the constitutional issues. But at a very minimum today’s SCOTUS decision puts a hard stop of no later than next June on litigation over the net worth sweep, which now has been going on for seven years. That, to me, is good news any way you cut it.

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      1. Tim/ROLG,
        Why would SCOTUS stay silent on Collins until it decided Seila and then all of a sudden decide to take the case? What could possibly make the judges decide to hear the case and not apply the Seila ruling to it?

        Thanks

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        1. There wasn’t a ruling in Seila on the remedy for the unconstitutionality of the CFBP director; that was sent back to the lower court to determine whether the civil investigative demand had been ratified. Also, there are two claims against the net worth sweep in Collins, and SCOTUS will want to hear argument on them.

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          1. Tim

            “There wasn’t a ruling in Seila on the remedy for the unconstitutionality of the CFBP director”

            I disagree. the CID was ruled invalid (subject to a “constitutional defect”), but remand was granted for a lower court to determine whether the CID was “ratified” (or resuscitated). backward relief was implicit, for if there was no backward relief there would be no reason for a remand to determine whether or not ratified.

            rolg

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          3. @Tim

            I didn’t mean to pounce, but I think Milbank will give a close reading to the situation as legal advisor to FHFA, and I cannot imagine how their excellent advice could end up recommending litigating the Collins claims to the end in front of Scotus. Settlement odds have risen.

            rolg

            Liked by 2 people

      2. @Tim

        GSE shareholders can now wear a placard saying “The End is Near”.

        the dynamics of a settlement before scotus decides Collins (which would moot Collins) are interesting to consider in the event of a Biden potus. in the event Biden would want to remove Calabria and Calabria resisted, Calabria could be assured on staying at fhfa until a whole new action was litigated by the Biden administration to final judgment…18-24 months? could insulate the recap process.

        @Sim

        it is hard in my mind for scotus to uphold the fhfa removal provision and not the cfpb removal provision. there was some language in Seila which referred to how fhfa regulates financial institutions but cfpb affects individual people, but it is simple to look through the GSEs to see that fhfa affects some half of homeowners with mortgages. this 2019-2020 term scotus had a couple of cases on its jurisprudence of severability, and fhfa (without a severability provision in HERA) affords scotus another opportunity to expand upon severability jurisprudence (or, in my view, metaphysics). but I would expect Fhfa’s legal advisor, Milbank, to provide a cold-blooded assessment of Fhfa’s chances for the NWS to survive after scotus decides both Collins claims, and Calabria should understand that sacrificing the NWS (which he never thought was legal) by way of settlement makes a lot more sense than going to the mat to defend the NWS and risk his own directorship and maybe, without a severability provision in HERA to hang FHFA’s hat on, the existence of the fhfa itself.

        rolg

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          1. @BIGe

            I think there has to be a lot of negotiation and legal and financial advisory work done in preparation for settlement (this is a big settlement and it needs a thorough supporting record), so even if it is full steam ahead for settlement, it might take until then to sign papers…and perhaps this is something that Potus doesnt want to happen before the election. my politics crystal ball is cloudy.

            rolg

            Liked by 1 person

          2. Do you think the gov will more likely just write off the liquidation preference and stop the sweep administratively or go through a full blown legal settlement? Removing the sweep by use of Calabria’s authority seems like the least politically threatening way to go about this….

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          3. @BIGe

            I have been thinking some about this. I expect to see either a 4 way deal, plaintiffs, GSEs, FHFA and Treasury, or a 3 way deal, without plaintiffs settling. the latter is certainly easier and, from a shareholder’s perspective, as long as the deal cant be changed without the GSEs consent, I dont know that the plaintiffs’ settlement is needed. certainly preferable. with Washington Federal out of the way for the moment, I dont know that new investors will really care since if the plaintiffs continue to litigate and win, the GSEs only get more money. right?

            rolg

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          1. @BIGe

            didn’t realize it until you mentioned it. Washington Federal dismissed for lack of standing. opinion currently sealed. I guess it occurred on a good day to receive bad news, given Collins. Washington Federal had (and if appealed, has) a few years more to run and with Collins cert granted on both claims, that timeframe was a bit slow to impact the process now.

            rolg

            Liked by 2 people

        3. Under the current SCOTUS case, I’ve been thinking about what you have to believe in order for the government to win (maintain NWS/conservatorship) and have come up with the following:

          Re APA claims:
          – SCOTUS will have to side against Collins en banc, and agree that FHFA NWS actions were not ultra vires.

          AND,

          Re Constitutional claims:
          – FHFA is acting constitutionally under it’s current “for cause” removal restriction because it is, for some yet-to-be-stated-reason-by-Scotus, distinctly different from CFPB and therefore a “for cause” removal restriction is constitutionally “in-bounds.” Therefore, no need for any constitutional relief (backward or forward) because there has been no constitutional breach, OR

          – If FHFA is like the CFPB in that it requires an “at will” removal provision to become constitutional again, then the court is willing to sever despite there not being a sever-ability provision in the boilerplate language in HERA (similar to Free Enterprise), AND SCOTUS believes, in the case of HERA, that forward relief (change to “at will”) is sufficient and backward relief is not needed.

          To win, the gov’t has to bank on ALL of the above happening, and if any of the above do not prove out, then we win, correct? Is this the right way to look at the situation?

          Assuming Calabria is successful in releasing them from the NWS/conservatorship (under consent decree or otherwise), winning in this case essentially means more negotiating leverage for a settlement does not it?

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  3. scotus announced 7/9 will be last day for opinions, which means that 7/10 likely will be last day for orders. we can expect the disposition of the two Collins cert petitions to be announced then.

    rolg

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    2. Tim / ROLG,
      I can see why the Collins request for Cert to SCOTUS has been held up waiting for a decision in Seila Law. But my question is the APA portion of the Collins case being held up. This has gone to conference on 1/10, 7/1 and 7/8. Is this a case of simply denying or granting Cert.? What in your opinion is happening with this review?

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      1. @jerry

        scotus doesnt want to grant cert on a petition where the claim (APA) would provide the same relief as another petition claim (removal/const) which is closely related to a scotus case granted cert and now decided (Seila), which is Collins situation (also, APA claim is “just” statutory interpretation, while removal/const claim is constitutional interpretation, so latter claim is more “important”). so assuming the justices want to skiddadle to their summer invites on Friday, we will hear about Collins removal/const…and if it is GVRed on Friday, I would expect the APA claim to sit at scotus pending the results of that GVR. we shall see.

        rolg

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        2. SCOTUS has granted cert on both petitions in Collins– plaintiffs’ and the government’s. The cases will be argued next term, so we should have definitive rulings on the APA and the constitutional claims by this time next year.

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    1. I watched Layton’s “Zoomcast” and thought he did an excellent job on it. I would recommend the slide pack, and also the video itself, to readers. There is some good material here for potential commenters on the proposed rule.

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      1. Hi Tim,

        Do you agree with Layton’s assertion that CRTs have proven themselves very well?

        Absent massive FED intervention would there be a market for CRTs today?

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        1. Layton’s criterion for claiming CRT effectiveness seems to be that they have transferred a significant amount of loss exposure away from Freddie (and Fannie) to third party investors. I agree with him on that point, but then would say that the large majority of the risk they have transferred is remote, and the companies have greatly overpaid for those risk transfers. For that reason I would not be using CRTs on a programmatic basis if I were CEO of Fannie.

