The Director Digs In

On May 20, the Federal Housing Financing Agency (FHFA) released its re-proposed capital rule for Fannie Mae and Freddie Mac. The new standard was bank-like both qualitatively—expressing required capital amounts not as percentages but as “Basel risk weights”—and quantitatively, requiring the same 4.0 percent minimum capital for the companies’ credit guaranty business as banks must hold for the mortgages they retain in portfolio (and on which they take liquidity and interest rate risk as well as credit risk). In addition, FHFA added a number of new cushions and elements of conservatism to the June 2018 risk-based standard to bring its required capital up to a level approximating the proposed new minimum. Under the May 20 proposal, total combined required capital for Fannie and Freddie as of September 31, 2019 was 71 percent above the June 2018 requirement. 

FHFA requested comments on the May 20 proposal, due on August 31. The majority of the 80 detailed comments posted to the FHFA website were critical, and most critics made the same four points: that (1) Fannie and Freddie were not banks and did not have the risks that banks do, so applying Basel bank capital requirements to them was not appropriate; (2) a 4.0 percent minimum capital requirement that generally would be binding on the companies gave them a perverse incentive to take risk, and discouraged the use of credit risk transfers (CRTs); (3) the large amount of add-ons and conservatism in the risk-based standard made it not risk-based in practice, and (4) FHFA had not given sufficient capital credit for the use of CRTs.  

Tellingly, even the American Bankers Association and the Mortgage Bankers Association were critical. The former said, “While we believe the re-proposal addresses some concerns raised by ABA and others with regard to the previous proposal, the re-proposal raises concerns of its own, particularly with regard to the implications for the primary market and our members’ continued ability to sell loans to the GSEs in the revised GSE marketplace implied by the re-proposal.” And the MBA stated flatly, “The level of required capital implied by the framework is too high and may be determined too frequently by a leverage ratio rather than risk-based standards.”

I had speculated in an earlier post (Now We Know) that Director Calabria might not be receptive to suggestions that he change either the structure of the May 20 capital rule or its required capital levels. Two recent developments indicate that this indeed will be the case. First, in testimony before the House Financial Services Committee on September 16 he defended the 4.0 percent minimum capital number, made no mention of any criticisms of it or the risk-based standard, and gratuitously said about the companies’ managements, with no context or elaboration, “Fannie and Freddie have what I would consider some of the worst corporate cultures I’ve ever seen in corporate America.” Then, shortly after this hearing  we learned that Calabria had sought, and received, an endorsement of his capital rule from the Financial Stability Oversight Council (FSOC), a group of financial regulators chaired by the Secretary of the Treasury and including three more bank regulators—the Federal Reserve, the Comptroller of the Currency and the FDIC—as well as FHFA, four other regulatory bodies (the SEC, the CFPB, the CFTC and the NCUA) and “an independent member with insurance expertise.”  

In a four-page statement issued on September 25, the FSOC said, “The proposed [FHFA capital] rule would require aggregate credit risk capital on mortgage exposures that, as of September 2019, would lead to a substantially lower risk-based capital requirement than the bank capital framework…which would create an advantage that could maintain significant concentration of risk with the Enterprises.” And Calabria himself summarized the FSOC findings (in remarks he gave at the FSOC meeting) by saying, “As the Council found, risk-based capital and leverage ratio requirements materially less than those in the proposed rule would likely not adequately mitigate the potential stability risk posed by the Enterprises. Indeed, more capital might be necessary. In other findings and recommendations related to the capital rule, the Council confirms the importance of ensuring that each Enterprise is capitalized to remain a viable going concern both during and after a severe economic downturn. A ‘claims paying capacity’ or similar standard is not appropriate for financial institutions of this size and importance. The Council also affirms the necessity of a dedicated capital buffer that is tailored to mitigate the potential stability risk posed by an Enterprise.”

There is little question that the Director intends the FSOC review to serve as a rebuttal to the major substantive criticisms made of the May 20 standard, and thus a rationale for not changing it (with the exception of credit for CRTs, which he may make more generous). The FSOC endorsement, however, has two disqualifying weaknesses. The first is its source. It is hardly news that a group dominated by bank regulators would prescribe bank-type and bank-level capital for Fannie and Freddie. They have done so for at least three decades, and I strongly suspect that there is little institutional recognition at any of the FSOC-member institutions that the one (weak) rationale that used to exist for applying bank-like capital requirements to the companies—that they, like banks, held large amounts of mortgages in portfolio, funded by debt—no longer is true. And that leads to the second disqualifier of the FSOC statement: it contains almost no documented facts, and literally no risk-related data; its conclusions and recommendations all stem from unsupported assertions and generalities.

Actual mortgage market and credit risk data paint a much different picture of Fannie and Freddie’s potential risks to the financial system than Calabria and the FSOC have put forth. To begin with, they reveal how low single-family residential mortgage credit losses are in a normal environment. Between the time Fannie was spun out of the government in 1968 through the year before the financial crisis, 2007—a near four-decade period that includes six recessions—the highest the company’s single-family credit loss rate (net credit losses as a percentage of total mortgages owned or guaranteed) ever got was 11 basis points, in 1988. And during the fifteen years I was Fannie’s CFO, from 1990 through 2004, its average annual credit loss rate was only 2.5 basis points per year. But then the bottom fell out, for all mortgage lenders, in 2008. What happened?

There have been two periods in the past 100 years when a sharp and protracted decline in U.S. home prices has occurred nationwide. The first was during the Great Depression, when home prices are believed to have fallen by about one-third (reliable data for this period do not exist), and the second was between mid-2006 and mid-2011, when home prices fell by about 25 percent. Each episode was the consequence of unique and identifiable circumstances.

The home price decline during the Depression was triggered by the collapse of the stock market, a national unemployment rate approaching 25 percent, and the failure of many regional banks. This last was problematic because the predominant mortgage at the time was a balloon loan which had to be repaid or refinanced within 3 to 5 years; with so many banks failing there were few lenders able or willing to roll over the maturing loans, leading to widespread defaults. The government responded by creating the FHA, the 30-year fixed-rate fully amortizing mortgage, and Fannie Mae. These innovations kept the mortgage market stable and home prices rising, with no annual declines, for almost 70 years.    

Advocates of bank-like capital for Fannie and Freddie’s credit guaranty business pretend not to know what triggered the collapse in home prices in the mid-2000s, but the record is clear. Disastrous decisions by Treasury and the Federal Reserve in the early 2000s first to not regulate subprime lending practices and then to promote the development of a private-label securities (PLS) financing mechanism that put few if any restrictions on the risks of the loans it accepted led to a collapse in underwriting standards and near-unlimited access to mortgages for unqualified borrowers, which in turn fueled an unsustainable boom in home sales, construction and prices. When the PLS market finally collapsed in the fall of 2007—and banks effectively ceased mortgage lending because of soaring delinquencies—housing sales and starts plummeted, and home prices fell by 25 percent peak-to-trough before they could stabilize.

As after the Depression, policymakers responded to the causes of the meltdown. The Fed and Treasury acknowledged that their deregulatory posture was an error. And Congress in 2010 passed the Dodd-Frank Act, requiring lenders to apply an “ability to repay” standard to mortgage borrowers, and through its qualified mortgage standard effectively prohibited the riskiest mortgage products and loan features that proliferated during the PLS bubble. Reflecting these reforms, the credit loss rate on loans Fannie has purchased or guaranteed since 2009, which now make up 95 percent of its current book of business, has averaged 2.7 basis points over the last five years—virtually the same as during the 15 years before PLS became the predominant source of mortgage financing a decade and a half ago.

This quick review of history highlights three important points: first, the fundamental credit quality of the single-family mortgage is very high; second, the stress test used to determine Fannie and Freddie’s new capital requirement is extremely severe, and absent a repeat of the pre-crisis policy mistakes highly unlikely to recur; and third, because of the first two points there is little justification for the amount and type of capital buffers, add-ons and conservatism in the capital rule proposed by FHFA and endorsed by the FSOC, particularly when one considers the loss data and the realities of the companies’ business, as Calabria and the FSOC conspicuously do not.

