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.

400 thoughts on “The Director Digs In

  1. Tim, would you mind commenting on this fascinating interpretation of the LAs here? https://twitter.com/UrbanKaoboy/status/1351185902207426563

    The gist is that Mnuchin felt handcuffed by litigations and set up the LAs in such a way that all stakeholders are incentivized to quickly get to global settlement. Of course the wrinkle is it still requires Yellen’s approval (as exercising warrants is a precondition), and we don’t know what Yellen’s thinking is.

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    1. I normally do not comment on speculative pieces, but I’ll make an exception for this one in order to make a broader point.

      Many, and perhaps the majority, of the speculations about why the January 14 letter agreements are really good news for a rapid resolution of the conservatorships are flawed both on the substance–they involve a misunderstanding of something fundamental about the companies or their capital structures–and the politics (they assume a degree of consensus or co-ordination that isn’t there). An example of a fundamental understanding is the notion that converting Fannie or Freddie’s senior preferred to common will add to the companies’ capital (it won’t; it will just dilute their existing and future common, and give rise to more litigation). This article by Michael Kao (who I don’t know) at least is built on a sensible financial proposition: the idea that new issues of common will be matched, by Treasury, with cancellations of the senior preferred on a dollar-for-dollar basis. But I still can’t see the politics of this working. With Mnuchin unwilling to be responsible for cancelling the senior preferred himself, why would Janet Yellen take on this commitment, while locking into an arrangement designed by Mnuchin? Assuming that she’s engaged in this issue at all (which she may not yet be), why wouldn’t she instead say, “Let’s see how the Supreme Court rules, then I’ll figure out the best way to finally address the Fannie and Freddie conservatorships in a way that meets MY objectives, not Steve Mnuchin’s?” So, I’ll give Mr. Kao good marks for financial savvy and creativity but mark him down on political realism, and say that what he proposes is unlikely to be what ends up actually happening.

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      1. Thanks Tim.

        Please correct me if I’m wrong, but can’t SPS convert to JPS, then all JPS convert to common to boost CET1?

        Lets assume Yellen DID agree on the “global settlement then recap” strategy. It’s clear from Mnuchin’s position this would be the best move to make, instead of doing anything major last minute that could potentially destabilize the one bright spot we have in the economy.

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        1. The APA challenge to the net worth sweep in the Collins case, soon to be decided by the Supreme Court, would result in the elimination of the senior preferred entirely. Given the likelihood of a ruling in favor of the plaintiffs on this issue, they have no reason to “settle” by agreeing to allow the government to convert the SPS to common (and certainly not to junior preferred). If plaintiffs lose at SCOTUS, then the incentives would change, but we’re not there yet–and hopefully we’ll never get there.

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  2. Tim

    there is some question in my mind as to the enforceability of many of these letter agreement provisions if SCOTUS gives Ps a win…which can lead to a T obligation owed to the GSEs in an amount in excess of the senior preference amount both FHFA and T presume to be outstanding. put another way, if the 3rdA is found to be invalid which gives rise to a massive T obligation (in an amount in excess of the preference amount which was presumed to be outstanding), are these letter agreement provisions what FHFA as conservator would have negotiated? when there is a massive misunderstanding of fact between the parties, agreement provisions based upon this massive misunderstanding of fact often are subject to attack. Yes, more litigation if these provisions are not revised in a post-SCOTUS win negotiation.

    rolg

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    1. Letter agreements between a Republican Secretary of the Treasury and Director of FHFA are not binding on a subsequent Treasury Secretary and FHFA Director serving under a Democratic president, although the latter two parties would in most cases need to execute new letter agreements to change the provisions of the ones signed this month. (And when they do re-do the agreements, they ought to correct a glaring mistake in the current ones, in which the letter intended for Fannie–citing its $25 billion Applicable Capital Reserve Amount–is signed by Calabria as conservator of the Federal Home Loan Mortgage Corporation, while the reverse is true of the letter intended for Freddie. Sloppy work.)

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      1. Tim

        Oh, I agree this letter agreement is some kind of (imo obnoxious and incoherent) placeholder that has no preclusive effect on subsequent fhfa D and T secretary…but the clearer this letter agreement is understood to be operating under a massive fictitious assumption regarding the senior preferred the better. and it is my expectation that at some point after SCOTUS’s Collins decision, there will become a new operating assumption regarding the senior preferred.

        rolg

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      2. Tim,

        In an earlier post, you stated that you have positions in Fannie Mae. Can you disclose again what those positions are? Is it in the commons or the JPS?

        Thanks,
        Zak

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        1. I have positions in both Fannie Mae common and preferred. As I’ve noted in the past, both holdings are legacies of my time as a Fannie Mae executive. I held nothing but common shares until August of 2009, when I sold half my common shares (at a price of $1.93 per share) and used the proceeds to buy the Series N preferred (at a price of $3.40 per share), chosen because it was the last I issued as CFO of Fannie. I’ve done no trading in either Fannie common or preferred since then (and do not own, and never have owned, any shares of Freddie).

          I’ve never disclosed the dollar amounts of my Fannie holdings–and do not intend to–but I have said that they were a very small percentage of my and my family’s net worth. They still are. The flip side of that, though, is that I have very large unrealized losses in my Fannie common. And for me, one of the negatives of having the conservatorships of Fannie and Freddie drag on as long as they have is that my self-imposed ban against trading in Fannie shares has prevented me from using any of my capital losses in Fannie common to offset capital gains elsewhere. So this seems like a good time to publicly give myself permission to sell some Fannie common for tax purposes should I have a good reason to. My “no net sales” of Fannie discipline began with the issuance of the “Report of the Findings to Date” of the “Special Examination of Fannie Mae” by OFHEO (FHFA’s predecessor agency) on September 17, 2004. A sixteen-year lockout period for net sales seems long enough to have made the point I intended to make with this discipline. I still would not do short-term trading in either the common or the preferred, however.

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  3. Tim–On Nov 10th you commented, “I do not know what Biden thinks about the ‘recap and release’ of Fannie and Freddie, or whether he even is aware of the issue (although I suspect he is). My point is that once the net worth sweep (and Treasury’s liquidation preference) is either canceled in settlement or ruled invalid by SCOTUS–and I believe one of those WILL happen–there is no defensible rationale for keeping the companies in conservatorship. Given their financial health and earnings power it is clear that they have been ‘conserved,’ and that the next step is to return them to private ownership. The alternative would be to nationalize them, which I do not believe Biden would support, nor would a divided Congress be able to legislate.” How might this comment change now that the Democrats have both houses, though marginally?