          I did note in Layton’s presentation that he described CRTs as providing “catastrophic risk insurance.” That simply is not correct. Given the proposed FHFA capital rule, virtually all of the losses transferred by Fannie and Freddie’s CRTs are below their average minimum capital requirement of 4.27 percent of assets (equal to 4.0 percent of “adjusted assets”.) Cat risk is risk that isn’t covered by capital. CRTs transfer unexpected losses, not catastrophic ones. The “insurance” provided by CRTs is either insurance against earnings volatility (you’re paying a known amount each year to protect against a spike in credit losses, and thus a decline in earnings, at some point in the future), or insurance against having to go into the market during a time of stress and raise equity to replace lost capital. The latter may be worth having on selective books of business, depending on the cost of the CRTs. But I wouldn’t issue them programatically, as Layton advocates.

          It does appear that the current FHFA capital proposal includes disincentives for CRT issuance by the companies, while it treats private mortgage insurance much more favorably. (In one of the many oddities and anomalies of the proposed rule, Fannie and Freddie actually have to hold capital against the mortgage insurance they are required by statute to have on loans with LTVs over 80, because the capital requirements for MIs are so much lower than those proposed for the companies, who as a result have to compensate for this “counterparty risk” by holding the capital the MIs don’t have.) While this unfavorable treatment of CRTs is problematic, it’s not something I plan to comment on, since there will be many others who will do that. My concern with the CRT treatment in the June 2018 proposal had been the opposite–FHFA had given too much credit for CRTs, encouraging Fannie and Freddie to subject contingent capital (CRTs) for capital actually on the balance sheet, thus weakening their safety and soundness. That’s not the issue in the current rule.

          The market for CRTs is a different matter. It dried up when investors thought that the Covid-19 pandemic might result in a surprise spike in credit losses. That concern seems to have eased significantly–even with Covid-19 cases surging again–because loan forbearance at Fannie and Freddie has been less than people feared, and home prices continue to rise. Should those trends continue, we may well see CRT issuance resume in the future.

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          1. Tim

            given the high capital levels set forth in the proposed capital rule, and the difficulty raising these amounts in the public equity markets (especially with treasury’s overhang), wouldn’t it be a net positive for CRTs to be given the highest capital credit treatment possible? forgetting about what one may think of CRTs, it would seem the CRT market will persist, though not evenly and necessarily when you would want it…but that is somewhat in the nature of markets. given the existence of CRTs, wouldn’t one want their outstanding balance to “help out” the equity markets by reducing by as much as possible the amount of capital otherwise needed to be raised by equity? I saw a tweet that apparently Mncuchin and Powell also testified yesterday before HFSC that they would want CRTs to count for more capital than its in proposed capital rule.

            rolg

            Liked by 1 person

          2. There are conflicting objectives here, although I recognize not everyone will see it that way, or that some will weigh one objective more heavily than others. What I am advocating is that Fannie and Freddie’s capital standard be based on the risk of the loans the companies guarantee, with a reasonable amount of conservatism and a realistic going-concern buffer. This would result in a very high level of protection for the taxpayer, and a maximum volume and scope of credit guarantees by Fannie and Freddie, at the lowest practical cost, benefiting all of the companies’ constituencies, including shareholders. Consistent with that, I would wish for CRTs to be given capital credit on an equity-equivalent basis, so that substituting CRTs for upfront equity would leave the companies’ resistance to a stress environment unchanged.

            FHFA’S May 2020 capital proposal is a very long way from being economically sensible; as I discussed in my current post, I think Calabria has deliberately engineered it to overcapitalize the companies in order to make them less efficient to the benefit of what he considers “private sector” alternatives. I still think–and will be emphasizing in the comment I file–that the best way to get this at least partially fixed is to have the investment community convince him that the disconnect his capital rule has created between the risk of the loans Fannie and Freddie are guaranteeing and their required capital is so extreme that it will not work in the market, for readily identifiable reasons, and that unless the capital rule is pulled back the companies will not be attractive as investments. This is the approach I am focused on. To me, giving excessive credit to CRTs as a means of lowering the equity requirement is “fixing one wrong with another.” I understand how some constituencies might think that’s fine–the ends justify the means–but I’m not among that group.

            Liked by 5 people

  5. Tim

    seila: 5-4 for removal for cause=unconstitutionally structured. 5-4 for severance re future relief (as I predicted).

    backward relief? the judgment is vacated and remanded. so backward relief is implicit.

    what was vacated? ct of appeals judgment that enforced CID. so backward relief granted.

    from Roberts opinion: “Because we find the Director’s removal protection sever- able from the other provisions of Dodd-Frank that establish the CFPB, we remand for the Court of Appeals to consider whether the civil investigative demand was validly ratified.”

    no need to pursue ratification inquiry if the CID has not been invalidated by scotus opinion finding unconstitutionally structured.

    rolg

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      1. @jerry

        good question. I dont know whether collins counsel will request a GVR on collins on its own motion, or just wait for scotus to consider what to do with collins on their own.

        this is a somewhat confusing opinion (and since I have just skimmed it as of yet, the confusion may be mine). but Roberts clearly vacated lower court’s judgment by holding single agency director for cause removal unconstitutional, and since that judgment enforced the CID, I dont see how the CID has not been invalidated as well. Roberts next analytical step was to address the question as to whether the CID was ratified…well, why pursue the ratification inquiry unless the CID is as of now vacated. Roberts wants to remand for the ratification inquiry (fact based so not a pure question of law for scotus to decide), but his next analytical move is to determine whether there is a cfpb that could have ratified the CID…hence the severance analysis.

        so if you are looking for a clear statement in the opinion that “the CID is invalidated” I dont think you will see it (I didn’t on a quick read). but the only conclusion that can be reached based upon this majority opinion is that the CID is as now invalidated (BACKWARD RELIEF) and there is a cfpb that continues (severance), and that cfpb may have ratified the CID (which would resuscitate an invalidated CID), but that is for a lower court to decide on remand

        rolg

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    2. With my usual “not a lawyer” caveat, I saw the severability and backward relief issues as separate. That is, SCOTUS chose Seila Law as the vehicle to decide on the constitutionality of the CFPB Director, and ruled that the removal for cause provision IS unconstitutional and that the remedy is to sever that provision for the statue. But it left the (thorny) issue of what to do with all the decisions and directives made by an unconstitutional Director–including the CID in Seila Law–to be decided by the Appellate Court, a decision that may well come back to SCOTUS in the future.

      Am I missing something in my analysis?