FHFA’s May 20 capital proposal gives two dollar amounts for Fannie and Freddie’s “net credit losses”—that is, stress test losses after private mortgage insurance, but before any credits from securitized risk transfers—on their September 30, 2019 books of business: $109.1 billion and $134.9 billion. The latter figure, however, incorporates FHFA’s proposal to set a floor of 1.2 percent on credit losses for all loans, and thus is an inflated number. Assuming that $109 billion (or 1.80 percent of adjusted assets) is an accurate estimate of the lifetime credit losses Fannie and Freddie would incur today in response to a 25 percent decline in home prices (and it may still be high), FHFA adds another $124.8 billion through various cushions and buffers to get to the risk-based capital requirement of $233.9 billion (3.85 percent of adjusted assets), then a further $9.0 billion through the 4.0 percent minimum capital requirement, which was binding on September 30, 2019, to reach a total capital requirement of $242.9 billion for the companies.

As numerous commenters on the capital rule pointed out, the $133.8 billion in combined cushions and add-ons to the risk-based requirement in the May 20 rule exceeds by a large margin the $109.1 billion in worst-case credit losses being cushioned or added on to. FHFA and the FSOC claim this is necessary to cover risks other than credit—market, operations, and model or measurement risk—and to enable the companies to survive the stress period as going concerns. But here the disconnect with market reality becomes untenable.

Beginning with the June 2018 version of the Fannie-Freddie capital rule, FHFA consistently has refused to acknowledge that the companies’ guaranty fees constitute revenues capable of absorbing credit losses. While some version of discounting the value of guaranty fees may be reasonable in a stress test conducted on a liquidating book of business (which is how the risk-based capital requirement is derived), ignoring guaranty fees in assessing a company’s ability to survive a stress period as a going concern is nonsensical. Those fees will be there, and moreover many of them (in Fannie’s case, over 40 percent) already have been received in cash, as loan-level price adjustments on higher-risk loans, and literally are present on the balance sheet.  

In the second quarter of 2020, Fannie and Freddie’s combined guaranty fees, excluding the TCCA fees payable to Treasury, totaled $7.6 billion, or more than $30 billion annualized. After deducting annualized administrative expenses of $5.4 billion, Fannie and Freddie’s net guaranty fees currently are running at a rate of $25 billion a year. If the $109 billion in combined lifetime stress credit losses FHFA is projecting for Fannie and Freddie follow the same annual pattern as the losses from Fannie’s 2007 book—which is the one subjected to the financial crisis—they would look like this over the first five years: $7.4 billion, $14.5 billion, $24.5 billion (peak in year 3), $19.4 billion, and $14.4 billion. Note that each year’s loss is less than the companies’ current amount of annual net guaranty fees (although year three just barely), and that over the full five-year period the companies would have earned guaranty fees of $125 billion while suffering credit losses from their pre-stress period books of $80.2 billion, leaving their capital accounts not just intact, but increased. (Credit losses at both companies from new business put on during the first five years of the stress period would be only another $8.0 billion if they followed the post-2007 pattern.) That is their business reality.

Contrast this with the unreality of the FHFA capital scheme, endorsed by the FSOC. FHFA projects credit losses of $109 billion from a stress scenario that is highly unlikely to occur, ignores the fact that as the going concerns FHFA (properly) insists the companies be they would be able to cover these stress losses with guaranty fees, and then requires them to protect against “other risks” with a dollar amount of capital, $134 billion, greater than the projected stress credit losses themselves. Yet what, besides going concern risk, might those other unquantified risks be? Unlike commercial banks, Fannie and Freddie do not have the interest rate risk of funding 30-year mortgages with short-term debt; they have virtually no liquidity risk (the threat of deposit flight, or an inability to roll over debt); their market risk is low because their guaranty fees are locked in up front and tend to be recaptured (and can be increased) when mortgages refinance, and they now hold few securitized mortgages in portfolio; their business is not operationally complex and the operations risk they do have is not correlated with credit risk, and finally, in their one line of permitted business their credit losses occur with considerable advance warning, and even in a worst-case scenario are spread out over many years.

When I worked with former Fed Chairman Paul Volcker on the risk-based standard that became the basis for Fannie and Freddie’s 1992 capital legislation, he often expressed his strong view that the capital standard for any regulated financial institution must not go so far in pursuit of a subjective safety and soundness goal that it impeded the ability of a regulated entity to conduct its business on an economic basis. Director Calabria, to my knowledge, has never addressed this balance issue in any form or forum. Instead, for whatever reason he seems determined to subject Fannie and Freddie to a bank-level capital requirement that does not remotely align with the risks of the mortgages they guarantee, despite what he now knows the consequences of this will be: distorted credit pricing, greatly hindered competitiveness, a significant reduction in the volume and breadth of the companies’ business, and quite possibly discouraging investors from supplying the equity required for them to become fully free of the regulatory restrictions imposed upon them more than a dozen years ago. 

The fact that Director Calabria has been able to obtain the support of the Financial Stability Oversight Council for his May 20 capital proposal may give him temporary regulatory cover for making only modest adjustments before the rule becomes final, but it does not change the reality that the standard is seriously misguided, and inconsistent with readily available historical and market data. And that inevitably will limit its lifespan. At some point Fannie and Freddie will have a regulator who does not insist that they be arbitrarily and punitively overcapitalized, and understands that hamstringing the operations of two companies at the center of a $10 trillion market critical to the health and growth of the U.S. economy, for no demonstrable reason, is disastrous public policy. For this reason, even if the May 20 FHFA capital standard goes into effect as proposed, it is highly unlikely that Fannie and Freddie will have to recapitalize solely through retained earnings, over a period as long as ten years. They will be given a sensible and workable capital requirement long before then.

77 thoughts on “The Director Digs In

  1. Tim

    GSEs’ Q3 20 financial results were released today and were excellent as expected. I would look forward to any insights you have. My reaction was that the “tone” of the whole GSE conversation has changed.

    There are still some references to protecting taxpayers from greedy hedge funds, such as the Sen. Warner/Rounds letter from a few weeks ago, but this was an isolated and weak missive, in my view. What seems to have more consequence now is to focus on the positive role that the GSEs played as a solution to the covid economic stress, and their important role going forward as well capitalized institutions…that being part of the solution going forward is a 180 degree turnaround from being (improperly) blamed for the GFC problems. we can all focus on the details of SCOTUS arguments, capital rules and capital raising plans, but I would also pause for a moment and notice that the lay of the GSE landscape has shifted favorably.

    you would never see a quote like this just a few quarters ago, from FNMA CEO in today’s earnings release: ““Fannie Mae has helped more than 1.2 million homeowners with forbearance plans so far in 2020, while providing record levels of critical liquidity to the mortgage market through one of the most severe and sudden economic shocks in a century. Our performance this year demonstrates our ability to support the mortgage market in a safe and sound manner even during these uniquely challenging times. To continue meeting these challenges, we believe our company and the broader housing finance system would be best served by a responsible end to Fannie Mae’s conservatorship, consistent with FHFA’s goals.”

    for long time observers of things GSE, this is a welcome reversal.

    rolg

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    1. I’ll focus on Fannie’s earnings. The “headline” 3rd quarter numbers–$5.4 billion in pre-tax net income and $4.2 billion in after-tax net income–were well above what I would peg as Fannie’s current baseline earning power of about $3.5 billion pre-tax and $2.8 billion after-tax per quarter. But when you look at the details, the above-trend result is readily explainable by two factors: (1) Fannie had a huge jump in amortized guaranty fees–from $1.49 billion in the second quarter to $2.71 billion in the third quarter–due to the impact of lower interest rates and accelerated refinances on its outstanding book of business, and (2) Fannie continued to draw down on its allowance for losses, by $1.26 billion in the third quarter. While welcome and a boost to retained earnings, both of these factors are temporary. And there is another, less positive, aspect of the refi wave that also showed up in the third quarter numbers. In the third quarter of 2019 (pre-refi wave), Fannie’s average charged fee (net of TCCA) on new business was 45.9 basis points, 2.4 basis points higher than its average charged fee on outstanding business (also net of TCCA) of 43.5 basis points. But in the third quarter of this year, the average new business charged fee of 44.9 basis points was only half a basis point above the average 44.4 basis point fee on outstanding business. So we’re now seeing a leveling off in Fannie’s guaranty fee rate, with the faster amortization of upfront fees pushing the average fee up, and the higher quality of the refi business pushing the new business charged guaranty fee rate down. Fannie and Freddie were hoping to avoid this leveling off by charging a half-basis point upfront fee on refi business last quarter, but this fee has been deferred until December 1. By that time, though, a considerable amount of business already will have repriced, and that will make Fannie’s average outstanding guaranty fee rate “sticky” at around 45 basis points–which is not where the company will want it to be if it has to hold 4.0-plus percent capital against that business.