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    1. The Democrats’ narrow majority in the Senate doesn’t affect my outlook for Fannie and Freddie at all, since I don’t anticipate there being a legislative solution. And I have not yet attempted to gain access to any members of the Biden economic team, since I know they have a lot on their plates at the moment. I intend to begin making inquiries about the right “entry points” to the team sometime after the inauguration.

      Liked by 1 person

      1. Tim

        I must say you have been very prescient on your analysis of the evolving state of play. bravo! there is a lot of fluff, as I see it, in the last letter agreement which a Collins win will render surplusage. the underlying issue imo was the difficulty of raising sufficient capital to meet MC’s capital targets without being able to use a consent decree to replace conservatorship in connection with the first offering (since I feel rather certain that FAs have advised that no money can be raised if after closing GSEs remain in conservatorship )…and I suspect that consent decrees were something that SM didnt buy into, with Pimco and Blackrock whispering in his ear. If MC’s replacement is willing to reduce capital levels, then you can have a large stock offering, after a period of capital retention, at the closing of which T exercises its warrants and conservatorship is exited, all at a simultaneous closing. in effect, MC’s excessive capital levels met SM’s unwillingness to agree to an elimination of the SP and entry of GSEs into consent decrees, and the collision made a real path to recap impossible. so now the GSEs are set to be put on a path should the new fhfa director and Ms. Yellen choose to pursue it, and I think the collins scotus decision will grease those skids. turns out that MC and SM were not capable of acting in the GSEs’ best interests, as opposed to their own as they perceived them. should have known.

        rolg

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          1. Mnuchin didn’t have any choice. Calabria had the statutory authority to set Fannie and Freddie’s capital requirement, and he was bound and determined to make it “bank-like,” irrespective of the consequences. One of those consequences was complicating the recapitalization to the point where Mnuchin could not get comfortable with the role Calabria was asking him to play, which was to give up the net worth sweep and allow Calabria to try to negotiate a consent decree with Fannie and Freddie that would have locked in his (Calabria’s) vision of the companies, before the end of the Trump presidency. Mnuchin wasn’t willing to play Robin to Calabria’s Batman.

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  4. “It’s been a while since I’ve seen any writings about Fannie or Freddie from Ms. Wachter.”

    NAR just featured a white paper she co-authored (https://narfocus.com/billdatabase/clientfiles/172/21/4233.pdf) about the GSEs as public utilities with SIFMU designations.

    I read it today and it seems to share several points you have made about the GSEs (capital rule, stress losses, ROEs, G-fees and market share, etc.).

    Would be curious if you have a reaction to the paper or the concept in general.

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    1. @Patrick

      I would only add that Sen Sherrod Brown, who may become the new chair of the SBC, once mused aloud during a hearing that the utility model for the GSEs was the way to go. whether that involves a duopoly (Fannie and Freddie)/monopoly (Frannie) one might wonder, but not sure how multiple guarantors beyond F/F could work in that model. for example, public electric utilities have local geographic dominance. doesn’t make sense for multiple locally dominant mbs guarantors. my own view is that any congressional/administrative solution to the GSEs are either a long way off or will not occur in our lifetimes. in the meanwhile it is on to scotus for a collins decision. maybe a favorable scotus decision will precipitate a resolution.

      rolg

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    2. Long-time readers of this blog (which I find hard to believe is about to complete its fifth year of existence) may recall that one of first posts I did, on March 31, 2016, was a submission for the Urban Institute’s “Housing Finance Reform Incubator,” in response to its invitation for “short essays about the future of housing finance reform.” Mine was titled “Fixing What Works,” (accessible under the heading of “Reference Documents” on the right-hand side of the blog, near the top), and in it I advocated the adoption of a utility model as the most effective way to channel the value of Fannie and Freddie’s charter to low- and moderate-income homebuyers, while also allowing shareholders to earn a reasonable return on the capital they provide to back the companies’ risks and protect taxpayers. From a quick scan of the Wachter article it seems that she shares this view, which I find encouraging. I also note that Section 5, “FHFA’s Capital Proposal,” of the paper she co-authored has a good analysis of the negative effects Director Calabria’s arbitrary 4 percent bank-like minimum capital requirement will have on Fannie and Freddie’s ability to price their affordable housing business economically and competitively. I find that even more encouraging, and it makes me a supporter of Wachter’s candidacy to replace Calabria at the new administration’s earliest opportunity.

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      1. Tim

        seems to me after reading the piece, that a utility regulatory model would not require congressional legislation.

        you already have a duopoly; if capital levels are reduced by administrative rule, then the sort of balancing off i) return to shareholders ii )protect taxpayers and iii) provide mortgage funds across cycles to achieve liquidity and provide low income support could be achieved. I dont know of anything in HERA that would prevent a prudential regulator from pursuing a utility model. of course, the senior preferred would need to be dealt with to raise funds.

        I realize that the Yellen T is to report to congress by 9/2021 about alternatives, but if this utility model is put forth as the chosen one, what is to prevent a Wachter fhfa from running with it if congress dilly dallies?

        rolg

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        1. This was one of the main points of “Fixing What Works”–reforming, recapitalizing and releasing Fannie and Freddie as regulated-return utilities did not require legislation, but could be done administratively. That was true then, and remains true now.

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          1. Tim, thank you for your leadership in past years. Now that a new administration is about to start, I was wondering whether you could write a new post on ways forward like a letter to Biden, Meese, and Yellen. (Don Layton has a similar article.) I believe government needs first to change its attitude before a win-win resolution.

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          2. I’ve been thinking that as the 5th anniversary of this blog (February 1, 2021) approaches I would do a post that summarizes the current state of play, then looks forward to how the conservatorships of Fannie and Freddie might get resolved under a Biden administration. I haven’t yet begun working on that, however.

            Liked by 1 person

    1. I was not expecting much from Treasury and FHFA prior to the end of the Trump administration, but the letter agreements announced today did even less for the companies than I thought they might, while adding several additional impediments or constraints, a couple of them curious.

      The one element almost everyone was anticipating was an increase in the retained earnings cap. FHFA and Treasury will increase the caps for Fannie and Freddie “up to their regulatory minimums, including buffers, as prescribed in the FHFA Enterprise Capital Framework finalized in December 2020.” Treasury’s liquidation preference would increase dollar-for-dollar as long as the cap is in place, and once the companies reach their minimum capital requirements (which were a combined $265 billion at June 30, 2020, and will be higher now and in the future because of book growth) “the GSEs will resume quarterly dividend payments. The dividend amount at that time will be equal to the lesser of 10% of the liquidation preference of Treasury’s senior preferred stock, or the incremental increase in the GSE’s net worth in the prior quarter.”