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      1. Tim

        clearly scotus did what you said, declared the legal principle as to the unconstitutionality of the single agency director removal provision, and made clear the agency still exists since the unconstitutional provision is severable.

        there is a passage where Roberts states “Accordingly, there is a live controversy over the question of severability. And that controversy is essential to our ability to provide petitioner the relief it seeks: If the removal restriction is not severable, then we must grant the relief requested, promptly rejecting the demand outright. If, on the other hand, the removal restriction is severable, we must instead remand for the Government to press its ratification arguments in further proceedings.”

        as I understand this, since the cfpb exists (because the unconstitutional provision is severable), the cfpb may have ratified the CID. why engage in this inquiry if the CID has not been invalidated (backward relief)? backward relief must have necessarily been granted, subject to the question on remand is whether there was a ratification by the cfpb? why engage in this inquiry if there has been no backward relief? if there has been no backward relief, then the CID is still valid, ratification or no ratification. and a ratification inquiry would be unnecessary.

        this is the only way I can understand this opinion. perhaps collins counsel can seek clarification if/when it seeks GVR.

        rolg

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          1. That’s good that SCOTUS will address Collins on Wednesday. On the remand of Seila Law–and I have not yet read the entire opinion–it struck me that the SCOTUS majority might be drawing a distinction between actions of an agency headed by an unconstitutional director that were taken by the board as a whole (ratified) and those that were taken by the director (unratified), with the former standing and the latter being invalid.

            Liked by 4 people

          3. Tim

            remember that the SG made a big point in oral argument in seila that a cfpb director who claimed that she was removable at will by potus (Kraininger) had ratified the CID. so while this might tread upon the metaphysical, scotus is effectively asking the lower court whether, because scotus did find the unconstitutional provision severable, such that Ms. Kraininger was an effective director of an existing cfpb at the time she purported to ratify the CID, Ms. Kraininger did everything that was sufficient in order for the CID to have been ratified….but again, at least to my poor brain, this all necessarily implies that the CID was invalid up until the time of any such ratification, otherwise why inquire as to ratification?….and this ratification question did not arise in Collins. the most I can see Calabria doing is ratifying the NWS in the future…but wouldn’t that take the building of another administrative record, and wouldn’t ratification need to be based upon the facts that existed in 2012, and isn’t Calabria already on record (certainly before he was director) for saying that the NWS was invalid?

            rolg

            Liked by 3 people

          4. @sim

            thanks for reminding me that there is no severability clause in HERA. certainly adds to the distinction between cfpb and fhfa and may affect severability. collins counsel never pounded the table in briefing or oral argument as to the absence of a severability clause in HERA, as main focus was in securing backward relief and invalidating the NWS. if scotus GVRs collins, I would expect that it would simply tell the lower court (5th C) to redecide Collins in light of Seila…without getting into too many specifics.

            rolg

            Liked by 4 people

          5. The Selia SCOTUS opinion has the following statement (p. 31)

            “If the removal restriction is not severable, then we MUST grant the relief requested, promptly rejecting the demand (CID demand) outright.”

            Questions:
            1. Doesn’t this mean that if CFPB did NOT have a severability restriction the court would have to provide the remedy of invaliding the CID demand (backward relief)?

            2. If the answer to question 1, is “yes,” doesn’t this further mean that since HERA does NOT have a severability clause, then SCOTUS (or 5th circuit) has to provide backward relief (invalidate the NWS)?

            Liked by 2 people

          6. On question 1, that’s how I read the SCOTUS statement. On question 2, there still is ambiguity as to whether SCOTUS’ ruling on the unconstitutionality of the CFPB director would lead to the same ruling about the FHFA director. Perhaps some clarity on that will be provided tomorrow morning, when SCOTUS reports on its discussion of Collins scheduled for today.

            Liked by 2 people

          7. @colorado kid

            as I read Roberts, he is making a compound point: i) the CID is invalid having been issued by an unconstitutional agency, such that the CID suffers from a “constitutional defect” (this is “backward relief” but scotus needs to see if CID has been ratified before granting this backward relief); ii) however since the removal provision is severable, then cfpb continues as a constitutional agency (with a director removable at will by potus); iii) because cfpb exists (and presumably existed at the time Kraninger “ratified” the CID) there may have been an effective ratification of the CID which prevents scotus from granting backward relief; iv) if nonseverable, then cfpb would not exist and ratification couldn’t occur, then scotus would grant immediate relief to P (simple judgment invalidating CID); v) but scotus vacates lower court judgment (which had upheld the court order enforcing the CID) and remands for a fact inquiry (did Kraninger do what the Solicitor General said she did in oral argument) and law inquiry (what would be the legal conditions for an effective ratification…ie does the APA require certain actions to negate any finding that it the ratification decision was arbitrary and capricious…and were those conditions satisfied.)

            the most important read through to Collins and fhfa is that there was never any assertion that the NWS had been ratified.

            rolg

            Liked by 3 people

        2. @ROLG

          I also thought interesting, the distinction made between CFPB and FHFA in the opinion,

          “The only remaining example is the Federal Housing Finance Agency (FHFA), created in 2008 to assume responsibility for Fannie Mae and Freddie Mac. That agency is essentially a companion of the CFPB, established in response to the same financial crisis. See Housing and Economic Recovery Act of 2008, 122 Stat. 2654. It regulates primarily Government-sponsored enterprises, not purely private actors. And its single-Director structure is a source of ongoing controversy. Indeed, it was recently held unconstitutional by the Fifth Circuit, sitting en banc. See Collins v. Mnuchin, 938 F. 3d 553, 587–588 (2019).”

          It appears that some justice or justices (at least Roberts given he wrote that) are attempting to draw a constitutional fine line between agencies regulating other government actors vs. regulating purely private entities. I don’t see how such a line could be drawn by precedent (would they be arguing that there is overlapping legislative and executive powers if it regulates a mostly governmental body?) and it almost seems like they may request a brief on it if they do grant Cert. If FHFA wins on a question because it regulates what are now (and was at the time of the NWS) mostly (79.9%) government entities, it would somehow be constitutional for the director of FHFA to remain removable “for cause”. I find that hard to swallow given their explanations on why CFPB is not constitutional, the most obvious being that some presidents may not ever get to appoint, much less remove a director of FHFA. They only need one justice to flip sides (and Roberts could well be the one) based on that argument though and the 5-4 decision goes in favor of director not being removable except for cause. That would actually be beneficial though since it would drag out well into 2021 and Calabria would have more time to recap and release even if Trump loses the election.

          In any case, we might find out on Wednesday after conference it seems.

          Cheers,
          Fishermanjuice22

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          1. @juice. well done

            I would think scotus wouldn’t refer to this distinction in granting a GVR to collins, which is what I expect it will do. now, will some of the “losing” judges from 5th C en banc point to this on remand? perhaps. will it make a difference in outcome. doubt it.

            rolg

            Liked by 3 people

    3. Tim

      while I have been thinking that backward relief was implicit in the Seila opinion after skimming it, now having read it, I note pps 30-31:

      ““As the defendant in this action, petitioner seeks a straightforward remedy. It asks us to deny the Government’s petition to enforce the civil investigative demand and dismiss the case. The Government counters that the demand, though initially issued by a Director unconstitutionally insulated from removal, can still be enforced on remand because it has since been ratified by an Acting Director accountable to the President. The parties dispute whether this alleged ratification in fact occurred and whether, if so, it is legally sufficient to cure the constitutional defect in the original demand. That debate turns on case-specific factual and legal questions not addressed below and not briefed here. A remand for the lower Courts to consider those questions in the first instance is therefore the appropriate course—unless such a remand would be futile.”

      the constitutional defect in the original CID! so backward relief is explicit. so all of the severance discussion, and remand to determine if a ratification in fact occurred by a constitutionally structured cfpb director (who espoused at will removal) subsequent to the original CID, and whether this is legally sufficient to cure the constitutional defect of the CID, all follows because there was an explicit constitutional defect in the CID (issued under a cfpb director who rejected at will removal), and such constitutional defect continues unless the CID has been appropriately ratified.

      rolg

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      1. from Katy O’Donnell at Politico: FHFA Director Mark Calabria responds to today’s SCOTUS ruling on single-director structure of CFPB: “I respect the Supreme Court’s decision in the Seila Law case. This ruling does not directly affect the constitutionality of FHFA, including the for-cause removal provision.”