      So I view the third quarter results somewhat less optimistically than you do. Yes, the “tone” of the earnings release is clearly positive, but the accelerated turnover of the existing book at a 45 basis point guaranty fee rate is going to be a handicap if Fannie (and Freddie) has to significantly increase its average fee rate because of much higher required capital. Potential investors will note that as well.

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      1. Tim

        picking up on your observation that the average new business G fee has trended downward, and accepting that it will have to trend upward in view of future capital raising, typically the principal impediment to raising a fee is competition. since both Fannie and Freddie will have to raise G fees, I dont see the one posing a particular competitive constraint on the other. so competition would have to come from outside the GSE space, I suppose principally PLS issuances and large banks and perhaps REITS etc holding more mortgage loans in portfolio. isn’t this non-GSE space a somewhat weak competitive threat to the GSEs (considered as a unity since they will both be raising G fees), in terms of its capacity to significantly increase mortgage loan volume away from the GSEs?

        rolg

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        1. There are three elements that will affect by how much, and how quickly, Fannie and Freddie can raise their average guaranty fee rates. For me the most important will be whether the Temporary Payroll Tax Cut Continuation Act (TCCA) expires next October. If it does, the companies should be able to begin picking up for themselves the 10 basis they’ve been charging on behalf of Treasury for the past nine-plus years, with no adverse market impact. Next there are competitive constraints. In my FHFA capital comment, I noted that there appeared to be market resistance in the past when Fannie and Freddie’s fees hit an average of 60 basis points (which currently is 50 basis points for the companies and 10 for Treasury, through the TCCA), because at 50 basis points on low-risk business they would lose significant share to bank portfolios, and at 75 basis points on high-risk business they would lose significant share to the FHA and Ginnie Mae. I have no reason to think those competitive “resistance points” have changed. The third constraint on fee raising is how quickly the companies can (a) grow, and (b) turn over their existing book. For Fannie, this book turnover is occurring rapidly now (29 percent of its $3.25 billion in single-family credit guarantees as of September 30, 2020 will have been put on and priced this year), as is strong growth (9.8 percent annualized in the first three quarters)–but without higher fee rates. If Fannie and Freddie’s fee increases begin after turnover and growth slow down, as now appears likely, it will take longer for those higher fees on new business to pull up the average.

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    1. Thanks ruleoflawguy – excellent point! If I was the Government I would call it a day and pack my briefcase and go home. How do you see a possible settlement along the lines you have suggested affecting the other major ongoing related cases (either the outcomes or the timelines)? Thanks – always look forward to your and Tim’s insightful comments!

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      1. @jim

        the principal case other than Collins is Fairholme, scheduled for trial before Judge Lamberth in spring 2022 (individual and class action plaintiffs). govt will argue that this case has been mooted by a Collins settlement that involves an economic recovery along the lines discussed in the article, though there may be some hold up value if plaintiffs can present a credible claim for additional damages since any such additional damages would be paid by the GSEs themselves, which would represent a contingent liability for the GSEs as they try to raise capital.

        rolg

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        1. @ROLG

          Washington Federal is still on in Sweeneys Court, so not clear if a Collins settlement would moot that case and conversely what is the significance of that case still outstanding as potential future damages?

          Also, back to Collins, isn’t it abundantly clear that if this admin is serious about raising private capital to protect the taxpayer and Mnuchin pushes this to be heard on 12/9, they are not serious about exiting conservatorship even if Trump wins the election? I say this cause if they hear the case and the Government prevails next spring, then zero private capital comes in. If they lose the case they risk huge damages and other cases are emboldened. What am I missing here?

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    2. This article by ROLG postulates that the existence of a substantial amount of prejudgment interest that would be awarded following the invalidation of the net worth sweep by SCOTUS (whether for reasons of constitutionality or a violation of the APA) gives plaintiffs substantial leverage in negotiating a settlement of the Collins and other cases before oral argument is heard on December 9. I believe, however, that in the event the Court finds that the net worth sweep IS invalid and the remedy should be to unwind it retroactively (as plaintiffs have requested), then no additional prejudgment interest will be owed.

      There are two ways plaintiffs could receive relief on a ruling invalidating the net worth sweep. The first is that the excess sweep amounts Fannie and Freddie have paid over the 10 percent (at a quarterly rate) on the balance of their outstanding senior preferred stock, owed under the original PSPA, would be refunded to the companies in cash. In calculating the amount of this refund, both companies would be credited with prejudgment interest on the excess payments made to Treasury each quarter. The interest rate used to calculate this credit would be no less than the companies’ cost of borrowing (since in practice they were required to replace their “swept” retained earnings with a mix of short- and long-term debt), and at the Court’s discretion it could be higher. In this alternative, Fannie and Freddie would receive a cash award composed of the cumulative overage of their excess net worth sweep payments—relative to the $19 billion or so they would have owed each year under their original 10 percent dividend arrangements—since the beginning of the sweep, plus the pre-judgment interest. But their now $193.5 billion in Treasury senior preferred stock would remain outstanding, and they would continue to be required to pay 10 percent per year on it.

      The second way of invalidating the sweep is to retroactively recharacterize each quarter’s sweep payment in excess of that quarter’s owed 10 percent dividend as a paydown of the outstanding senior preferred. Plaintiffs have done this calculation, and the result is that up to the point at which Fannie and Freddie were permitted to retain a limited amount of earnings (up to $25 billion for Fannie and $20 billion for Freddie), this method results in the senior preferred for each company being paid off entirely, and Treasury owing each about $12.5 billion, which could be paid either in cash or (more likely) as credits against future federal income taxes payable. In this second method, however, Fannie and Freddie’s sweep payments in excess of the 10 percent dividend effectively get credited with “earning” that percentage as the senior preferred is paid down, and no additional prejudgment interest is owed.

      It’s possible to make an argument for using the implicit 10 percent crediting rate of the second alternative as the interest rate for calculating prejudgment interest under the first method (although I doubt the Court would be persuaded by it). But even if so, under the first method the senior preferred would remain outstanding, and neither the government nor the plaintiffs will want that. The government won’t want to write combined checks for more than $200 billion to Fannie and Freddie, and the companies would much rather have the senior preferred—and its required (punitive) 10 percent dividend—gone, so they can quickly rebuild their capital base.

      If this analysis is correct, as I think it is, then plaintiffs do not have the “additional leverage” of prejudgment interest to use in negotiating a settlement. And we’re back to asking whether plaintiffs are better off trying to settle before SCOTUS hears the case, and whether Treasury can come up with a defensible rationale for giving up its current claim to the companies’ annual income, and a $200 billion-plus liquidation preference, without having been told to do so by SCOTUS. I’m still waiting to hear an argument I find convincing for such a settlement scenario.

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      1. Tim

        I agree with almost all of this. at the end of the day, prejudgment interest (imo plaintiffs have a good case for 10% compounded under the forced investment theory) on the excess over 10% dividends paid pursuant to the NWS (your first method), plus the cumulative excess dividend amount, is not less than, and unless my hobbled math talents mislead me, somewhat more than what would be called for under the “IRR 10% moment” calculation (your second method) that Pollock first published, and which has been picked up by Craig Phillips and others. I think the portion of the thrust of my argument, that there should be a satisfactory economic settlement, is bolstered by the availability of prejudgment interest, and I agree that I was wrong to believe that prejudgment interest provides such additional leverage as to result in a contemporaneous release from conservatorship (and one may credibly wonder whether FHFA could even move this fast before 12/9).

        as for your skepticism that Treasury will not settle Collins before SCOTUS decides it for Treasury, that would simply be a continuation of the overall govt strategy incoherence that I refer to in the article, and so your skepticism is warranted. I do think that Collins en banc decision was a wakeup call for the govt (not having lost in litigation before then), and the prospects for a SCOTUS govt win are not worth the risk of an embarrassing economic loss, whose genesis can be traced to the Obama administration, but whose blame will be left at the feet of the Trump administration. Clearly, I have been wrong before.

        rolg

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        1. ROLG: One clarification on your response: My second method (which really is the plaintiffs’ proposed method) is not the same as Alex Pollock’s “10 percent moment” calculation. That IRR-based calculation is one that sometimes is used to justify a lower repayment to Fannie and Freddie (in the event that the net worth sweep is reversed) than would be the case using the plaintiffs’ method.

