A Capital Reality Check

On April 28, Freddie Mac filed its 10Q for the first quarter of 2022 with the Securities and Exchange Commission, while Fannie Mae filed its first quarter 2022 10Q on May 3. These were the first times either company reported on their actual and required capital under the Enterprise Regulatory Capital Requirement (or ERCF) made final by former FHFA director Mark Calabria in December of 2020 and amended by acting director Sandra Thompson in March of this year.

I had been looking forward to the filings. Having read the text and reviewed the tables of former director Calabria’s final capital rule—and taken note of how much capital it would have required Fannie and Freddie to hold as of June 30, 2020—I was eager to learn what each company’s binding capital requirement was as of the end of the first quarter of this year, how much progress they had made in reducing their capital shortfalls, and what they would say about how they intended to ultimately come into full capital compliance.

I might have expected how they would treat this topic. Both said very little about it. Each reported on their capital requirements using similar (but not identical) formats, very likely designed and approved by FHFA, leaving it to the reader to determine what most of the data meant. Freddie’s 10K did not even identify which of its two capital amounts (risk-based or leverage) were binding, nor state what that capital amount was or how far the company was from meeting it. Fannie, at least, did that, saying, “as of March 31, 2022, we had a $272 billion shortfall of our available capital (deficit) to the adjusted total capital requirement (including buffers) of $190 billion under the standardized approach to the rule,” after earlier having said, “the amount of capital we will be required to hold under the amended enterprise regulatory capital framework remains substantially higher than the previously applicable statutory minimum capital requirement.” But Fannie said nothing further, and Freddie said nothing at all, about the new standard.

Fannie, Freddie and FHFA all can try to ignore or obfuscate the real-world impact of having former director Calabria’s grossly excessive and unjustified new capital requirement now be binding on the companies, but that won’t make this issue go away. Yet before discussing the implications of the Calabria capital requirements, I first need to give some facts and figures about them, since the companies (and FHFA) did not.

The March 31, 2022 capital numbers. Because of the way the ERCF has been constructed, its risk-based standard, and not the leverage standard, is currently the binding one on the companies (and, as I note below, will be for the foreseeable future).

The presentation of the capital numbers in both companies’ first quarter 2022 10Qs was a construction, with no explanation. The total required risk-based capital number was shown as the sum of three components: a (misleadingly named) “total capital” amount, derived by multiplying each company’s “risk-weighted assets” by 8 percent, and two buffer amounts—a “stress capital buffer” equal to 0.75 percent of each company’s “adjusted total assets,” and a “stability capital buffer” linked to FHFA’s definition of each company’s market share. The two buffer amounts are arbitrary but at least straightforward, and together make up the “Prescribed Capital Conservation Buffer Amount,” or PCCBA. “Risk-weighted assets” is a concept drawn from the Basel bank regulatory capital scheme, and FHFA’s version mixes credit risk, other risks, capital minimums and cushions in a way that makes it impossible to untangle analytically. Neither Fannie nor Freddie gave any indication as to how their risk-weighted assets were derived; they just presented a number, which, multiplied by .08 and rounded to the nearest whole digit, is labeled the total capital requirement (before buffers). 

At March 31, 2022, Fannie’s total required risk-based capital was $190 billion, made up of $111 billion in risk-weighted asset capital, a $34 billion stress capital buffer, and a $45 billion stability capital buffer. While the percentage was not published anywhere, Fannie’s total required risk-based capital at March 31, 2022 was 4.20 percent of its adjusted total assets. To get the comparable numbers for Freddie, you have to hunt through its capital table. Doing so, at March 31, 2022 its total required risk-based capital was $122 billion, made up of $73 billion in risk-weighted asset capital, a $26 billion stress capital buffer, and a $23 billion stability capital buffer. Since Freddie and Fannie are in the same business and have very similar credit risk profiles, one might have expected Freddie’s required ERCF risk-based capital percentage to be very close to Fannie’s. It was not. Freddie’s required capital was 3.38 percent of its adjusted total assets, 82 basis points lower than Fannie’s.