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        1. @gordon

          to take it a step further: if scotus GVRs Collins const claim on Wednesday (we will find out Thursday), the V in GVR stands for vacate. 5th C en banc has to take up the const claim again in its entirety, such that there is no extant holding of any court that Calabria is removable at will.

          now that will come in good time, but my bet is not until well after a potus inauguration on 1/21. so Calabria can resist any attempt for a biden potus to remove him at least until the 5th C has reconsidered the claim on remand…and this tweet presages that.

          rolg

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        2. Applying Seila case opinion established that a single director is now removable “at-will” by POTUS, and assuming that the 5th Circuit does eventually (re)confirm this fact does apply to FHFA.

          Two Questions:

          1). If the backward relief standard gets explictly established (in that actions under an unconstitutionally structured agency can be set aside) in the remand on the Selia case as well as the 5th circuit Collins case (assuming GVR), does that not set-up the government to claim in the future that any of Calabria’s decisions now, as well as future decisions (consent decree), need to be set aside later under the precedent of “backward relief?” as required for decisions under an un-constitutionally structured agency?

          Said differently, if FHFA is currently still operating as an unconstitutional structured agency now, then shouldn’t all decisions they are making now/in-the-future be subject to “backward relief” as unconstitutional actions after they have been completed? This is particularly concerning if there is a consent decree issued is it not? Will investors invest with the the risk of “backward relief” on future actions (after the future actions are completed) if backward relief truly gets established now via Selia and Collins (GVR)?

          2). If the FHFA director is decided by the courts to be truly removable “at will” and that is what the courts have deemed “constitutional,” then if Calabria’s current position is counter to that in that HE, as Director, believes HE is operating “constitutionally” under a “for cause” removal requirement, then doesn’t Calabria’s position as counter to the courts in fact make him operating “unconstitutionally” now and therefore all his actions are subject to being undone under the concept of backward relief (assuming backward relief gets established in Selia/Collins)? This is highly nuanced question, but I’m concerned it may be important (not to our favor) that Calabria is taking his current position.

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          1. @ colorado kid

            quickly, I dont see a court deciding that HERA should be stricken in total even given the absence of a severability provision, and I do see courts limiting backward relief to a P that brings the first claim (ie Collins), following the Lucia case, but not providing same relief to copycat plaintiffs (which giving severance cuts off in essence). not intellectually coherent but welcome to the real world of the judicial system.

            rolg

            Like

    4. @BIGe

      my understanding is that proposed rule is published on fed register today, so comment period runs out at end for August. once capital rule is finalized then GSEs can produce capital restoration plans (and I imagine MS and JPM will be done with their work by end of August). so that leaves at least 4 months for something to be done.

      rolg

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  6. Legal settlements for loans written down by the GSE’s and later recovered via legal settlements totaling approximately $42 billion (e.g., Citigroup $7 billion; Bank of America $16.65 billion; JP Morgan $4 billion; Goldman Sachs $3.15 billion; RBS $5.5 billion; Deutsche Bank $1.92 billion; et.al.)

    Did defendants give the money directly to Treasury? Why not GSEs?

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    1. @mark, these recoveries were eventually swept to treasury under the NWS. when you do a “10% moment”, calculation, you would include these recoveries.

      @Tim, the comment that GFC losses should be net of fraud recoveries may be something you should amplify in your comment, inasmuch as the proposed rule places such importance on GFC loss amount. I assume fhfa wants to build capital against economic cycle losses, and not untold fraud losses.

      rolg

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      1. Also, FnF paid a combined $36.3B in dividends to Treasury between the start of conservatorship and the end of 2011. These were all the result of circular draws, ones made against Treasury’s funding commitment that were immediately paid back to Treasury as 10% cash dividends on the seniors.

        The final figure on settlement money received in PLS cases was $24.9B.
        https://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Final-Update-on-Private-Label-Securities-Actions-9172018.aspx

        As such, shouldn’t the $265B “Peak Cumulative Losses” number for both companies ($167 B Fannie and $98B Freddie) in the proposed capital rule be $204B instead?

        Calabria might be able to justify keeping the baseline capital requirements ($135B risk-based, $152B minimum/leverage as of the end of September 2019) in place, but correcting the “Peak Cumulative Losses” number should allow him to reduce the size of the buffers considerably. That, in turn, would both make it easier/possible for FnF to provide a market-based ROE with little or no increase to g-fees, as well as grease the skids for earlier dividend payments to facilitate the equity raise.

        Tim, if you feel this is important to include in your comment please do so. The same goes for anyone who chooses to submit their own comment.

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        1. For ROLG: When I discuss Fannie and Freddie’s credit losses during and after the financial crisis, I always point out that about half of them were on loans with product types or risk features now prohibited by Dodd-Frank, and thus should not be included in assessments of future risk. A very large majority of the fraudulent loans for which Fannie and Freddie received reimbursements fell into these high-risk categories, so they already are effectively eliminated in my analyses. And the fraudulent loans shouldn’t (and I believe don’t) affect the proposed risk-based standard. The stress loss rates FHFA (and Fannie and Freddie) incorporate in the risk-based capital grids have been adjusted for the effects of the loan types and features not present in the mortgages the companies are guaranteeing currently.

          For Midas: There are a host of temporary, artificial or other types of book expenses in the $265 billion peak cumulative capital loss number for both companies that reversed and came back as income after the peak period passed. Losses reimbursed by settlements of cases of mortgage fraud were one element of those reversals, but there were many others. The $265 billion combined loss figure is not a legitimate number, and should be dismissed out of hand, rather than “adjusted down” by crediting only a portion of the activities that inflated it.

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      1. I’ve decided that I WILL make a formal comment on FHFA’s May 2020 capital proposal. I’m now beginning to work on what my comment will focus on, how I’ll structure it, and what specific data I’ll offer in support of its main points.

        There are lots of ways I could take this, so at this point I can’t give an estimate on when the comment will be complete and posted on the FHFA site (I’ll likely also incorporate the comment in a blog post). My goal, though, is to have my comment in well before the deadline, so others can evaluate its arguments as they prepare their own submissions.

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      1. Tim

        I listened to the webinar. VERY depressing for at least two reasons.

        1. it was a deep dive into the weeds, but it did not explain anything that could not be readily gleaned from a careful reading of the proposed rule. apparently FHFA thinks we cannot read a lengthy document with some measure of understanding. bureaucrats being bureaucrats.