      That’s the good news. Treasury then specified that “there will be no exit [from conservatorship] until all material litigation relating to the conservatorship is resolved or settled, and the GSE has common equity tier 1 capital of at least 3% of its assets,” and added that during the period in which the companies are building capital to the 3% threshold and still in conservatorship, “Treasury will allow each GSE to issue common stock upon the achievement of future conditions: first, Treasury must have exercised in full its warrant to acquire 79.9% of the GSE’s common stock, and second, all material litigation relating to the conservatorship must have been resolved or settled. Treasury will permit up to $70 billion in proceeds of stock issuances by each GSE to be used to build capital.”

      It’s curious that Treasury would set the same dollar maximum for external capital for both Fannie and Freddie, despite the large size disparity in their minimum capital requirements. Three percent of Fannie’s adjusted total assets at June 30, 2020 was $116 billion; three percent of Freddie’s was $83 billion. With a $70 billion cap on both companies’ external capital raises while in conservatorship, Fannie would need to retain at least $46 billion in earnings (and more with growth) to meet the 3% capital threshold, while Freddie only would need to retain $13 billion. It’s also curious (to me, at least) that Treasury would think either company could raise $70 billion in outside capital while still controlled in conservatorship by a hostile FHFA director.

      The other elements of the agreement had been rumored: a modestly lower portfolio cap, operational protections for small lenders, a formal cap on multifamily lending, and limits on certain types of higher-risk mortgages.

      To me, the big negative in this agreement is the commitment not to release the companies from conservatorship, even under a consent decree, until they build their capital to 3% of adjusted total assets. I’ll be very interested to see how the investment community reacts to that. I may be wrong, but I think it will be very difficult for either company to sell any significant amount of new shares while still in conservatorship.

      As to the “what needs to happen next,” certainly Fannie and Freddie must get a favorable ruling from the Supreme Court in the Collins case–either on the constitutional claim or the APA claim– that ends the net worth sweep, and I think they also must be given a new FHFA Director, who will not insist on requiring them to get three quarters of the way to a bank-like level of minimum capital–in spite of the fact the credit risk of the one asset they are able to finance is a fraction of the credit risk of the mix of assets banks finance–before they can be released from conservatorship.

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      1. Tim

        “It’s also curious (to me, at least) that Treasury would think either company could raise $70 billion in outside capital while still controlled in conservatorship by a hostile FHFA director.”

        curious to me too.

        it’s on to SCOTUS. if/when Ps get a favorable ruling from SCOTUS on at least one of the claims, then this agreement becomes more fragile…treasury won’t be a “creditor” anymore once Collins plays out after a favorable SCOTUS ruling (all of the fairness to taxpayers language will be risible)….though Calabria’s replacement may think it is just fine.

        seems to me that Sen Warner wrote this while Mnuchin was packing his bags.

        rolg

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          1. It appears as if Ms. Waters staff either did not read or did not understand the letter agreements or the joint FHFA/Treasury press release explaining them. There is nothing remotely resembling a “bailout of hedge funds” outlined in or even suggested by the agreements.

            Liked by 1 person

        1. 1. By raising the cap on capital treasury can’t touch the dividends as it lays in escrow, or is at least accounted for and not swept into a black hole. By doing it this way rather than with full write down, isn’t equity value suppressed, which is good for secondary offering? Yet capital increases. How else could commons be suppressed while equity builds, assuming that was Tsy’s goal in order to attract new money? If the sequence were write down first then capital raise, would new money be as interested at higher pps. Explosion through implosion?

          2. Given the potential danger of an economic downturn and housing crisis, a fast recap is desirable. Does the rising SPS liquidation preference bring pressure to bear to reach settlement with jps / derivative claims, which would in turn coincide with write down? (Tsy has direct claims slush fund of 5 billion.)

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          1. My interpretation of Treasury raising the retained earnings cap to 4 percent of Fannie and Freddie’s adjusted assets while adding these retained earnings dollar-for-dollar to its liquidation preference is that this was Mnuchin’s way of passing the problem of what to do about the senior preferred on to his successor, Janet Yellen. The impact on the companies’ common stock price from this decision was a by-product of it, not a reason for it. No new equity can be raised before investors know the future status of the senior preferred. It should be eliminated entirely pursuant to a ruling by SCOTUS in favor of the Collins plaintiffs, but in the unlikely event that it isn’t it will be up to Secretary Yellen to decide what to do with it. (And I wouldn’t take the September 30, 2021 deadline given her by Mnuchin too seriously; that was a parting shot intended to convey a sense urgency to the issue, coming from a man whose definition of “reasonably fast” turned out to be a period of time exceeding four years.)

            In my view the speed of the recap will depend on two factors: when and how the senior preferred is dealt with, and whether the FHFA capital rule is made more reasonable by Calabria’s successor (whenever he or she is appointed and in place). Nothing will happen until the senior preferred is either eliminated or amended, and once that occurs the speed of the recap will be driven by the amount of capital that needs to be raised, and whether the companies’ issuing it are viewed by potential new investors as attractive investments (which they are unlikely to be if the Calabria capital rule remains in place).

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          2. “No new equity can be raised before investors know the future status of the senior preferred…. Nothing will happen until the senior preferred is either eliminated or amended…”

            Tim,

            Of course a deal with investment banks will coincide with full write down. Notwithstanding, does full write down need to be announced prior to a deal being consummated? In fact, would not doing so raise equity value (pps) to the detriment of IBs?

            Also, it occurs to me that if settlement doesn’t occur prior to SCOTUS ruling, SCOTUS ruling in P’s favor will raise common pps by an order of magnitude, again to the detriment of IBs.

            I see pressure from all sides to resolve this prior to SCOTUS, but what do I know?!

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          3. Settlement of the lawsuits would require agreement between plaintiffs (representing both preferred and common shareholders) and the government. The fact that we did not see a settlement prior to the change in administrations means the two sides could not agree on the terms. My analysis is that plaintiffs are very confident that they will prevail on the APA claim at SCOTUS (i.e., that SCOTUS will not reverse the finding of the Fifth Circuit en banc that the net worth sweep was ultra vires under HERA), and as a result are not willing to settle for much less than they have asked for in their prayer for relief in the lawsuits; the Mnuchin Treasury wanted much more than that in order to be seen as voluntarily giving up on the sweep and its liquidation preference, so no deal was made. I don’t see any reason why this dynamic would change under a Yellen Treasury. She has every reason to wait to see how SCOTUS rules (she has “no dog in the fight”), then once she knows the outcome she can decide whether and how to respond. In contrast to your seeing “pressure from all sides to resolve this prior to SCOTUS,” I don’t see pressure from either side to do so.