Before addressing why the Calabria capital standard produced such significantly different required capital percentages for two companies with essentially the same credit risk profiles (at March 31, 2022, Fannie’s actually was a little better), I first should note that measuring both companies’ required capital as a percentage of their “adjusted total assets” understates the burden this capital places on their business. Adjusted total assets is a concept introduced by Calabria. His final capital rule detailed the types of exposures FHFA can add to Fannie and Freddie’s total assets to create their adjusted total assets. It runs for eight pages (174 to 182), and has nine categories, most of which relate to exposures to derivatives or repurchase agreements (which in my experience posed little financial risk). At March 31, 2022 Fannie’s adjusted total assets were 5.7 percent greater than its total assets, while on the same date Freddie’s adjusted total assets were 16.1 percent greater. I have seen no explanation from either FHFA or the companies as to what specific exposures lead to such a large difference in adjusted total asset add-ons.

There are two more straightforward, and understandable, ways to calculate capital ratios: as a percentage of published total assets, and (for a credit guarantor) as a percentage of average mortgage assets. The difference between adjusted total assets and published total assets is mostly non-earning “exposures,” while the difference between mortgage assets and published total assets is mostly cash and liquidity, on which the companies lose money (because the cost of their debt is greater than the yield on the cash or liquid assets). Fannie and Freddie have to earn a market return on the capital they are required to hold against their liquid assets and their adjusted asset exposures, and their primary way of doing that is through the fees they charge for their credit guarantees. At March 31, 2022, Fannie’s $190 billion in required risk-based capital was 4.20 percent of its adjusted total assets, 4.43 percent of its published total assets, and 4.74 percent of its average mortgage assets. Freddie’s same capital percentages were 3.38 percent, 3.92 percent, and 4.25 percent. Expressing the Calabria standard’s required capital as a percentage of adjusted total assets obscures the important facts that at March 31, 2022 Fannie was having to price to almost 4 ¾ percent capital, while Freddie was having to price to almost 4 ¼ percent capital.

Fannie versus Freddie required capital. Why, though, was Freddie’s required capital as a percentage of mortgage assets at the end of the last quarter so much lower than Fannie’s? There are two reasons—one simple and one not. The simple reason is how the “stability capital buffer” is determined. FHFA computes Fannie and Freddie’s credit guarantees as a percentage of estimated residential mortgage debt (single- and multifamily) outstanding each quarter, and assesses them a charge of 5 basis points of capital for each percentage point their “share of market” exceeds 5 percent. Since Fannie is larger than Freddie, it got a larger capital charge in the first quarter—107 basis points compared with Freddie’s 74 basis points. The only way Fannie could lower this capital charge is by doing less of the one business—mortgage credit guarantees—its charter and regulator now permit it to do.

The second reason for Freddie’s lower risk-based capital requirement at March 31, 2022 has to do with “risk-weighted assets.” The only other date for which FHFA has published risk-weighted asset percentages for the companies is June 30, 2020, as part of its revised capital proposal. Then, Freddie’s risk-weighted assets were 33.3 percent, while Fannie’s actually were somewhat lower, at 32.4 percent. At March 31, 2022, however, Freddie’s risk-weighted assets had fallen to only 25.5 percent of its adjusted total assets, while Fannie’s were 30.7 percent. Had Fannie’s also been 25.5 percent, its first quarter 2022 required risk-based capital would have been 44 basis points less. But since the risk-weighted asset numbers for both companies come from an FHFA “black box,” there is no way to know why Freddie’s risk-weighted assets fell so much more than Fannie’s. (Freddie’s greater use of credit risk transfers can only be a partial explanation, given that Freddie—which always has used more CRTs than Fannie—had higher risk-weighted assets at June 30, 2020.) The lack of transparency in both companies’ risk-weighted asset numbers is highly problematic.

Progress in closing capital gaps. Fannie and Freddie’s first quarter 2022 capital tables also enable us to calculate their recent progress in closing their ERCF capital gaps. We’ll start with Fannie. When FHFA published its final capital rule, it said that at June 30, 2020, Fannie’s total required risk-based capital was $171 billion, its adjusted total capital was a negative $118 billion, and its shortfall to full capitalization was $289 billion. At March 31, 2022, Fannie’s total required risk-based capital was $190 billion, its adjusted total capital was a negative $82 billion, and its capital shortfall was $272 billion. During this seven-quarter interval, therefore, Fannie’s required capital increased by $19 billion, its adjusted total capital rose by $36 billion, and it reduced its capital gap by $17 billion, or 5.9 percent, leaving 94.1 percent of its June 30, 2020 capital shortfall still to be covered in the future.