        2. after making a big to-do about how the 2018 proposed rule was academic, since there was no anticipation to a recap, and how this 2020 proposed rule should be reproposed since it actually lays the groundwork for a recap, the webinar spent zero time explaining how this rule was financeable. some discussion at end of webinar how fhfa will talk to its own financial advisor and the financial advisors retained by GSEs, so this proposed rule is just another academic exercise with no real world financial feasibility input yet…even though it purports to lay the groundwork for a recap.

        you have to laugh to keep from crying. good enough for government work.

        rolg

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        1. I had the same reaction about the content of the FHFA webinar; there was nothing presented that hadn’t been in the rule or the summary. But besides the detachment from reality you noted (more on that in a bit), the presenters made clear that those who read the proposal and said, “It’s not really 4.0 percent capital; it’s 2.5 percent” aren’t reading it correctly. The deputy principal director, Adolfo Marzol, stated directly, “The goal of the proposed rule is that we are at or below 25:1 [leverage].” That’s 4.0 percent capital or more. (And remember, the 4.0 percent minimum capital required on Fannie and Freddie’s “adjusted” assets is about 4.25 percent on their reported balance sheet assets.) In addition, Ms. Tagoe went on at some length explaining why the risk-based capital percentage of 3.85 percent was unusually low (having to do with the very low mark-to-market LTVs as of September 30, 2019, as well as the very strong economy then), and that it’s likely to be above the minimum most of the time. So if the leverage requirement is 4.25 percent of actual (not adjusted) assets, the risk-based will on average be at least 4.5 percent of actual assets.

          In response to a question about whether FHFA would raise guaranty fees as a consequence of these much higher required capital percentages, Adolfo first restated a point he’d made earlier (with which I strongly disagree)–that the rule was good for affordable housing borrowers, because it ensured that Fannie and Freddie would be around in bad times. He didn’t, though, answer the implied and obvious follow-up question, “but at what cost”? Instead, that’s where he said “it’s too early to speculate” about what would happen to guaranty fees, and that now that the rule is out FHFA will talk to its financial advisor and capital market participants about what returns are necessary to attract private capital.

          That answer reinforced my view–which I stated in the current blog post–that this capital requirement is driven by Director Calabria’s ideological goal of redefining Fannie and Freddie roles in the mortgage market, and that FHFA wants to see whether this flies with the investment community. Otherwise, how could FHFA not have tried to put at least a rough box around the issues of required returns and target guaranty fees before putting out a proposal that was dramatically more punitive on the companies than the 2018 proposal that “capital market participants” already had raised questions about? At 4.0 percent capital (and no higher), Fannie and Freddie’s guaranty fees are about 20 basis points below where they’ll likely need to be to provide a competitive return on equity. Even with today’s average net guaranty fee of “only” around 42 basis points, the FHFA pricing grids would set the target fee for the riskiest 20 percent of the companies’ business (mainly for lower-income borrowers) at nearly 100 basis points. If the average fee rises to 62 basis points, the fee for the riskiest 20 percent would be close to 150 basis points, per year. How many people–let alone low-income ones– could, or would, pay that for credit insurance on loans whose probable losses are a fraction of that amount? At some degree of overcapitalization the entity-based credit guaranty business model ceases to work, and I didn’t get the sense that any of the presenters at today’s webinar had given this notion a moment of thought.

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          1. Tim

            I do get the sense that the fhfa game plan is to put out a capital rule that fits with Calabria’s ideological bias, then have the financial advisors respond by saying that g fees need to be raised 25bps (or more) (and the common share price will go to hell in a bucket at the start of the capital raising process…tant pis!), at which point fhfa says the market made us do it, fhfa washes our hands. I dont like the gamesmanship, but I do acknowledge if not admire the strategic guile.

            rolg

            Liked by 2 people

          2. Two reactions, first policy then financial. The current FHFA leadership will not be able to “wash its hands” of the consequences of its capital rule. It is aggressively anti-homeowner, and will have the effect of taking money out of the pockets of a segment of the U.S. population that was struggling before and now is bearing the brunt of the economic costs of the pandemic, and effectively funneling that money to the big banks. That policy is on Director Calabria and his team, as it should be. And it’s not driven by economics or “safety and soundness,” but by ideology, which I hope some future leadership at FHFA has the vision, courage and compassion to abandon and change.

            In the meantime, it will be up to the investment community to decide whether to play on Director Calabria’s field. Many of these investors will understand that “raising guaranty fees 25bps (or more)” is not a given. We’ve already seen a substantial market reaction to the fee raises that have occurred since before the financial crisis. One obvious change is that in 2007, 37 percent of Fannie’s credit guarantees were on loans with credit scores under 700; in 2019 only 14 percent were. The reason, almost certainly, was pricing. Grids published by FHFA in 2014 showed that the target guaranty fee for loans between 61 and 80 LTV and a credit score less than 700 was 129 basis points; for the same credit scores and an LTV from 81 to 100 the target fee, even after private mortgage insurance, was 142 basis points. Fannie and Freddie didn’t charge those fees in 2014–they “only” charged 80 basis points for loans in those LTV and credit score ranges– but in the proposed rule they would have to, because FHFA’s “minimum risk weight” of 15 percent on high-quality loans takes away much of Fannie and Freddie’s ability to cross-subsidize. But the point is that even before any future round of fee increases, most of Fannie and Freddie’s high-risk business already has been priced out by past fee hikes. Another interesting historical fact (that I doubt the current team at FHFA is aware of) is that under Ed DeMarco, Fannie and Freddie were told to raise fees to “encourage more private sector participation” and “reduce [their] market share” (sound familiar?). They did that fairly steadily through 2014, when, for Fannie, a 53 basis point net fee on new business caused its total volume of single-family credit guarantees outstanding to fall from the previous year (and again slightly further in 2015). Fees on new business haven’t been close to that level since (they averaged 47 basis points last year). The 2014 fee experience strongly suggests that there IS a limit to how high fees can go before the volume effect offsets the fee effect, and it may not be that far from where we are now. Potential new investors, I’m confident, will be very interested in understanding this pricing dynamic before they agree to put $150 billion, or more, of new money into two companies whose regulator seems determined to make them fight to keep their heads above water.

            Liked by 3 people

        2. Totally agree. A question came in at the end about how you raise capital for something like this and they did not answer the question. Something is so strange….There must be something behind the scenes that they cannot discuss.

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          1. @BIGe

            the only thing I can think of that might ameliorate a capital raise (apart from increasing g fees) is for treasury to reduce its warrant position. now why would treasury do this? TARP warrant returns were modest compared to what treasury will earn if it is able to successfully sell all of its current position of GSE warrants/shares. if treasury wants to target an acceptable return, it doesn’t need 79.9% of the GSEs to do this, and if treasury did reduce its warrant position, its probabilistic return would probably be greater than if it doesn’t (owing to enhanced likelihood of execution). in effect, treasury would be foregoing a possible enhanced return in exchange for an acceptable return and the achievement of a more secure capital position for GSEs going forward…yes, a little magical thinking on my part.

            rolg

            Liked by 1 person

          2. Another way to look at this is that FHFA has no intention to raise capital hence why they don’t care about financial feasibility of their capital rule. They will let the companies operate under a consent decree. The companies will recap through retained earnings and FHFA will have control of them for another 10-12 years.