          I have not tried to replicate the Pollard calculation, and don’t intend to now because it’s not currently on the table as an alternative way to award damages. The plaintiffs’ method also has the advantage of simplicity: take the net worth sweep payment in Quarter X, subtract the 10 precent dividend (at a quarterly rate) owed on balance of senior preferred outstanding at end of Quarter X-1, then deduct this amount from the amount of outstanding senior preferred at Quarter X-1 to produce the amount of outstanding senior preferred amount at the end of Quarter X; repeat this process for each subsequent quarter until the senior preferred is paid off, after which all further sweep payments are deemed owed to the companies. That’s now a known number, and requires no assumptions to produce it.

          I also see the political calculus differently. This administration has been making the argument that the net worth sweep was legal and justified for over three and a half years. It’s had multiple opportunities to repudiate the “Obama-era” sweep–publicly opposed by the current FHFA Director (albeit in a prior position)–and not taken any of them. If it sticks with its current argument and loses the sweep case at SCOTUS, it can say, “well, we played the hand we were dealt, and it didn’t work out.” If it settles now, it has to both address its defense of the sweep for the past three and a half years (it can’t just say, “oh, never mind all that,”) and defend itself against the “giveaway to the hedge funds for not much in return” argument.

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          1. 3.5 year defense of sweep would be it benefited taxpayers. Settling would be due to the risk of severe loss to taxpayers in light of 5th Circuit. Appeal to SCOTUS is just what lawyers do even when looking to settle (in this case, on behalf of taxpayers).

            The spin is easy and, relatively speaking, nobody is even watching let alone able to show GOP inconsistency within the strictures of political soundbites.

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          2. The decision of the Fifth Circuit en banc occurred over a year ago. In lieu of settling then, Treasury filed an interlocutory petition for certiorari with SCOTUS because it said it sought to remove the “legal uncertainty” about the outcome the net worth sweep cases so it could proceed with ending Fannie and Freddie’s conservatorship; so, why not wait to see what SCOTUS does–particularly since settling won’t resolve all the legal uncertainties, whereas a ruling from SCOTUS will. And finally, the one significant change that’s happened since the Fifth Circuit en banc decision is that Calabria’s draconian capital rule has greatly reduced the value of the warrants Treasury holds for 79.9 percent for Fannie and Freddie’s common stock, which weakens Treasury’s settlement incentive (and its potential for claiming future financial benefits for taxpayers).

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          3. @frances

            warrants, warrants, warrants. Warrants have obvious economic value, but they also have strategic value if Treasury wants to entice some whale to invest. because they have no real exercise price, they do not contribute to raising capital through exercise. but if some whale wants to buy alot of common stock in the offerings (creating capital) but wants a sweetener, Treasury might wish to sell the whale a slug of its warrants in connection with the offering at an attractive price. If this were to occur, it would most likely occur in connection with a pre-public offering private placement.

            Rolg

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          4. Just wanted to put my two cents in on the argument whether anything happens prior to SCOTUS argument 12/9. In my opinion, if Trump wins, he will want to see what SCOTUS does with the case to have a definitive answer on a net worth sweep type of charade in the future, to remove the temptation from the likes of Parrott to repeat the action if/when Dems win the Presidency. This also gives the Administration cover to proceed with a recap and IPO once one of the decision tree iterations have been narrowed. Gov’t was told to settle by SCOTUS and the hedge funds argument is moot. I don’t see a settlement if Trump wins. It will likely be decided by SCOTUS.

            Just like Trump wants SCOTUS to eliminate Obamacare so he can negotiate what he perceives to be a better solution for healthcare. He is not tipping his hand on keeping ACA intact even if he wins at SCOTUS because if he did so, he’d lose negotiating leverage with the Dems. Same logic applies to the GSEs, he won’t settle until forced to do so, keeping optimal leverage in the process.

            On the other hand, if Biden is elected, decision tree opens up and we have more uncertainty as a result. Ultimately, the case shouldn’t go to SCOTUS by 12/9 because Calabria will want to protect his job, but FHFA isn’t the lead on the settlement and Mnuchin may or may not do anything.

            I hope I’m wrong on this and there is a settlement by 12/9, but overall, I think there is a 75/25 chance of SCOTUS deciding this. (100% if Trump wins, 50/50 if Biden wins)

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          5. Tim

            Wasn’t the decision to file for cert post 5th circuit ruling really the DOJ and the SG more so than Sec Mnuchin, despite him being the named defendant? Also, wouldn’t it have been premature to settle before all advisors were in place and a formal exit strategy solidified and able to be announced? In the meantime, this allows more time for negotiations up to the last minute and in this case ROLG suggests 12/9.

            Speaking of the advisors I imagine they may be opining on settlement v SCOTUS decision based on institutional investor feedback. A government win would really scuttle any exit plan.

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          6. Favorable resolution or settlement of the lawsuits is an absolute prerequisite for Fannie and Freddie’s release from conservatorship under a consent decree and subsequent recapitalization, but I don’t know why the parties would feel they have to have a capital plan in place before settlement could occur. Settlement of the suits is a matter between Treasury–which is both the instigator and the beneficiary of the net worth sweep–and the plaintiffs, while the recapitalization plan is a matter between the companies and FHFA. I would be surprised if Treasury has been holding up settlement negotiations pending promulgation of a final capital rule and the development (with advisor input) and approval (by FHFA) of the companies’ recapitalization plans.

            Liked by 1 person

        2. Response to Alecmazo, if the gov’t waits on SCOTUS to decide and the ruling favors Plaintiffs, then the Gov’t leverage to negotiate diminishes dramatically…that seems like a bad idea for them

          Liked by 1 person

  2. “And neither Mnuchin nor Treasury have given any indication that they’re about to throw in the towel on the claims the government has been making since 2012 that the net worth sweep was valid and necessary.”

    Tim,

    Could it be as simple as this?

    Mnuchin realizes there will be a day of reckoning. (He even acknowledged on Maria’s show the illicit nature of the NWS and he can’t ignore the likelihood of SCOTUS upholding the Fifth Circuit.) It seems reasonable to me that his mindset simply is if Trump loses in November, then let NWS overage (and any punitive damage for 10% usury or whatever) be paid back by Biden’s Treasury, especially since Obama’s Treasury began the NWS. In other words, there is zero political motive to settle before the election given (a) the bad press for doing so – e.g. favoring Hedge Funds etc., and (b) the possibility that Biden’s Treasury might have to foot the bill, which surely doesn’t bother Mnuchin. (Might even delight him as a consolation prize for a Biden win.)

    But there could be some pragmatic reasons why they might settle if they are holding the purse strings in spring or 2021. They could reduce the amount of payback that they might otherwise pay under a severe SCOTUS ruling. They also wouldn’t have to carry the baggage of a SCOTUS rebuke for theft.

    It would be nice to see Trump’s Treasury throw in the towel based upon pure integrity, but we know that hasn’t happened and, therefore, won’t happen. Notwithstanding, although I see no political incentive and plenty of political disincentive to settle given the possibility of a Biden victory, I do see advantages (with zero downside) to settling if Trump wins in two weeks. Aside from saving money, they can settle with no serious consequence to the GOP in 2024, if that were a concern for the party or the president. They could even possibly still distance themselves from the illicit nature of the NWS with a bit of spin and use of Sweeney’s documents.

    Ron

    Liked by 1 person

  3. Is the Fifth Circuit En Banc Opinion a Bad Call or Have the Treasury and FHFA

    Perpetrated a Fraud on the Court in Collins v. Mnuchin ?

    https://www.jurist.org/commentary/2020/10/joseph-marren-collins-v-mnunchin/#

    The purpose of this article is to slow down the action so that everyone understands
    what the real facts and issues are in the case.