            Like

          4. Tim,

            This will be my last post on this.

            We agree two things are needed, new money and an attractive public offering. We should also agree that the latter is curtailed by massively increasing valuation prior to IPO. Therefore, the conundrum is, how can both conditions be met? Abductive reasoning leads me only to one viable solution, an escrow lockbox for retained earnings with only one key to unlock the box – a *simultaneous* settlement plus new investors with sufficient bucks lined up and ready to go. The two must be occur concurrently, not sequentially, for reasons already cited.

            Your major premise is that because there was no settlement, plaintiffs were not willing to accept Treasury’s offer. You bring force to your premise by pointing to the amount of time Treasury had to bring together such a deal but without success.

            However, you do acknowledge that it was feasible to close such a deal in the past few months, and I agree. BUT, if such a deal was ready to be consummated either prior to or after the election, isn’t it reasonable that given the timing of the change in administration and all the politics around the GSEs, it would be politically prudent to let Yellen execute the deal with fluidity from the Mnuchin treasury, assuming she’s willing, rather than have it look like a republican “cramdown” from the Trump administration? In other words, if there was a deal ready to go, why would it not be better to have waited for Yellen to execute if Mnuchin learned she would be agreeable?

            I don’t think Yellen and Mnuchin are political ideologues. Their ability to agree is much more tenable, and given the manner in which the Treasury statement was crafted, it seems apparent there’s general alignment between the two.

            In a word, I find no other viable solution to the conundrum and striking a deal in the last few months does not seem ripe in retrospect.

            Again, that’s all I care to say.

            Thanks for this forum.

            Like

          5. Ron: I think you may have misinterpreted my last comment. I don’t believe there is, or was, a “deal ready to go.” And I think the notion of a simultaneous settlement and massive private placement of equity with new investors is a fantasy (cooked up by holders of Fannie and Freddie junior preferred stock hoping for a quick way out of a “quagmire” trade), with neither any observable evidence nor a defensible rationale to justify it. Treasury has limited new equity investments in the companies to $70 billion for as long as they remain in conservatorship, and has not authorized FHFA to release them from conservatorship until their tier 1 capital equals or exceeds 3 percent of adjusted total assets. Even if Fannie were to receive an injection of $70 billion in new equity tomorrow, it is still, under Treasury’s letter agreement with FHFA, three to four years away from being able to emerge from conservatorship. Who, exactly, are the investors who would put that amount of money into Fannie while it still could remain under the control of a FHFA director, who thinks it shouldn’t exist at all, for three to four more years? No, the far more defensible interpretation of Mnuchin’s action (or rather, inaction) last week is that he wasn’t able to figure out a way to deliver on his promise to “get [Fannie and Freddie] out of government control…reasonably fast,” and has kicked the can to Janet Yellen, making it her problem.

            Liked by 2 people

  5. A bloomberg headline from 1.12.21: *TREASURY OPPOSES REDUCING U.S.’S $220 BILLION STAKE IN GSES

    Looks like there will be no write down.

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    1. This is the article:

      https://www.bloomberg.com/news/articles/2021-01-13/trump-team-s-final-act-on-fannie-freddie-leaves-fates-to-biden

      The authors (Joe Light and Saleha Moshin) state that officials from Treasury are briefing congressional staff on a likely fourth amendment to the PSPA that would increase the retained earnings cap, attempt to codify certain “reforms” to the companies’ business practices (although these could be changed by a different agreement between FHFA and Treasury later on), and offer guidelines for accomplishing the release of Fannie and Freddie from conservatorship in the future. Since this essentially was my expectation I’m not surprised by it, although we should learn more details from Treasury and FHFA in the next day or two.

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      1. Tim-

        The article includes these two sections. Can you comment on what you think they mean and how they could impact the future of Fannie/Freddie and potential capital raises:

        1. “People briefed on the plans said it wasn’t clear how much capital the companies will be permitted to keep but said the changes were framed as an end to the so-called net-worth sweep, ”

        2. “Whether to modify the Treasury’s senior preferred stake is under consideration at the White House, said one person familiar with the matter.”

        Thanks!

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        1. I’m guessing here (and we should know shortly), but I would think Treasury and FHFA would want to raise the retained earnings cap to a level which, once reached, would allow the companies to be released from conservatorship under a consent decree, at which time they could accelerate their recapitalization through external equity raises (assuming that at some point before then the net worth sweep either is invalidated by SCOTUS or dropped voluntarily by the Biden Treasury). Although that’s not really “ending the net worth sweep,” Treasury and FHFA could claim that it is.

          On the issue of modifying Treasury’s senior preferred, that has been “under consideration” for months if not years, and since Treasury and FHFA haven’t agreed on whether or how to do that before now, I don’t know what would cause them to agree on it today or tomorrow. But again, we’ll know soon.

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          1. Tim,

            What does “retained earnings” even mean apart from having paid down 180 billion? In other words, either we’ve paid down zero or we’ve paid down everything (if not then some or overage). It seems to me that a path to increased retained earnings is only intelligible in the context of at least an implicit senior preferred write down due to an implicit “paid in full.” If we don’t have that, then raising the cap on retained earnings seems almost worthless.

            Furthermore, this quote seems to suggest that what I find implicit could end up becoming explicit:

            “Whether to modify the Treasury’s senior preferred stake is under consideration at the White House, said one person familiar with the matter.”

            Would appreciate your thoughts.

            Like

          2. Ron: “Retained earnings” means not remitting them to Treasury through the net worth sweep, but leaving them on the balance sheet to build capital. Once Treasury gets them it becomes complicated getting them back. And I’ve always said that for the companies to return to private ownership the net worth sweep must be unwound–in the manner sought by the plaintiffs in Collins–and Treasury’s liquidation preference eliminated. It’s becoming increasingly clear that Mnuchin won’t do either one of these (leaving them to SCOTUS or, in the unlikely event it does not rule for the plaintiffs on either the constitutional or APA claim, the Biden administration), so a higher retained earnings cap at least is something.