            Like

          1. @J barnes

            I am on record for saying that if scotus finds in Seila that CFPB is unconstitutionally structured, and invalidates the Seila CID (backward relief), then fhfa and treasury will know that Calabria can be removed if Biden is elected, and the NWS will likely not survive when the Seila case reasoning is applied to the FHFA…and one will be able to see the writing on the wall if scotus GVRs the Collins separation of powers cert petition. FHFA and CFPB are on almost all points the same, and to extent of differences, the Collins case is stronger than Seila (the fhfa acting director signed the NWS, whereas some ALJ signed the Siela CID, making the case stronger in Collins).

            we should hear this month in Seila. you may hear commentary if scouts rules against CFPB that Seila doesnt really affect Collins. dont belive it. fhfa’s legal advisor, Milbank, wont believe it.

            rolg

            Liked by 2 people

          2. ROLG what are the chances SCOTUS moves Seila to the next session? I heard this has happened in the past.

            Like

          3. @sim

            dont think case will be put over. I expect a 5-4 vote for unconstitutionally structured, with at least a 5-4 for severance prospectively (all 4 dissenting on merits will want severance). question is whether someone like Thomas can convince kavanaugh to go with something like no severance but delayed enforcement to give congress time to amend statute. as for backward relief, it should be 5-4 granted, as scotus just last term in kagan opinion held that Ps should be encouraged to bring constitutional claims, and granting relief in the case does this.

            rolg

            Liked by 3 people

          4. @Dave

            if Roberts assigns the opinion to Breyer, that means that Roberts votes in favor of constitutionality. I understand that conservatives are disgruntled with Roberts, but this would surprise me. just picking up on what Roberts said at oral argument, Robert focused on both Potus removal for cause AND no congressional appropriation constraint. that might have just been a feeler he put out to see if any other conservative justice would bite, and none did. but I could see Roberts saying that both insulations from agency control by Potus and congress is unconstitutional, not just the removal part. of course, both cfpb and fhfa would fail both tests. so you could have multiple opinions on the merits of the constitutional claim, and again on severance.

            rolg

            Liked by 2 people

          1. @David

            there are a lot of justices working issues back and forth on principled matters but GSE-specific? no.

            the whole question of severance is a big deal, brings into question separation of powers, how can judicial branch “amend” a statute? all it can do is declare a provision unconstitutional, one would think…and yet Roberts is attuned to matters that relate to political sensitivities…and so declaring an agency “constitutionally reformed” that permits an agency to go forward is an attractive result. what to do with “fourth” branch of govt, administrative state, which Gorsuch is particularly adverse to. Roberts is in the middle of all of this and he has become a lightening rod, so fasten seat belts, folks.

            rolg

            Liked by 2 people

    2. Tim,

      This is late news but Fannie has hired Morgan Stanley while Freddie has hired JPM. It seems the Freddie decision to hire JPM has a conflict of interest. Don’t the big banks want a piece of the GSEs’ business?

      Liked by 1 person

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      1. There is no conflict of interest; Freddie is doing the hiring, and can hire whomever it wants. Freddie’s senior financial people must have believed the JP Morgan advisory team was best suited to give them (the Freddie execs) the advice and counsel they’re seeking.

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  9. Please do submit a comment. I am sure most every shareholder hopes you will. Truth has to be disseminated even if no one appears to be listening. You never know. You may be underestimating your influence. Thank you very much for all of your expert contributions.

    Liked by 7 people

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  10. Am i wrong, or is this simply not simply usual negotiations? FHFA/Calabria proposes something that probably even they know is to high and then they can walk it back to a more reasonable level. When you sell something it is easy to come down on your price, quite hard to go up. If they figure they will lose a court case then they can say “Ok, well there was the plan but now the courts say X” Seems quite logical to me.

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      1. Travis– The only negotiations Calabria is going to have will be with plaintiffs (existing shareholders of Fannie and Freddie) in the lawsuits he and Mnuchin need to settle in order to follow through on their pledge to get the companies out of conservatorship, and potential new investors he wants to have buy new Fannie and Freddie shares to complete their recapitalization. It’s not clear to me how having come out with burdensome and potentially crippling capital standards helps him with either. I don’t see existing shareholders taking less to settle the lawsuits in exchange for a more favorable capital rule going forward–their objective is to get out of the companies’ shares on the best terms possible. And Calabria is the one who wants new shareholders to buy equity issues to make his recapitalization plan look successful, and the rules he’s just put out are an obstacle to that. That’s why I’m thinking he’s decided, “I’m going to use the capital standard to reshape Fannie and Freddie the way I think they ought to function, and see if the investment community will accept that.” I don’t think I’d call that a negotiating strategy.

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        1. @Tim/travis

          It is my hope that the GSE bankers are chosen and have an opportunity to meet with Calabria before the comment period expires. inasmuch as these bankers have no relationship with fhfa, they may even be candid. perhaps the result of this meeting, if it happens, will provide the most salient (unpublished) comments that fhfa will receive on this rule, and based upon this meeting(s), there may be a little rule loosening around the edges. I happen to think this rule is financeable if fhfa provides some regulatory runway before the payout restrictions kick in, but the execution risk is huge, and it “should” be in Calabria’s interest to modulate the rule to reduce this execution risk…but I am not sure an academic thinktankish economist has the real world bruises to understand this execution risk as he should.

          rolg

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          1. ROLG, I hope you are right. I personally have difficulties envisioning big investors putting money in these two companies. While the Fed and pretty much everybody is trying to save the banking system every time the banks get into trouble when it comes to the GSEs for 12 years the Treasury tried to kill them and now on top of that their regulator wants to murder them.

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          2. To me the biggest hurdles to financeability of the recaps are the limits on the ROE achievable on Fannie and Freddie’s credit guaranty business (the only one they’re permitted to be in) given the degree of proposed overcapitalization, and the ongoing threat to new investors of dividend restrictions–particularly on non-cumulative preferred stock (the only type the companies can issue). The rest of the financial issues can be dealt with by price, albeit at the cost of upside on the common stock, which in itself is a deterrent to potential investment.

            What SimSla is referring to–the political risk the companies always have had and always will have, and have just been reminded of by the new capital rule–is also a significant headwind for the recap. While many of the largest institutional investors understand this risk and aren’t deterred by it, the number that are further reduces the pool of capital potentially available to the companies.

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          3. Tim/SS

            a pricing meeting the night before an IPO is a sausage factory setting. I say IPO because the initial GSE common offering (re-IPO) will really resemble this. in the typical IPO, banker says “here is the underwriting book, we recommend pricing at $X”. the control shareholder pukes, and says “are you out of your effing mind, $2X raises enough funds.” Banker reminds control shareholder that “it is in everyone’s best interests to have stock price go up after offering”. Control shareholder says “easy for you to have me leave money on the table”. and so on…until some middle ground is reached and the control shareholder realizes that the perfect can be the enemy of the good.

            that is a typical IPO.

            with the GSEs, where is the control shareholder to argue for as high a price as possible? Treasury you say? I dont see Treasury hunting for the last cent. to the extent Treasury cares at the re-IPO stage, it wants execution, not price maximization. GSE execs? they have a greater stake in their job security than their shareholdings. fhfa? could care less.

            so the GSE re-IPO price will be sacrificed on the altar of Calabria’s ideology. this deal will get done, though the common stock share price will not buy you much sausage.

            rolg

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          4. The pricing meeting for the last offering of common equity by Fannie Mae—with three-quarters of the shares offered in the U.S. and one-quarter in Europe—was done by conference call, with the Chairman of Fannie Mae, the international bankers for Credit Suisse First Boston and myself on the phone from a bar at the Hessischer Hof Hotel in Frankfurt, Germany, at 9:00 pm in the evening, linked up with the lead U.S. bankers from Shearson Lehman in New York, and it went much more smoothly, collaboratively and collegially than the process ROLG describes. But we all have our stories, and the circumstances today are certainly different from what they were 30-plus years ago.