    Hopefully, the United States Supreme Court may conclude in its upcoming review of the case that:

    1. The Agencies pleadings were in bad faith and that Federal Rule of Civil Procedure 11 has been violated; and

    2. The Agencies have committed a fraud on the court under FRCP 60.

    Like

    1. This is a speculative article that presents its author’s opinions and theories as accepted fact, then goes on to argue that in light of these alleged “facts,” which FHFA and Treasury did not acknowledge in their pleadings, the Supreme Court should find these pleadings to be fraudulent. It is not clear, at least to me, what the author thinks should happen after that. But it doesn’t matter, because this argument is not before the Court, will not be put before the court, and even were it to be, would be dismissed out of hand.

      I won’t recap the article, except to say that the author (Joseph H. Marren, President, Chief Executive Officer and Chief Compliance Officer of KStone Partners, LLC) believes that (a) the Office of Management and Budget improperly modified the government’s “Combined Statement of Receipts and Balances” in 1953, and (b) this act somehow invalidated the government’s decision to remove Fannie Mae’s liabilities from the federal budget when it was privatized in 1968 (and to keep Freddie’s liabilities out of the federal budget after it was created in 1970). From that point, though, I literally cannot follow the author’s argument as to why these two developments make Treasury and FHFA’s pleadings in the Collins case false. I would counsel readers not to waste as much time on this article as I did.

      Liked by 2 people

        1. Thanks; I hadn’t known that Mr. Marren had tried to get his argument in front of the Fifth Circuit Court of Appeals, and been roundly rejected. This makes it all the more puzzling why he thinks he might have more success with SCOTUS. (It could be a case of “nothing else to do during a pandemic….”)

          Liked by 2 people

  4. Tim,

    Director Calabria continues to point to the FSOC’s position that “the re-proposed capital rule may not provide enough capital to withstand a serious downturn in the housing market.” Do you think he’s trying to prepare the market for an even more onerous capital rule than the re-proposed one or do you think this is just cover for him pushing through the reproposed rule in its current form?

    Like

    1. I believe Calabria is just laying the groundwork for publishing the rule in close to its current form (with a probable increase in the credit given to securitized credit risk transfers, and possibly also some relaxation in the restrictions on dividends paid on new issues of preferred stock–and potentially also common–during the recapitalization period).

      Like

      1. What do you think the timeline looks like at this point? FHFA has had almost two months to review comments. What’s the reason for the delay in publishing the final rule?

        Do you think there is still time to get everything done (settlement and Fannie/Freddie coming up with plans for capital raise(s)) if President Trump is not re-elected?

        Like

        1. I don’t have any insight into the timing for the publication of a final FHFA capital rule, although I would be surprised if the rule is made final before the election (which now is only two weeks away). After that, the handicapping will depend heavily on who won, or appears to be in the best position to win (should mail-in ballots be required to declare a winner). But as I say below, should Trump lose I think Calabria will want to move quickly to finalize the capital rule and settle the lawsuits prior to the December 9 oral argument before SCOTUS in Collins v. Mnuchin (and Mnuchin v. Collins), in order to avoid the possibility of having his directorship of FHFA be ruled unconstitutional in a decision in these cases. But that process is not his to run; it’s Mnuchin’s. And neither Mnuchin nor Treasury have given any indication that they’re about to throw in the towel on the claims the government has been making since 2012 that the net worth sweep was valid and necessary. A settlement of the lawsuits before December 9 would require Treasury to effectively say, “We still think we’re right on the net worth sweep; we know the issue is being argued at the Supreme Court in early December for a definitive decision next spring, but we’ve nonetheless decided that this is the right time to give the plaintiffs what they’ve been demanding to settle these cases, so Fannie and Freddie can be returned to shareholder-owned status.” I personally have a hard time seeing how Mnuchin as an individual, and Treasury as an institution, could get to the point where that looks to be their best option.

          Like

          1. Is it fair to say that you do not see a consent decree being put in place prior to a transition of power if Biden wins in November? If that’s the case, will we just continue in this state of purgatory for the next 4-8 years unless the Supreme Court strikes down the NWS?

            Like

          2. All I’m saying at this point is that I do not see a good argument for a consent decree being issued before the December 9 oral argument, given the current state of play, which includes (a) Treasury’s continuing to defend the rationale for and legality of the sweep; (b) the case coming before the court in December, and (c) FHFA Director Calabria’s capital rule removing a very large amount of value from the warrants Treasury holds for 79.9 percent of Fannie and Freddie’s common stock, which would be Treasury’s financial rationale for giving up the sweep and the liquidation preference voluntarily. Perhaps someone has made a good argument for this, and I just haven’t heard or seen it.

            We may get a sense of how SCOTUS will rule on both the constitutionality and the APA issues after oral argument on the 9th. If so, that could shed some light on what, if anything, the administration may do between then and January 20, 2021 (assuming Trump loses).

            Like

    1. The Layton piece is largely speculative, and I didn’t find it to be particularly informative (of course, I’m up to date on all these issues) or insightful. I also found it odd that he largely avoided any discussion of the lawsuits, and the role either a favorable or an unfavorable ruling for the plaintiffs by SCOTUS–or a pre-emptive settlement of the cases between the election and the December 9 date of oral argument–would play in any of the outcome scenarios he’s postulating. This, in my view, was not one of Layton’s better pieces.

      The brief for the court-appointed amicus was about what I expected. Amicus Nielson claims that the Seila Law precedent on the constitutionality of the CFPB director is not applicable to the director of FHFA, for three reasons: (1) the head of FHFA who agreed to the net worth sweep, Ed DeMarco, was an acting director, who COULD (according to the argument of the amicus) be removed at will; (2) FHFA does not deal directly with the public and thus does not pose the threat to individual liberty that the CFPB does (so that having a director removable only for cause does not raise the same constitutional issues as in Seila Law), and (3) the “for cause” restriction on the removal of the FHFA director is not as limiting as the “inefficiency, neglect or malfeasance” standard that constrains the ability of the president to remove the director of the CFPB. None of these are new arguments, and plaintiffs counsel (Cooper & Kirk) will have the opportunity to respond to them in the consolidated reply and response brief they will file on November 23. At that point we’ll be able to evaluate the arguments made by both sides, and assess which appear likely to carry more weight with SCOTUS.

      Liked by 4 people

      1. Tim

        I would only add that amicus really had two paths: i) to distinguish FHFA from CFPB (former regulates 13 entities, latter regulates millions of people and entities), so that Seila does not apply to Collins (remembering that even though Seila was a 5-4 majority, if FHFA=CFPB, then Collins will be 9-0…this is precisely the effect of precedent), and ii) distinguish the NWS in Collins from the CID in Seila, insofar as the former was decided by an acting director, and the latter by the director, of the respective agencies. as for the removal standard, Roberts has already said in oral argument to the amicus in Seila that removal for cause is tantamount to removal for inefficiency, neglect or malfeasance…that dog not only won’t hunt, it won’t bark.

        These arguments are very weak, though presented in the brief as best as they could have been. Which circles back to your point re the Layton piece. Collins is a case the government does not want to argue, and it makes no sense to handicap the parties’ actions going forward without considering the long shadow Collins casts back from the 12/9/20 oral argument.

        rolg

        Liked by 2 people

        1. Rolg,
          When you say the Collins case is a case the government doesn’t want to argue, a part of me hopes you’re right but I’ve struggled with wanting to believe that but questioning, particularly if Trump were not be re-elected, why Mnuchin/Treasury and Calabria/FHFA will ultimately care seeing they would both likely be replaced. I just don’t see either truly ever owning or taking ultimate responsibility for the current situation and or adverse ruling against the government. What are the main reasons you see it that way, I’m very interested in your perspective. Thank you!