            On your second point, the use of the word “modify” for the senior preferred effectively rules out canceling it, and even the reference to its modification is nonspecific, rumored rather than reported, and described as merely “under consideration”.

            Like

  6. Tim, Bloomberg mentioned Susan Wachter as a possible Calabria replacement under the Biden administration. Curious if you have any thoughts about her since much of her thinking about GSE reform is public.

    She appears to be pro the utility model, less stringent capital requirements, and agrees in private equity capital taking the place of taxpayer risk.

    Liked by 1 person

    1. It’s been a while since I’ve seen any writings about Fannie or Freddie from Ms. Wachter. What I recall from her earlier pieces on the companies is that they were “okay”–not ideological, which is good, but also somewhat theoretical and academic, which can result in policy or regulatory prescriptions that are not well suited to the unique charter and business of the companies. If she were to get the position of Director of FHFA, however, I suspect she would be open to some “on the job learning” in a way that Mark Calabria so clearly was not.

      Liked by 1 person

      1. https://books.google.com/books?id=k-PfDwAAQBAJ&pg=PR18&lpg=PR18&dq=franny+meg&source=bl&ots=CbbR-_dhVn&sig=ACfU3U14d-YwgHJXzpSHWTU1r4QHf1mXvA&hl=en&sa=X&ved=2ahUKEwjXyajplJfuAhVqJTQIHV-LCVIQ6AEwA3oECA8QAQ#v=onepage&q=franny%20meg&f=false
        A book, ”The Great American Housing Bubble,” co authored by Wachter and Adam Levitin, explains their position, and recommends Franny Meg, a utility model, to replace Fannie and Freddie. .

        Liked by 1 person

        1. The preface to this book–reproduced at the beginning of the link above–gives Wachter and Levitin’s thesis of the cause of the mortgage crisis, which I think they’ve pegged correctly. That’s a big plus, because if you set out to fix a problem it’s essential to have properly diagnosed it to begin with. I’m not wild about the “Franny Meg” idea (a combination of Fannie and Freddie), but the recommendations of significant but not excessive capital, selective use of risk-sharing techniques, and a paid-for federal backstop all could be adapted for the two companies that exist today, without the legislation required to combine them.

          It’s interesting that at the beginning of the preface the authors describe themselves as “an odd couple…a law professor and a real estate economist separated by a generation….Adam knew something about the mechanics of securitization and foreclosures, and Susan knew quite a bit more about real estate economics.” In my earlier comment about Ms. Wachter I described her previous work on Fannie and Freddie I was familiar with as “somewhat theoretical and academic.” It appears that the collaboration with Mr. Levitin has improved her real-world orientation and experience, which also is a big plus if she were to become Director of FHFA in the Biden administration.

          Liked by 1 person

          1. Tim

            I read a lot of Levitin’s writing (Georgetown Law Prof) when I was doing research into the rep/warranty lawsuits that the monoline insurers brought against the banks. He knows his stuff. as for Wachter, I have only seen her give testimony at congressional hearings…she reminds me some of a think tank Calabria, without the libertarian bias.

            rolg

            Liked by 1 person

  7. Part of 2019 Treasury’s housing finance reform plan

    Preconditions for Ending the Conservatorships

    The guiding principle for ending the conservatorships should be that each GSE should remain in conservatorship until FHFA determines that that particular GSE can operate safely and soundly and without posing an undue systemic risk. The specific preconditions for FHFA considering a particular GSE’s exit from conservatorship should include, at a minimum, that:

     FHFA has prescribed regulatory capital requirements for both GSEs;

     FHFA has approved the GSE’s capital restoration plan, and the GSE has retained or raised sufficient capital and other loss-absorbing capacity to operate in a safe and sound manner;

     The PSPA between Treasury and the GSE has been amended to:
    (i) require the GSE to fully compensate the Federal Government in the form of an ongoing payment for the ongoing support provided to the GSE under the PSPA;
    (ii) focus the GSE’s activities on its core statutory mission and otherwise tailor Government support to the underlying rationale for that support;
    (iii) further limit the size of the retained mortgage portfolio of the GSE;
    (iv) subject the GSE to heightened prudential requirements and safety and soundness standards, including increased capital requirements, designed to prevent a future taxpayer bailout and minimize risks to financial stability; and
    (v) ensure that the risk posed by the GSE’s activities is calibrated to the amount of the remaining commitment under the PSPA;

     Appropriate provision has been made to ensure there is no disruption to the market for the GSE’s MBS, including its previously issued MBS;

     FHFA, after consulting with the Financial Stability Oversight Council (“FSOC”), has determined that the heightened prudential requirements incorporated into the amended PSPAs are, together with the requirements and restrictions imposed by FHFA in its capacity as regulator, appropriate to minimize risks to financial stability; and

     Any other conditions that FHFA, in its discretion, determines are necessary to ensure that the GSE would operate in a safe and sound manner after the conservatorship, including as to the GSE’s compliance with FHFA’s directives or other requirements and also as to the build out of FHFA’s supervisory function.

    Treasury recommends:
     Pending legislation, FHFA should exercise its authority as conservator to begin the process to end each GSE’s conservatorship in a manner consistent with the preconditions set forth in this plan. (administrative)

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    1. Conspicuously absent from this “to do” list is having Treasury end the net worth sweep and cancel its liquidation preference in Fannie and Freddie, so that once released from conservatorship under a consent decree from FHFA and with Treasury approval, the companies can raise external equity in order to meet their new capital standards over a reasonable period of time.

      Everyone knows what needs to be done; the question now is, will Secretary Mnuchin do them in the six business days he has left as Treasury Secretary, or will these two essential elements of “reform, recapitalization and release” carry over into the new administration?

      Mnuchin’s statements and actions (or, rather, inactions) in recent months and weeks have made it hard for me to envision how or why he would end the sweep and cancel the liquidation preference before he leaves. But, to put it mildly, this has not been a normal transition period. Just as there was no precedent for what occurred last week, there is no precedent for what might occur this week. As President Trump has been fond of saying, “we’ll see what happens.”

      Like

  8. Charlie Gasparino tweeted that 1. PSPA still in play but is focused on capital requirements and DoJ apparently will need to sign off on any 4th Amendment. 2. Mark Zandi is on a short list for FHFA Director if SCOTUS rules director is removable by president at will in Collins.