            I’m less uncertain about how the first deal might go than the one after that, or the one after that, or the one after that. For Fannie to hit its full proposed minimum capital requirement of 4.0 percent of adjusted assets—$142 billion on its September 30, 2019 book—within the next three years, it’s going to need to raise $90 billion, or perhaps more, in a combination of common and preferred stock issues. That’s a huge lift, which Director Calabria has made a good deal harder by putting the specter of future dividend restrictions into the mix. I’m not saying it can’t be done; I’m not an investment banker. But I find it interesting that all of the indications of positivity and optimism I’ve read or heard (including in private conversations or correspondence) in the days since the new proposed capital standards were released have come from existing investors, who are seeking to get their money out of the companies; I haven’t heard a peep from the investors who will need to put money into them to make this all work. I understand that it’s smart for these investors not to say anything publicly, and to do their work behind the scenes, but until they’ve been heard from I wouldn’t say this is anywhere close to being a “done deal.”

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          5. A couple of quick addenda to the above comment. One is a correction: an executive at Fannie pointed out to me that the company did issue $2.5 billion in common stock as part of its $7 billion May 2008 capital raise; for some reason I’d remembered that as consisting only of issues of junior preferred and mandatory convertible preferred. So the common equity deal we priced by phone from a bar in Frankfurt back in 1987 was not the most recent.

            But I also want to comment on the constant use of the term IPO (initial public offering) to describe the expected future issues of common equity by Fannie and Freddie. Not only are these not “initial” public offerings, they are different from a typical IPO in a very critical respect. A firm doing a typical IPO will have a limited track record–or be in a business or niche that is new and untested–and thus there will substantial uncertainty about its future prospects or profitability. That’s why there can be such a wide range of estimates among the bankers and firm executives on how to price the issue. Fannie has been around for over eighty years and Freddie for fifty, and pre-conservatorship their earnings were the most consistent and predictable of any in the S & P 500. In fact, the biggest source of uncertainty about their earnings for the past forty years has been political or regulatory risk–which is precisely what has been brought to the fore by Director Calabria through his proposed capital rule that, if sustained, will decouple the pricing of the companies’ credit guarantees from the risk for which they’re providing insurance.

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          6. Tim, don’t you think the unprecedented interest rate environment creates a unique demand for these securities relative to any previous such offerings? Yes there is risk as it relates to non-cumulative dividends and government involvement, but on the other hand it seems like a security that would easily be bought up given current alternatives.

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          7. Today’s interest rate environment actually works against perpetual fixed-rate preferred stock because of its duration risk, or price sensitivity to interest rate changes. Issuers compensate for this risk by offering higher dividend rates at pricing time, but can’t eliminate the statistical likelihood that from here interest rates are more likely to rise significantly (with preferred stock prices falling) than to fall significantly (with preferred prices rising).

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          8. @birdcamp/Tim

            the question as to whether the benefit of a low interest rate environment is lost re perpetual preferred is a debate that goes both ways in my mind, but I will take bird’s side on this one. my take is that there are plenty of insurance companies and pension funds that have long duration liabilities, and would love to match fund these liabilities with a relatively safe security having as generous rate as possible. GSEs, which are usually stable cash flow cows, will be able to issue preferred at a rate that is both attractively low to the issuer and attractively high for an institutional investor, and I expect this will be something that the GSEs can take advantage of…once a large slug of common has been issued and the high rate existing junior preferred are dealt with by redemption or exchange for common.

            rolg

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  12. We are fighting the wrong battle. Both Calabria and Mnuchin have publicly acknowledged that the “bailout” has been paid. Canceling the SPS adds that much to the CET1. Credit for the overpayment adds another $30 billion. Absolutely no money has to be transferred. The extra high capital levels keep potential competitors at bay.

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    1. @gd

      Fannie core capital was ($106B) as of end of 2019. see 10k, p F-50. nuking the senior prefs doesn’t get any capital standard satisfied.

      rolg

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      2. No. An easy and understandable way to see this, for Fannie, is from the balance sheet data it gives on page 11 of its first quarter 2020 earnings press release. There it shows Senior preferred stock of $120.8 billion, and a few lines below that an Accumulated deficit of $119.5 billion. Virtually all of the benefit of canceling the senior preferred would be used to eliminate the accumulated deficit, leaving only a small ($1.3 billion) increment to Total stockholders equity. But even then you wouldn’t be done. As you’ll note from the parenthetical next to the Senior preferred label, Treasury’s liquidation preference in the company at March 31, 2020 was $135.4 billion–$14.6.billion more than the outstanding senior preferred–because Treasury deems the net worth sweep payments suspended last year as still being owed to it. It needs to cancel the entire liquidation preference.

        Finally, note that if all Treasury were to do is cancel the senior preferred and the rest of the liquidation preference, there would be no “overpayment” to be credited to the companies–either immediately or over time. The concept of an overpayment comes from implementing the remedy plaintiffs are asking for in the net worth sweep cases, which is to characterize each quarter’s sweep payments in excess of the pro-rated 10 percent dividend as paydowns of the outstanding senior preferred. Doing so not only eventually eliminates the full balance of the senior preferred, but it also reduces the cumulative dividend payments owed, because they are calculated on a declining balance. That’s the source of the overpayment, which for Fannie is $12.7 billion and for Freddie $12.3 billion. Most of us who follow the court cases believe that if this method of eliminating the senior preferred and the liquidation preference were followed–either as the result of a final verdict in one of the lawsuits or in settlement–Treasury would pay the overages as credits to federal taxes owed on pre-tax earnings in the periods they are reported.

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  13. Pingback: Good recap of GSE story – Part II | Timeless Investor

  14. Thank you Tim for your writeup. I am struggling to reconcile HL’s role in FHFA’s proposal. I assume they advised on potential investor interest and the ROE question is front and center. How is it possible they could give the go ahead with this plan knowing that the GSEs won’t raise a dime under the current proposal?

    Also, we assume that Mnuchin is an expert in this field and he had to have some input on the rule. Something here doesn’t fit for me. Almost as if the buffer is up for negotiation…

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    1. Alec–Both good questions. I don’t know that Fannie and Freddie “won’t raise a dime” under FHFA’s capital proposal; it’s possible that some investors will think that even with a capital requirement so mismatched with the economics of the one business the companies are allowed to do (there’s very little chance they’ll be permitted to grow their portfolios again) there’s still potential there. And it’s also possible that Calabria and HL have “assumed away” the problem by thinking too optimistically about the companies’ ability to raise guaranty fees without serious erosion in their business volumes, or a mix shift to riskier business that will drive the risk-based capital percentage even higher. Calabria doesn’t have “on the ground” experience with the credit guaranty business, and I wouldn’t expect HL to either, because it’s really a business only Fannie and Freddie do.