          Like

          1. @jack

            well, when I refer to the govt not wanting to argue Collins in front of SCOTUS, I refer principally to the Solicitor General (who is now an acting SG) rather than Calabria/Mnuchin. assuming there is a Justice Barrett installed before 12/9, the SG is left with 6 “conservative” justices, who are not overly inclined to give the govt the benefit of the doubt regarding matters of separation of powers and administrative agency overreach, to hear a very weak argument (remembering that the SG is not even arguing that FHFA=/=CFPB). in front of SCOTUS, it is the DOJ and specifically the SG who calls the shots, not Calabria or Mnuchin. and the last thing the SG wants to do is argue the case on 12/9 and then be told by Calabria and Mnuchin that they have a settlement. the SG, as a repeat player in front of SCOTUS, would find that to be disrespectful of SCOTUS. So what I think you have is a weak case on the merits, where the govt’s position is not even conducive to an administrative recap and release, and which if it is to be settled, really has to be settled before 12/9. I have been wrong before.

            Remember, the govt “won” the Collins constitutional claim at the 5th C en banc, insofar as it held FHFA was unconstitutionally structured but there was only prospective relief available (these two points were what the DOJ argued for). Now comes Seila, and CFPB is both found to be unconstitutionally structured AND there was backward relief granted (subject to a determination whether the CID had been subsequently ratified by a” removable at will” CFPB director…there is no ratification question to be answered in Collins). Now comes SCOTUS granting Ps cert petition in Collins on the question of backward relief ( and whether FHFA=CFPB). and I haven’t even gotten to the APA claim, which Collins Ps won at the 5th C en banc. so I have to believe the SG thinks this is an ugly case to argue, and he certainly doesn’t want to argue it if FHFA/T have any intention of settling it.

            rolg

            Liked by 2 people

          2. I think it’s very likely that if President Trump loses the election, Director Calabria will be strongly in favor of settling the lawsuits. He would like to be able to publish a final capital rule, and– with the net worth sweep unwound and the liquidation preference eliminated–negotiate a consent decree that would lock in some of the changes he would like to see Fannie and Freddie adopt as concessions for being allowed to exit conservatorship. And I have no doubt he would like to remove the issue of the constitutionality of his directorship from the SCOTUS calendar, and thereby maintain his position in a Biden administration until his tenure is challenged in the courts (which will take a while to resolve). I also accept the judgment of ROLG that the Solicitor General would rather not argue the Collins case before SCOTUS if he doesn’t have to. My question, though, is: where is Secretary Mnuchin on this? While Calabria has been making his preferences on the recapitalization process known to anyone who is willing to interview him, there has been absolute radio silence from Mnuchin, and Treasury, on THEIR preferences. And they are the ones who will have to give up the rights to $15 to $20 billion in annual net income from Fannie and Freddie–and a $200 billion-plus liquidation preference–for “nothing.” It’s easy for Calabria to say, “go for it”; it’s a much trickier matter for Mnuchin to come up with a defensible rationale for taking that step.

            I’ve been saying for some time that I believe Treasury is looking for political cover to insulate it from the criticism it will receive for “giving away billions of dollars of taxpayer money to hedge funds.” It doesn’t have any more cover today than it had nine months ago, and it won’t have any more in the period between the election and the December oral argument at SCOTUS. I’ve heard the theory that if the president loses, that will free up FHFA and Treasury to push through a settlement and consent decree. But I’ve yet to hear a convincing argument as to why that should be. Indeed, I just as easily can see it running the other way. Mnuchin’s choice essentially will be: (a) “I gave it my best, but we just ran out of time; let’s see what the Ds can do with this,” or (b) “Before I go, here’s $100 billion-plus for my buddies in the private sector.” I’m glad I’m not in the prediction business. Again, this would be more straightforward if it were Calabria’s call, but it’s not.

            Like

          3. Tim, just my two cents. The letter from Senator Warner gives a hint what the Treasury is cooking up. Not wanting to advertise it is understandable knowing how everything this administration does is spun negatively by MSM.

            Like

          4. Tim

            Regarding Mnuchin, and where he has been, I would say that he has been busy. But it seems to me that the math is compelling to Mnuchin…as a price to get the GSEs recapitalized, every dollar the GSE shareholders “get”, Treasury “pays” 20 cents, by virtue of Treasury’s warrant position. As for political cover, I suppose that FSOC putting its imprimatur behind the GSE recap goes a long way, and the political pushback represented by the letter from Sens Warner/Rounds seemed pretty weak to me. The letter’s political pushback was whether a GSE recap was a good financial deal for taxpayers (not whether it was good housing policy), and the answer will be that this is the best financial deal for taxpayers since the Louisiana Purchase. I never quite understood the disconnect over the past 18 months between Treasury’s litigating position (inherited from the Obama administration) and Treasury’s recap the GSEs policy position (a break from the Obama administration). I just think it will be time soon for Treasury’s policy position to win out over its litigating position, most likely more with a whimper than fanfare, as incoherencies usually do. given the tumult over the next few months, no one will notice.

            rolg

            Like

          5. In addition to the disconnect between Treasury’s litigating position on Fannie and Freddie and its (rumored but nowhere explicitly stated) economic position on the companies’ recapitalization, there also is a major disconnect between Calabria’s insistence on greatly overcapitalizing Fannie and Freddie as a condition of their release from conservatorship and Treasury’s position as holder of warrants for 79.9 percent of their common stock, whose value for the foreseeable future would be greatly diminished if Calabria sticks with his May 20 capital rule (as he’s giving every indication of doing). Treasury’s payoff for voluntarily relinquishing its right to Fannie and Freddie’s earnings and asset value thus seems much lower today than it did at the beginning of the year.

            Like

    1. @BIGe

      Pricing.

      if fhfa came out with a realistic capital rule, then the capital raise would be easier, and the common stock price at which the offerings would be executed would be higher. Calabria’s capital rule will be more onerous, making the capital raise harder, making the offering price of the common stock lower. of course, this adversely affects Treasury the most as a 79.9% holder of the common stock, but Treasury would appear to be price insensitive (on the low end).

      the mantra on Wall Street is “we can do this deal for you, but you may not like the price”…but the GSEs are a compliant issuer, because they have no options other than to let the underwriters play the “how low can you go” pricing game, because fhfa and Treasury are sacrificing the GSEs’ common stock price at the altar of “bank like capital” levels.

      rolg

      Like

      1. Did anyone ever answer Vartanian’s question about why new equity would come in since they could be sacrificed on any number of alters at anytime and the courts won’t say boo about it for …oh a decade or so?

        To me, that makes it nearly impossible before getting out of the gate. People forget, sure, but not the kind with the capital required here.

        Like

        1. @anon

          as I read vartanian, he was simply pointing out that the GSEs could not raise any money while in conservatorship, given the unsettled legal status of fhfa’s power as conservator…a point I entirely agree with. of course if scotus were to affirm the APA decision of 5th C en banc, then there would be legal clarity…but in the event there is a settlement before a collins scotus decision, the capital markets should be receptive to offerings from the GSEs once they have been released from conservatorship, likely into a consent decree where the obligations of the GSEs are specified and the fhfa director can no longer exercise conservator powers under HERA….and can not put the GSEs back into conservatorship given their current and prospective earnings.

          rolg

          Liked by 1 person

        2. To me, both the attitude of the regulator and the huge total volume of capital he is requiring are going to pose not just pricing, but potentially feasibility issues for the first public offering the companies make.

          The potential buyer of a new issue of Fannie or Freddie stock has to “back in” to an offering price, by estimating both the future earnings of the companies and the number of new common shares they ultimately will issue to reach full recapitalization (which implies an estimate of the mix of retained earnings to new publicly obtained capital, and also an estimate of the preferred to common ratio of that new capital–and obviously an assumption that the Treasury warrants convert to common). Next, once they have their estimate of common shares outstanding at the time of full recapitalization (call that “Year X”), they’ll need both an estimate of company earnings in that year and a guess at an earnings multiple to arrive at a projected Year X share price. Finally, they will discount that Year X estimated share price back by the return they, as an investor, would require to buy those shares today. The “unfriendly regulator,” past history of political risk, and estimation uncertainties for the various variables in question all would be factors that increase this discount rate.

          I’ve done some rough work along these lines, and given a 4 percent-plus capital requirement and the investor-unfriendly regulatory and political environment at the moment, the first public offering looks like a very heavy lift.