    Tim or ROLG, What are your thoughts on either point? Zandi as director is a bit scary, but didn’t he also submit comments on the capital rule that were more in-line with lower capital? Would seem to fit into the 1st point about capital requirements being part of PSPA 4th amendment. Would the amendment be an attempt to lock in high capital requirements outside of HERA to prevent the next admin/FHFA director from lowering them? That is, in exchange for the amendment ending the NWS and possibly eliminating the liquidation preference, the companies, FHFA and Treasury agree to meet the higher capital requirements regardless of a future FHFA capital rule that may attempt to lower them. Would that be possible? Seems to negate FHFA as an independent agency. They would be beholden to Treasury. The next FHFA director (and the GSEs) would be stuck needing a 5th amendment with the next Treasury Secretary to get out from under it and lower the capital requirements. Thoughts? I feel like we are going to get an 4th amendment we may not like.

    Cheers,
    Fishermanjuice

    Liked by 1 person

    1. There are many rumors swirling around about a potential Fourth Amendment and what might be in it. Other than a higher retained earnings cap (or an indefinite suspension of the net worth sweep), I don’t have any good information about what else might be included in any amendment agreed to prior to January 20. On your capital question, no, the current FHFA Director cannot bind what a future director might do on Fannie and Freddie’s capital requirements.

      As to the rumor that Mark Zandi might be on a short list for FHFA Director in the Biden administration, he wouldn’t be the worst choice. He at least has an understanding of the credit and financial dynamics behind Fannie and Freddie’s risk-based capital rule, and also of the problems caused by a capital standard that is disconnected from the economics of the companies’ credit guaranty business, as the current Calabria standard so obviously is.

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      1. Would it be fair to say that some of the blame for the GSE problems in 2008 were related to Moody’s and the rating agencies in which Zandi was at the helm.

        Like

      2. Tim-

        It sounds like “higher retained earnings or suspension of NWS” means there’s little hope that a writedown of Sr Preferreds is likely to be part of a 4th amendment. Is that fair to say? If that’s the case, how are the GSEs ever expected to raise private capital?

        Thanks

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        1. Less than one month ago, the acting solicitor general appeared before the justices of the Supreme Court and argued on behalf of Secretary Mnuchin that the requirement for Fannie and Freddie to pay all of their earnings (estimated at close to $20 billion per year) to Treasury in perpetuity was legal and proper. Given what’s happening with the president right now, it seems unrealistic to think that Mnuchin would ask permission to give up that income stream voluntarily, and even more unrealistic to think that if asked president would agree to do so. Stranger things have happened in this administration, though.

          I’m going to wait until January 20 to see what a possible Fourth Amendment to the PSPA might include before doing any analyses of the path forward for Fannie and Freddie out of conservatorship and towards recapitalization. But as I’ve said earlier, I think there WILL be such a path, although it may require a favorable ruling from SCOTUS in the Collins case (which I expect) to create the impetus to follow it.

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          1. Tim, this would contradict Calabria repeatedly making the point that a 4th would make the legal cases “go away.” I believe he even explicitly said in one forum that he hoped to cancel the NWS via 4th. I think its fair to assume Mnuchin supported Calabria being chosen to head FHFA, and that they are on the same page re: what needs to be done?

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          2. Tim

            I am unclear whether this means anything or not, but the acting SG did not argue for US in Collins before SCOTUS. It was Hashim M. Mooppan, who was acting as “Counselor to the Solicitor General” for the case, but who is a deputy attorney general in the civil division of the DOJ…one of the crew of DOJ that argued the lower court cases. now the SG is part of the DOJ, but the SG office usually guards its prerogative to argue SCOTUS cases closely. this may or may not indicate any position the SG office has on the case.

            my best guess is that T wants some sort of sign off, on legal matters, from the DOJ re any 4thA…that a 4thA would not contravene any laws binding on T. as to policy, it would be an abdication of authority if T wanted policy approval as well.

            one further small point: the govt did not argue that the NWS was “legal and proper”…it dropped the “may” argument before SCOTUS; it argued that these Ps could not bring this case under the statute, as to APA claim, and was mostly sniffing around the remedy as opposed to the merits portion of the unconstitutional agency structure claim.

            rolg

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  9. “If Calabria is replaced by a Biden Administration, you believe they would be willing to lower the capital requirements. Do you really think that the administration would be willing to lower capital requirements for FNF and take a potential political hit for requiring lower capital?”

    Mel Watt said 2.5%. At one time he would’ve danced alone. It wasn’t until Mnuchin that we got Calabria’s 4%. Also, Biden will be more in favor of housing initiatives. Pretty twisted ending to this saga.

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    1. Ron: The saga hasn’t ended, and where we seem to be now isn’t that surprising.

      You (and other readers) might want to go up to the beginning of the blog, then scroll down to where on the right side there is a listing of Top Posts. Click on the one titled “The Beginning of the End,” which I wrote in April of last year. In it, I identified the “strange bedfellows” of Steven Mnuchin, Larry Kudlow and Mark Calabria, who as a group were charged by the White House in March of 2019 to find a way to bring Fannie and Freddie out of conservatorship. As I discussed in the post, there was a clear conflict between the objectives Kudlow and Calabria had for Fannie and Freddie and what investors would require to make a recapitalization successful. I postulated that as the process unfolded, market reality, economics and Treasury’s stake in the companies (through the warrants) would prevail over the ideological objections of Kudlow and Calabria, and the recap and release would go forward.

      What’s happened, of course, is that nobody’s changed their objective. Mnuchin and Treasury still want to deliver on their promise to recapitalize Fannie and Freddie and release them from conservatorship, but Calabria (and presumably Kudlow as well) insists that this happen with the companies carrying heavy capital and regulatory burdens that make them unattractive as investments. That has made the recapitalization much harder—Mnuchin and Treasury don’t get a clean “win” for giving up the senior preferred and the liquidation preference, because the actual release has been pushed so far out into the future owing to the excessive capital requirements—and we remain at an impasse, at least for now.

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      1. Tim,

        By twisted ending, I didn’t mean to suggest it’s yet over, though we must be further along than “The Beginning of the End.” What I meant by a twisted ending to the saga is that the ball will once again be back in the Dems’ court. I don’t think anyone would’ve imagined that four years ago. Obama stated that it was time to “turn the page on Fannie and Freddie” and now their release will occur under his second in command. Who would’ve thunk it? Oh, the irony!