      The odd thing to me is that even the companies’ critics had gotten comfortable with the “conservatorship capital” levels produced by the 2018 rule. I doubt it was the financial advisors who said, “Here’s an idea for making the recap easier; let’s kick the required capital up another 70 percent.” And it wasn’t Mnuchin either. I’m as puzzled as you are as to how we ended up here, when the objective was supposed to be a successful series of capital raises.

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    2. @Alec

      sometimes, financial advisors are hired by principals more to deal with other financial advisors (here, the bankers the GSEs hire) than to provide substantive advice. it would not shock me that an academic economist such as Calabria would think he has everything under control without the need of HL’s substantive input, such that HL can grab some pine until such time as dealing with the GSEs bankers is timely…at which point the negotiating table has been set.

      as for Mnuchin, I think he is otherwise engaged for the most part. it’s not like the 79.9% warrant position is his personal money.

      as for raising funds, I believe this proposal is financeable provided that FHFA adopt what I believe are certain uncontroversial guidelines. see eg https://www.fhfa.gov//SupervisionRegulation/Rules/Pages/Comment-Detail.aspx?CommentId=15531. the common share price and dilution may not be optimal, but this is still doable. it’s always a question of price on Wall Street.

      rolg

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  16. “At some point there will be a FHFA Director who will look at his or her capital-setting authority not from Calabria’s ideological perspective but as a means of safely restoring Fannie and Freddie to their traditional roles of channeling large amounts of low-cost funds from the international capital markets to U.S. mortgages, to help a wider segment of the American population afford a home. This final step, which Director Calabria so adamantly refuses to take with the current proposed capital rule, will complete the companies’ full release from their 2008 conservatorships.“
    This last part of your post should be at the beginning when you decide to make comments on the proposed capital rule, and I suggest your title be “Capital rule to make housing affordable to wider segments of Americans “
    Thanks and keep up the good work!!

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  17. Thank you Tim. As always, Washington is firmly in the hands of Wall Street. Forget red and blue. The Trump administration is showing its true color, which, like the Obama administration and the Bush 2 administration and the Clinton administration, is green.

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  18. It looks as if FHFA wants to control the companies through a consent decree for another decade. If investors will not be inclined to invest on these terms recap will be done through retained earnings. It will take roughly 12 years to reach the 240 billion figure.

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  19. Tim, I agree with ruleoflawguy’s comment below:
    “You should comment. Your voice may not be as strong as the underwriters who will have to finance this capital rule, but at some point, the merits have to matter.”

    It’s really important that not only FHFA hears the force and reasoning of your arguments presented here, but that all interesting parties and the world hear your fact based analysis about what’s going on with the new proposed Capital rule.

    In my opinion, FHFA and even the large institutional Banks will ultimately have to realize the factual analysis behind your arguments and come to realize that unrealistic capital standards for Fannie Mae and Freddie Mac will not only damage the housing market but, will in the long run, weaken the US economy and banking industry as a whole, as the securitization process suffers from unrealistic capital retention standards.

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  20. Thank you for taking the time to post a detailed analysis of Mark Calabria’s proposed rule. If I am like the average person with regard to financial comprehension, perhaps a layman’s or eighth grader’s version could really help to make the main points sink in. What Mr. Calabria wants to impose is bad for the companies and investors that I get, but i fear people may not see the danger to their personal welfare without a few individual “for examples”, something that could be understood without too much thought and tweeted and retweeted. Thanks for your consideration.

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  21. The FHFA decided to give no credit for future revenue from the ongoing G-fee stream, citing its focus on immediately available loss-absorbing capital. Is there a case, perhaps to be made in a comment letter, that at least the upfront G-fees received should be counted as capital? The upfront G-fee assets would seem to be available to absorb losses.

    To the extent these assets are offset by liabilities that amortize into revenue over the course of the expected guaranty, they wouldn’t be currently counted in equity. Do you think this aspect of the GSE business model warrants a specific capital adjustment to the bank-like proposed capital rule?

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    1. Patrick–The adjustments you’re describing would be “tweaks” to what fundamentally is a bad rule for the companies. FHFA in its proposal has asked for responses to 106 questions, most of which deal with the rule’s minutiae (and the risk-based capital segment is extraordinarily and excessively complex). But the minutiae and tweaks aren’t the problem–it’s the basic structure, which as I said in the post I don’t believe FHFA will be inclined to fix, because it’s what Director Calabria wants.

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      1. The graphic on page 55 of FNMA’s 2019 10-k lists the amount of deferred amortization income as $33.6 billion.

        This tweak alone would seem to cover a large portion of the PLBA “buffer” required by the FHFA. Would be curious if you have a reaction as to the suitability of an adjustment for this balance.

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        1. You’re right; counting the deferred amortization income as capital wouldn’t be a “tweak.” But because it IS income, FHFA has ruled out counting it to determine required capital in the risk-based test (which I and almost everyone else disagrees with). And I understand that it’s cash in the door, but that cash doesn’t show up as equity on the balance sheet, so it’s not a help there either.

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  22. Please comment to FHFA. Even if the current leadership ignores your comments, future leaders can view your position. And future leaders may be in place in one year.

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  23. Tim

    Whither G fees?

    “It is axiomatic in finance that return is related to risk. A [bank] business that supports a margin of 300 basis points is in the judgment of the market far riskier than [a GSE] that supports a margin of 40 basis points. Yet FHFA would have us believe that the capital for these two businesses should be identical.” excellent point (and I suppose it is late in the day for the GSEs to acquire banking licenses and take deposits…)

    Are raising G fees (and implicitly raising bank profits from retaining mortgages) the next step in the process (indeed, is it the elephant in the room FHFA has not addressed)? how does that process play out, do the GSEs ask and FHFA decides?

    You should comment. Your voice may not be as strong as the underwriters who will have to finance this capital rule, but at some point, the merits have to matter.

    rolg

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    1. A couple of reactions to the “raising guaranty fees” question. The first–which is not a financial point–has to do with the affordability issue. We’ve already seen a very large reduction in guarantees by Fannie and Freddie of lower credit score-higher loan-to-value loans that typify the affordable housing borrower from the fee increases that have taken place since the crisis; the increase in average guaranty fees required to produce a market-competitive ROE on 4 percent capital would greatly worsen that impact. And then financially, there is a limit to how high guaranty fees can go before the one service Fannie and Freddie now are allowed to offer–providing protection against unexpected jumps in mortgage credit losses–ceases to be worth what they have to charge, based on their required capital. Today the average annual default rate on all of $2.8 trillion in loans Fannie has acquired since 2009–including its riskiest ones–is 2 basis points. Raising fees from this point will definitely cut into Fannie and Freddie’s business volumes, particularly on the higher-quality loans.

      It would surprise me if FHFA were to require Fannie and Freddie to raise guaranty fees–or add a fee surcharge itself–before a final capital rule has been promulgated. And if that’s right, potential investors will have to guess at the effect substantial hikes in fees would have on the companies’ business volumes, and hence their valuation.

      As for a comment, I haven’t ruled out making one, and still have plenty of time to decide on it.

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  24. If the investment firms won’t touch then this entire process Calabria is going though is a complete waste of time. Why hire financial advisors to accomplish nothing?

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