          Like

          1. Tim

            heavy lift indeed!

            as you intimate, one variable that I am sure JPM/MS are looking at is the mix of preferred to common to be offered, which is complicated by Calabria’s preference for common equity capital. given the current rate environment, I expect there to be a receptive market (as always, at a price!) for preferred, but Calabria would either have to loosen his focus on common equity capital (which as I recall was a focus of the Muirfield Capital Global Advisors LLC comment letter), or give common equity capital credit for convertible preferred prior to conversion.

            also, Calabria will have to phase in the binding effects of the final capital rule’s restrictions over time to provide the offerings what I call regulatory runway…about this, I have some trepidation simply because I do not value Calabria’s understanding of the capital markets…JPM/MS will just have to be insistent.

            I have been harping on price because I do not see any player in this offering that is a proponent for maximizing the price of the common stock…which of course is very strange for a common stock offering (in my experience, unprecedented)! Calabria could care less, and it seems that Treasury is price indifferent (a luxury it can afford to have, as it owns more warrants than the day is long). GSEs’ management are indifferent (putting aside the thought that they may actually prefer a low price if they ever are able to get stock options). the junior preferred holders are indifferent (and arguably happy to see a lower common price as well). who at the table is banging for as high a common stock price as possible? the simple answer is no-one.

            I have no idea how low the common stock price will have to go, but I would point out that the common stock will have to be listed on a national exchange in connection with any offering, and so the liquidity haircut now present due to pink sheet trading will disappear. moreover, there will be some price lift resulting from the actual commencement of the capital raise process. all this to say that there is plenty of room for the common stock price to be punished and, given the expected capital rule and the absence of anyone with an economic interest to maximize the common stock price, punished the common stock price will be.

            rolg

            Liked by 1 person

          2. Holding earnings and P/E estimates fixed, the offering common price strictly decreases as the capital required to raise increases. At some point the price crosses the axis, making the raise impossible. This is the point where investors wouldn’t even accept 100% of the common equity (which entails a full wipeout of the existing commons and warrants) for the capital they are being asked for.

            Theoretically the GSEs can raise the needed capital right up to that point assuming that Treasury really is insensitive to price. They have other ways of making money anyway, like partial monetization of the seniors (unlikely) and commitment fees (a virtual certainty). So if Treasury really doesn’t care about the warrants, the GSEs can price the offering all the way down to $0.01 if it can bring in enough capital. A heavy lift is fine, an impossible one isn’t.

            Given that the gap between Calabria’s CET1 and Tier 1 capital standards is only $25B, less than the $33B of outstanding junior prefs, I don’t think he would sign off on any new pref issuance unless the juniors are exchanged for commons. That puts a limit on how much of the common equity the GSEs can offer overall, though. The juniors won’t accept any offer that gives them less than $33B of value, and would likely require more due to the greater uncertainty involved. If the offering price is low enough (meaning the new investors get a bigger chunk of the common equity), the juniors won’t accept an exchange at any price, essentially preventing any new prefs from being issued.

            Also, the more the GSEs’ asset base expands, and it is exploding this year, the higher the dollar amount of 4% becomes. The heavy lift is getting heavier.

            Liked by 2 people

          3. @midas

            I appreciate the comment, but may I suggest that you have set up a straw man by saying “Holding earnings and P/E estimates fixed…” I can’t predict earnings (though I imagine that at end of month, we will see very good GSE Q3 earnings), but I can predict that P/E estimates will fluctuate. this is the whole dynamic created by pricing. every day in the equity capital markets, stock prices fluctuate (and do estimates of earnings, but let’s put that aside) which necessarily affects the P/E ratios for all trading companies. usually these P/E ratio fluctuations are range bound for public companies unless there is unexpected news, but one can expect that for the GSEs, needing to raise the capital required to satisfy Calabria’s capital rule, the P/E ratio will start out substantially less than one may expect, and certainly less than a fully-capitalized GSE would merit…hence common stock pricing will have to suffer, at least at the outset of the capital raising program.

            rolg

            Liked by 1 person

          4. At the risk of being overly simplistic, the price of a share of common stock is some multiple of its earnings (whether trailing, current or future) per share. For Fannie and Freddie today, the earnings component of this equality is the most predictable; the number of shares that will be outstanding when they reach full capitalization is the least predictable, and the multiple the market will assign to their earnings per share is the middle of this “range of predictability,” although probably closer to the high end.

            For the companies’ future earnings, several adjustments need to be made to the figures they’ve recently reported. The most important is to recognize that the significant (positive) benefits for credit losses they’ve been reporting for the last several years–the result of continuing to draw down on the mammoth over-reserving that was done prior to 2012–will turn to a modest (negative) provision for credit losses. Fannie reported an average of more than $3.0 billion in benefits for credit losses in the 2017-2019 period, and at some point fairly soon this should swing to a negative expense (provision for loan loss) of between $500 million and $1 billion (I have not done the numbers for Freddie). And once released from conservatorship under a consent decree, both companies also will need to pay their “periodic commitment fee” for the continuation of the Treasury backstop. Estimates of this vary widely, because it will depend on how Treasury chooses to price it. When I’m doing projections I use $500 million per year for Fannie, but I don’t have much confidence in that number. On the positive side, both companies will attempt to raise their average guaranty fee rates to increase the return on the (excessive) amount of capital they likely will be required to hold. But raising guaranty fees also will cut down on, and perhaps even reverse, their business growth, so holding the size of their business constant is probably the most reasonable assumption.

            But as I say, the earnings are the easy part. There are many unknowns and interactive variables in doing an estimate of the amount of new shares that will be need to be issued to reach full recapitalization. If I were looking at an investment in the companies (and to be clear, I am not), I would do a large number of projected scenarios with varying assumptions of variables including the mix of retained earnings to new equity issues, the proportion of preferred to common raised, and what (if anything) is done with the existing junior preferred, and see if there is a “central tendency” for the number of new shares likely to be issued before the companies fully meet their capital requirements (with some excess reserving also assumed, since it will be prudent for the companies to have those). That median estimate of shares outstanding (which would include the warrants converted to common) would give me the shares (“s”) to divide into my projected earnings (“e”) and thus a future eps estimate at time of full recap.

            Then I’d need an earnings multiple to get a share price. What should that be? Unfortunately, the further one goes out into the future the more difficult it is to estimate. Fannie and Freddie’s p/e ratios can be thought of in terms of two components: the market multiple (say of the S&P 500), and their relative multiple. The companies always have sold at a significant discount to the market multiple, for two reasons: one, they’re financials (which sell at discounts) and two, on top of that they have political risk (which has increased in recent years). Today the earnings multiple of the S&P 500 is close to 30:1, far above its historical average. This is mainly because interest rates are so low. The farther one goes out into the future, the more likely it would seem that market P/Es will “regress to the mean,” which for the S&P 500 is a LOT lower than it is today. And the Fannie and Freddie relative multiple is no easier to estimate.

            I’m sure Fannie and Freddie’s investment bankers are doing all of the analyses I’ve outlined above, but I don’t know what sorts of results they’re seeing. Whatever they are, however, the bankers will either use these analyses to try to convince new investors of the value of the stock at the offering price they recommend, or they will say to the companies, and FHFA, something along the lines of “at the level of capital that’s being required, and with the transition rules as currently posed, there is not a feasible way to begin recapitalizing with new equity at this time.”

            Like

          5. Tim

            while I agree with what you say, I just believe that the standard question, what is Fannie/Freddie’s P/E, is not going to be a given fixed multiple of steady state earnings, determined based upon baseline characteristics of the business/political risks, it will be depressed at the beginning of these capital raises, and increase over time as the capital raises are successfully executed to a steady multiple. No company that is going to raise this amount of capital will have a single multiple throughout the program. and I believe that you will never see JPM/MS say at the outset, this is a bridge too far. they will say, for this first capital raise, here is the price that clears out our book. GSEs’ management will likely be displeased with this price, but will be “assured” that the next capital raise will be at a price (multiple) more to their liking.

            rolg

            Like

          6. I’m not suggesting that either company will have a “single [p/e] multiple throughout the [capital raising] program.” I believe that because of all of the uncertainties associated with the recapitalization, the p/e multiple used to price the initial capital raise will be extremely low, and that–assuming the first issuance is successful–the p/e will rise over time with future issues. But I disagree with your statement that there is no such thing as a “bridge too far” for the investment bankers to cross. There is some share price at which the dilution caused by the large number of shares that have to be issued (because of that low price) LOWERS the p/e that will apply to the subsequent capital raise, and thus makes the ultimate capitalization objective unachievable. I have not attempted to estimate what that “death spiral” share price is, but I wouldn’t be surprised if a 4-plus percent capital requirement puts us close to, if not below, it (the bankers will know, at some point). And I’ll say one other thing. The excessive capital requirement has two effects. The first is obvious: you have to raise that much more equity. The second effect is not as obvious, but equally important: the more capital you require, the further into the future you push the point at which the exercise is completed. And the longer the process takes, the more the uncertainties associated with it compound and feed back on themselves, raising the discount rate investors apply to the process as a whole. At some point they simply say, “that’s too much uncertainty for me; I’m not going to play, at any price.”