        But yes, I always recognized the incongruity of Calabria and Kudlow trying to work with investors. Where we might part ways is on Mnuchin. I think four years ago Mnuchin was serious about doing all the right things. But as I’ve said here and elsewhere, something happened. He immediately dialed back his recap and release talk early into his term, and through the 11,000 documents he always had requisite political cover he needed – had he *truly* wanted to push recap and release through. We can’t deny that he availed himself to none of the incriminating proof. He also could’ve exposed the 4% myth on national television and the internet in at least two ways. First by proving that the initial bailout was a contrived story about undercapitalization, and secondly by pointing out that the GSEs aren’t banks. Not only did he do neither, he instead needlessly assumed the defense of the Treasury all the way to SCOTUS (even after losing at the 5th Circuit).

        In a word, that Calabria and Kudlow aren’t friends doesn’t suggest to me Mnuchin is a friend. I’m glad to see him go. He had great potential but in the final analysis he willfully failed. He was part of the problem, not the solution. Now what have I missed? 🙂

        Liked by 2 people

        1. I have a different view of Mnuchin. I think he came in believing this was a financial problem to solve, which, given his background at Goldman, he was well qualified to do. As he got into it, though, he was “swamped” (in both senses of the word) by the politics, and he hasn’t been able to figure out how to overcome that. He’s still got four and a half weeks, but it seems like he’s run out of enthusiasm as well as ideas.

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          1. I love the play on words, Tim.

            That’s a charitable interpretation and I can’t disprove it. You could be right. I surely hope you are.

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  10. Tim, enjoy your blog and insight. All things being equal regards MC capital requirements, if FNMA was stand-alone with no PSPA or NWS, could/would the company be profitable enough to garner a P/E? Seems to me with its wide moat the company would have value if properly managed. Would you care to comment?

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    1. Fannie has a P/E now, and it’s less than 1. The company’s third quarter 2020 earnings were $4.23 billion, or $16.92 billion annualized. As of September 30, 2020, Fannie had 1.158 billion shares of common stock outstanding, but Treasury also holds warrants for another 4.6 million shares, resulting in 5.76 billion fully diluted shares outstanding. Fannie’s third quarter earnings per share (annualized) thus are $2.94, which at yesterday’s closing common stock price of $2.40 makes for a for a price-earnings (P/E) ratio of 0.82.

      Why is Fannie’s P/E so low? Four reasons. First, Treasury holds $120.8 billion in senior preferred stock in Fannie, that if converted to common (which I believe is highly unlikely, but it has been discussed) at today’s share price would result in an additional 50.3 billion shares of common outstanding but no new capital; second, at December 31, 2020 Treasury will have a liquidation preference in the company’s assets of $142.3 billion; third, Fannie currently has $19.1 billion in junior preferred stock, which at some point will likely either be paid off or converted to common in order for the company to add new, lower-cost noncumulative preferred to its capital structure, and finally FHFA’s final capital requirements have left it more than $150 billion short of being classified as fully capitalized.

      Of these four reasons, the existence of Treasury’s $120.8 billion in senior preferred stock and $142.2 billion liquidation preference is clearly the most important factor holding down Fannie’s common stock price (and P/E). That’s why press articles speculating on the elimination of the net worth sweep and the liquidation preference have such pronounced market effects. If and when the senior preferred and liquidation preference are eliminated, Fannie’s stock price will then be driven by the market’s assessment of (a) how many new common shares will need to be issued before the company can fully meet its capital requirement; (b) how much of an impact will FHFA’s new capital requirement, other regulatory actions and the payment of a commitment fee for Treasury to leave its Senior Preferred Stock Agreement in place (which it will need to do in order for the yields on Fannie’s MBS to remain near current spreads to Treasury securities) have on the company’s sustainable earnings power, and (c) how will the market evaluate Fannie’s political risk in general (pre-conservatorship, Fannie’s P/E averaged only around 60 percent of the market multiple, largely, I believe, because of the perception of political risk, which won’t have diminished following the experience of the past twelve years).

      Liked by 4 people

      1. Tim

        I agree with your assessment of the capital markets process, which for the GSEs will be somewhat unique for mature and highly profitable companies. it is almost like a venture capital raise, where the early investors are betting that the “process” will come to fruition. with a venture capital investment, the “process” is all of the tech/business model/operations execution risks which need to be gotten right. with the GSEs, the business is humming and the investment merit, taken in isolation apart from capital needs, is evident. but the GSEs’ “process” at risk is the regulatory obligation to raise all of the required capital. of course the GSE FAs are confident since the more to raise, the more fees to reap, so they are in it for the long run. it is my view that given the investment merit of the GSEs, the capital raise will be successful although, like in the venture capital scenario, early investors will demand their discount. there are many things unnecessary with the capital rule, but at the right price early investors will discount the risk that the capital raise won’t be successful, and follow on investors will require lesser discounts as the process moves along. this all assumes that Mnuchin gets off the pot.

        rolg

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        1. Two comments. First, it seems as if Mnuchin has set at least a rough “percent of fully capitalized” threshold that must be achieved through retained earnings before he would authorize FHFA to release Fannie or Freddie from conservatorship under a consent decree. The companies cannot raise external capital until that (unknown) threshold is attained. Second, I think most observers underestimate the amount of uncertainty imposed on Fannie’s future earnings by both the final capital requirement and the regulatory hostility of the Calabria directorship. He truly does not like the companies (witness his “worst corporate cultures in America” comment), and does not want them to do well. That makes the discount required to sell new equity considerably higher than it would be otherwise.

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    1. I have (obviously) not read the full proposal, but this is more over-regulation on the part of FHFA, which will drive up Fannie and Freddie’s costs for only tiny incremental safety and soundness benefits.

      For the hundredth time, Fannie and Freddie are not banks. They don’t have deposits, and 90 percent of their assets are perfectly matched mortgage-backed securities, or MBS, which have zero liquidity risk. (Prior to the crisis 25 percent of the mortgages Fannie financed were held in portfolio, at the end of September 2020 only 5 percent were.) Pre-crisis, with a much higher percentage of loans in portfolio, Fannie had pledged to hold sufficient liquidity to survive for three months with no access to the debt markets (and in fact held that amount). While its debt spreads to Treasuries did widen out, it never suffered a liquidity crisis; its problems were credit-related. So now, with much smaller portfolios, Calabria finds it necessary to impose much more onerous liquidity requirements in the name of “safety and soundness.” There is no economic justification for it.

      Liked by 1 person

        1. FHFA has retained one investment bank, Houlihan Lokey, to advise it on Fannie and Freddie-related issues. But if your question is, “wouldn’t the financial advisor tell FHFA if its liquidity proposal was unnecessarily severe,” my answer is no, I don’t believe it would. That’s a judgment call they would defer to the regulator.