            Liked by 1 person

      2. Tim,

        An excellent writeup as always. It amazes me that Calabria talks about obeying the Rule of Law, and then talks out of the side of his mouth. Your writeup is well thought out and answers some of the ‘end game’ questions I had in earlier posts. Assuming the 4% is sacrosanct, rationality will return when Calabria is gone — either forcibly or at the end of his term.

        ROLG,

        This is extremely well stated on your part. It is very possible the highly-paid underwriters will simply do a deal at any (presumably low) price. This of course will be taken out of the hides of the current Common Shareholders.

        Calabria appears to be a stubborn mule on his 4% capital threshold. His Libertarian underpinning(s) are strong and to a fault IMO. Keep up the great comments!

        VM

        Liked by 1 person

        1. I guess when Calabria mentioned there will be no ‘’windfall’ for shareholders in the past, he had the 4% capital rule on his mind.

          Like

  5. ” their market risk is low because their guaranty fees are locked in up front and tend to be recaptured (and can be increased) when mortgages refinance”

    This is true today, but it wouldn’t necessarily be true always. If there were additional guarantors (private or government), mortgage holders could refinance away from a GSE and take those contractual G-fees with them to the new guarantor. This would decreases the reliability of those future G-fees and increase the volatility of the capital levels.

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    1. @ Patrick

      yes, but this gets at Calabria’s oft-mentioned remark about the supposed benefits of competition to the GSEs….how many alternative MBS guarantors do you expect to arise to compete against two trillion dollar entrenched guarantors? if someone at a tbtf bank submitted a business plan to enter this market (even if there is legislation expanding the federal charter), this would be career suicide. this gets at what galls me about Calabria…he has no market sense or savvy. anyone with common sense would realize that if you wanted to expand the universe of MBS guarantors, you would first have to break up the GSEs, as no-one is going into the business as the market landscape exists…and talk about winding down the GSEs seems to have thankfully dissipated.

      so net net, GSE guarantee fees as a counterbalance to losses are money good.

      rolg

      Liked by 1 person

        1. @zak

          this is a putrid area of the investment landscape that I know something about, as I studied the monoline insurers extensively at time of GFC (in connection with handicapping the putback litigation they all brought against the tbtf mortgage originators). the muni monoline guarantors such as MBIA, AMBAC, Assured Guaranty etc all thought in mid 2000’s that if insuring muni debt was so easy they would insure PLS MBS and CMBS. they all got their heads brutally handed to them (though Assured Guaranty less so than all of the others). None of these players would go near insuring MBS and CMBS today (indeed, only Assured Guaranty would have the wherewithal to even consider it), and their miserable experience guarantying MBS and CMBS stands as a cautionary tale for any other institution that might consider it. turns out the GSEs’ business execution is not that easy to replicate.

          rolg

          Like

    2. Patrick: Fannie and Freddie’s guaranty fees ARE locked in up front, and remain fixed for the life of the loan. And I said they “tend” to be recaptured– allowing for some refinance leakage. In fact, for the past 30 years Fannie and Freddie have had close to a 100 percent recapture rate, and indeed during refinance waves their volumes of outstanding credit guarantees almost always have grown, sometimes sharply. The assumption about the creation of new credit guarantors is not one that is sensible to be making today. Should Congress pass legislation permitting them, and should anyone start them and some be successful, then, as their market share increases the credit guarantor regulator could apply an appropriate “haircut” to Fannie and Freddie’s future guaranty fee streams to account for this effect. In its proposed capital rule, FHFA effectively applies a 100 percent haircut to Fannie and Freddie’s ongoing guaranty fees–the polar opposite of the zero percent leakage that has typified the companies for the last three decades. That is not defensible.

      Liked by 2 people

      1. Fair points, thank you for the comment.

        “…indeed during refinance waves their volumes of outstanding credit guarantees almost always have grown, sometimes sharply.”

        I am curious if you are inclined to indulge — why have GSE outstanding credit guarantees usually grown during refi waves? That’s an interesting trend with no obvious reason jumping to my mind.

        Like

        1. I’m not sure what the main reasons are behind the correlation between high mortgage liquidation rates and a faster growth in Fannie and Freddie’s credit guaranty business–it’s likely some combination of the fact that housing starts, sales, and prices all tend to grow faster when interest rates are low, and a shift in investor mortgage preferences–away from whole loans towards MBS–when refinancing is strong. Whatever the reasons, though, the correlation is well documented, and we’re seeing it again this year. During the previous three years–2017 through 2019–Fannie’s annual MBS liquidation rates stayed within a relatively narrow range of 14 to 17 percent, and its annual business growth was both fairly low (an average of 3.5%) and consistent, ranging from a high of 4.2% in 2017 to 3.0% last year.
          But so far in 2020 (through August), Fannie’s MBS liquidation rate is running at an annual rate of 29%, and the growth in its guaranty book of business has accelerated to an annual rate of 10.4%.

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  6. Tim,

    1. Why do you suppose FHFA even bothered to invite comments on the proposed capital rule, especially given the fact that Dr. Calabria made no attempt to respond to formidable criticism?

    2. Do you suppose the thoughtful and overwhelmingly negative comments came as a complete surprise?

    Bewildered,

    Ron

    Like

    1. Ron: On (1), proposed rules have a comment period as a matter of process. On (2), I don’t know that Calabria was surprised by the number and the intensity of the negative comments FHFA received on the rule, but he very likely was unhappy with them. In fact, I suspect the negative comments from Fannie and Freddie were what triggered his “worst corporate culture” remark about them.

      Liked by 2 people

      1. Tim

        I have been trying to understand Calabria’s unexplained/unsubstantiated “worst corporate culture” accusation. One may wonder, given the absence of any corporate business experience on Calabria’s resume, how he might have come to this conclusion objectively…which leads me to suspect that Calabria’s accusation was motivated more by ego and pride than developed business judgment.

        I recall Calabria’s HFSC testimony recently where he stated emphatically (and somewhat dismissively) that no one will have to pay more for their mortgages because of the proposed capital rule because it will be phased in over time. His body language and intonation showed real disdain when he said this. Now, this assertion may or may not prove to be true, but whether it will be true depends upon many variables relating to the GSEs business models and the state of the capital markets, about which no one can predict with assurance…but whose prediction would seem more reliable, the GSEs themselves who run these businesses, or their academic/think tank regulator? so when both GSEs predicted a substantial G fee raise caused by the proposed capital rule in their formal comments, it does seem to me that Calabria’s reaction was to ‘take it personally”, and reveal an egocentric bias to the whole capital setting process.

        If this is the wrong take, then the onus is on Calabria to explain himself.

        rolg

        Like

        1. I did not sit through (or read the transcript of) the entire HFSC hearing, but when I heard Calabria make the “no one will have to pay more for their mortgage” comment he was referring to the proposed 0.5 percent upfront fee Fannie and Freddie had proposed for refinances. And that very likely was true. People refinancing their mortgages do so in response to a drop in mortgage rates and to get a lower monthly payment, and even with the refi fee (which for loans at the low rates prevailing at the time would probably amount to only an extra 5 or 6 basis points per year) borrowers still would be saving money, compared with their previous monthly payment. If Calabria also DID say that moving from around 3 percent capital (which is what Fannie and Freddie are pricing to now) to over 4 percent capital would result in neither higher guaranty fees nor higher mortgage rates–whether the higher capital is phased in or not– then, yes, as Ricky Ricardo would say, “he’s got some ‘splainin to do.”

          Liked by 2 people

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