          And to be clear, my criticism of Calabria is that he is not even trying to find the balance point between safety and soundness and leaving Fannie and Freddie with a workable business model. His “price” for agreeing to release them from conservatorship is that they will have to be capitalized like banks, and apparently also have liquidity requirements more severe than banks (again, I’ve yet to read the full liquidity proposal).

          I personally think this decision by Calabria has been a serious impediment to coming up with a workable release proposal. For Fannie to get from its current capital level of $20.7 billion to the $171 billion Calabria insists it have to be considered fully capitalized as of June 30, 2020 (and the capital number will be higher now, due to growth), there’s too long of a “runway” during which it only would be able to use retained earnings to get to a capital percentage where Mnuchin would feel comfortable allowing FHFA to release them from conservatorship, even under a consent decree. But without being released, they can’t raise equity externally to get to the release point more quickly. Add three other realities to this mix–investors may not be wild about investing the required amount of new equity in two companies whose director seems committed to handicapping their business with excessive capital and regulation; Treasury would need to price its PSPA commitment at today’s very low capital levels, making the cost onerous and a drain to retained earnings, and the likelihood that Mnuchin is reluctant to take the political hit of giving up Treasury’s claim to the net worth sweep and liquidation preference voluntarily (and now may need President Trump’s explicit permission to do so)–and you have a recipe for the sort of wheel-spinning that seems to be occurring now.

          Liked by 1 person

          1. Tim,
            If Calabria is replaced by a Biden Administration, you believe they would be willing to lower the capital requirements. Do you really think that the administration would be willing to lower capital requirements for FNF and take a potential political hit for requiring lower capital?

            Liked by 1 person

          2. You have to start with the objectives of the administration, and the FHFA director it appoints. I don’t know what President Trump’s objectives were for Fannie and Freddie (if he had any) when he appointed Calabria, but Calabria was known to have had an ideological opposition to the companies’ existence long before he became the director of FHFA. His capital requirements are designed to effectively sideline Fannie and Freddie as functioning entities, in favor of the “purely private” lenders Calabria favors. If the Biden administration would like Fannie and Freddie to help sustain the mortgage market by providing secondary market liquidity at reasonable prices, it will need to appoint a director who shares this goal.

            Calabria was required by HERA to produce a risk-based capital requirement for the companies. As I explained in my comment letter and in many instances elsewhere, what he produced was not risk-based. It was arbitrary (to be “bank-like”). He added a large number of cushions and elements of conservatism to the stress capital amount (the capital required for the companies to survive a 25 percent nationwide decline in home prices, without counting on any of the guarantee fees they receive on their MBS, even those fees they’ve already collected and have on the balance sheet), in order to push the “risk-based” number above the arbitrary bank-like minimum. Even the American Bankers Association and the Mortgage Bankers Association said the Calabria standard was unjustifiably high. So a new FHFA director wouldn’t be “lowering” Fannie and Freddie’s capital; it would be giving them a standard that provided an exceptionally high degree of protection to the taxpayer, while still allowing the companies to price their business competitively, to the benefit of homebuyers and the economy. That’s eminently defensible.

            Liked by 1 person

    1. I don’t watch Fox Business, but this clip was eye-opening, and not in a good way. While Charlie Gasparino was droning on and on, and saying absolutely nothing, the screen showed a large chart of (alternately) Fannie’s and Freddie’s stock prices moving from the red to the green at the time of Gasparino’s tweet, and–for anyone dim enough to miss the message–at the end of the segment, Liz Claman said, “Well, the stocks are on the move on Charlie’s report.” As I said below, you pay attention to these stories at your own peril.

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  11. Tim,

    Any insights about Gasparino’s tweet today? So far you have been thoroughly right about the lack of incentives for Mnuchin to enact the consent order before leaving, but any chance that the NWS goes away before February even if there is not a formal consent decree as such?

    Thanks as always for your time.

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    1. The tweet was, “SCOOP—Wall street bankers have met with @US Treasury in recent weeks to discuss GSE reform including creation of a framework for eventual recap and release from conservatorship. The framework could be announced through an amended PSPA or regulation.”

      A meeting between bankers (presumably those hired by Fannie and Freddie) and Treasury isn’t something we’ve heard about before, but the meeting apparently took place some time ago, and the rest of the tweet is devoid of any specifics. So, no, I don’t read anything into it, other than that people who either want or don’t want a deal on the net worth sweep to be struck before the inauguration are working their press contacts to try to create pressure for their desired outcome, and those who have been covering Fannie and Freddie seem to be enjoying competing with each other in moving the prices of the companies’ shares through vague and generally unattributed reporting. I would be wary of speculative press stories at this point.

      Liked by 1 person

    1. Judge Lamberth approved a scheduling order this past July that outlined a series of deadlines for the completion of fact discovery (January 22, 2021), plaintiffs’ and defendants’ expert witness discovery (July 26, 2021), class certification (July 16, 2021) and motions for summary judgment and the related responses (November 5, 2021). Assuming the case is not dismissed in summary judgment, “Trial is set for May 16, 2022, or at the Court’s earliest convenience thereafter….”

      As slow as this is, I suspect Lamberth still will conclude his process before Judge Sweeney in the Court of Federal Claims can conclude hers (which could include the Washington Federal complaint, if its appeal of Sweeney’s jurisdictional ruling is successful).

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        1. My bet would be that Collins WILL be the fastest. There is some chance that it could get wrapped up by late spring of 2021 if SCOTUS upholds the decision of the Fifth Circuit en banc that the director of FHFA is unconstitutionally structured, but then reverses the Fifth Circuit and awards plaintiffs the retroactive relief they seek, which is revocation of the net worth sweep. Even if this does not happen, it in my view is highly likely that SCOTUS will uphold the Fifth Circuit’s finding that FHFA violated the plain terms of HERA when it agreed to the net worth sweep, and remand that case to the Southern District of Texas for trial on the facts. I expect this trial would end–or be settled by the government (to avoid the facts being made public, including Treasury’s internal memos admitting that it proposed the sweep to keep Fannie and Freddie from retaining their earnings, which it had lied about to the media)–before either Lamberth or Sweeney conclude their cases.

          Liked by 2 people

          1. I agree with this, but Collins if remanded on the statutory claim may not require a trial…there is a lot of deposition testimony and documentary evidence from Fairholme that can form the basis of a summary judgment motion, which would be quicker than a trial.

            rolg

            Liked by 1 person

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