Freddie’s progress was similar. At June 30, 2020, Freddie’s total required risk-based capital was $112 billion, its adjusted total capital was a negative $68 billion, and its shortfall to adequate capitalization was $180 billion. At March 31, 2022, Freddie’s total required risk-based capital was $122 billion, its adjusted total capital was a negative $47 billion, and its capital shortfall was $169 billion. So over the last seven quarters, Freddie’s required capital increased by $10 billion, its adjusted total capital rose by $21 billion, and it was able to trim $11 billion, or 6.1 percent, from its capital shortfall, with 93.9 percent still to go.

The ERCF allows both companies to begin paying partial dividends and some executive compensation before they are fully capitalized. They can pay out up to 20 percent of their after-tax net income in dividends (common and preferred) and executive compensation once they have capital equal to their risk-weighted capital requirement plus 25 percent of their total PCCBA buffer amounts, and they can pay out 40 percent when they’ve covered 50 percent of their PCCBA. Neither company, however, is anywhere near either threshold. Fannie must cut its capital gap by $213 billion before it can pay out 20 percent of its net income, and to pay out 40 percent it needs to cut that gap by $233 billion. The comparable capital gap reductions for Freddie are $132 billion and $145 billion, respectively.

At the end of this month, Fannie and Freddie are required to file the first of their annual capital plans—described in FHFA’s December 2021 ”Notice of Proposed Rulemaking on Enterprise Capital Planning”—in which they are supposed to detail their “plan to rebuild capital to come into compliance with the ERCF.” These plans will not be made public, but they will contain each company’s proprietary estimates of how much they might further reduce their capital shortfalls over the five-year projection horizon. I obviously don’t know what those internal projections will look like, but I’m certain that during this period both companies will be projecting significantly slower asset growth because of higher interest rates, fewer refinances, and attempts to increase guaranty fees, and also a return to more “normalized” (and lower) earnings compared with the last seven quarters, because of slower amortization of upfront guaranty fees, a shift from loss provision income to loss provision expense, and higher interest costs for credit risk transfers. When Fannie and Freddie run these numbers and give them to FHFA, therefore, I doubt if Fannie projects that it can cut its capital gap by more than around $50 billion by the end of 2026—leaving about $220 billion unaddressed—and I wouldn’t expect Freddie to project a capital gap reduction of more than around $30 billion, leaving about $140 billion still to go.

FHFA and Treasury are likely to be very surprised, and disappointed, by what they will perceive as Fannie and Freddie’s lack of progress in meeting the requirements of the ERCF, because neither understands how little ability the companies truly have to eliminate on their own the huge capital deficits imposed upon them by former director Calabria. For this reason, I believe the executives at Fannie and Freddie must use the opportunity presented by the close sequencing of the initial publication of the ERCF capital data in in their first quarter 2022 10Qs and the subsequent submission of their initial capital plans to FHFA to break their silence about the impossible position FHFA and Treasury have put them in, and, whether publicly or privately, state in no uncertain terms the stark realities of their current capital dilemma, which are neither of their own making nor within their power to remedy:

  • The huge difference between the positive book net worth of Fannie ($52 billion) and Freddie ($32 billion) at March 31, 2022 and their negative “adjusted total capital” on the same date (minus $82 billion and $47 billion, respectively) arises from Treasury’s refusal to consider any net worth sweep payments made by the companies over the last ten years as repayments of its senior preferred stock, even though financially they clearly were. Treasury senior preferred stock is not included in “adjusted total capital”.
  • For as long as their Treasury senior preferred remains outstanding—and Treasury’s $173 billion liquidation preference in Fannie and $104 billion in Freddie exists, and keeps growing—the companies will have no access to the capital markets; their sole means of closing their gaps to adequate capitalization will be through retained earnings.
  • The Calabria “risk-based” standard contains so many arbitrary buffers, cushions, and capital minimums that there is very little scope for Fannie or Freddie to reduce their required risk-based capital through changes in the risk of their books of business. For this reason, and those below, the companies’ risk-based standard will be binding for the foreseeable future, and their (lower) leverage requirements irrelevant.
  • The final Calabria standard was artificially calibrated to produce 4+ percent required risk-based capital at a time when Fannie and Freddie’s books of credit guarantees were near all-time highs in credit quality. It is a virtual certainly that with slowing home price growth, rising interest rates, and fewer refinances, the credit quality of these books will move back closer to normal (then at some point be below normal), and as this occurs the companies’ “risk-based” capital requirements will rise, no matter what they do.  
  • The guidance from acting director Thompson to attempt to earn a market return on FHFA’s (hugely excessive) amount of required capital by increasing fees on lower-risk business will drive more of these loans to banks and private-label securitization, and inevitably leave the companies with a larger proportion of higher-risk business, and as a consequence an even higher required risk-based capital percentage in the future.  

The senior executives at Fannie and Freddie know all this. That, I think, is why they had so little to say about the ERCF in their first quarter 2022 10Qs. But the data released in those 10Qs tell the story without words. At March 31, 2022, Fannie and Freddie had the highest-quality books of credit guarantees in their histories—with an average current loan-to-value ratio of 53 percent, and an average credit score of 752—yet together the companies found themselves $441 billion below their new “risk-based” capital requirement of $312 billion, or 4.5 percent of their average mortgage assets, with no way to reduce that gap other than to continue to retain their earnings at the expense of an ever-rising Treasury liquidation preference, and even then it would take decades to eliminate their capital gaps completely. What else can FHFA or Treasury possibly be expecting them to do to come into compliance with the ERCF as it’s now structured and specified?  

Treasury and FHFA are the ones that created Fannie and Freddie’s capital quandary, and they are the ones that can and must get them out of it. It won’t be difficult to do.

First, Treasury and FHFA must agree to cancel the net worth sweep, and eliminate Treasury’s liquidation preference. Fannie and Freddie already have repaid their senior preferred stock, with 10 percent interest. And Treasury should not require that the companies’ senior preferred be converted to common. To do so would be to require them to repay their indebtedness to Treasury twice, which is unjustifiable, and blatantly unfair. Without the senior preferred, Fannie and Freddie’s combined March 31, 2022 capital shortfall of $441 billion would be cut to $248 billion, or by 44 percent.

Then, FHFA must scrap the Calabria capital standard, and either go back to its June 2018 standard, or propose a new one. Calabria’s “risk-based” standard was cynically designed not to be risk-based, but instead to require Fannie and Freddie to hold a bank-like amount of capital no matter how little risk they took on their credit guarantees, with a “stability buffer” that penalized them for doing more than a token amount of business. There is no reason for the top economic officials in the Biden administration to keep former director Calabria’s punitive capital standard in place, particularly when a Fannie and Freddie with a properly designed capital standard, based on real data and economics, could be of such great value to a key Biden administration constituency—affordable housing borrowers.

This should not be a hard call.

55 thoughts on “A Capital Reality Check

  1. Tim: First off, thank you for the insight that you have provided on the GSEs over the years—the book, the blog, the briefs. It truly is invaluable. Secondly, wanted to get your thoughts regarding pricing in the mortgage market and two recent developments. One, the rate for a 30-year conforming loan is nearly 100 basis points higher than a 30-year jumbo loan, when historically jumbo loans have been more expensive. Do you believe any of this can attributed to the GSEs recent changes to their pricing framework, and if so, could the GSE’s almost be considered to be in breach of their mission? Two, when comparing a 30-year conforming loan against the 10-year Treasury, the current spread is nearly 300 basis points, whereas the historical average is approximately 170 basis points. Looking back at the past 40 years, the current differential seems to have only occurred two other times—during the financial crisis and the early stages of the pandemic. In neither of those periods, however, was the Fed unwinding more than $2.5 trillion of agency holdings. As a result, would you expect this historically wide spread to persist for a longer period of time here or instead create a catalyst to recapitalize the GSEs so they can step in to foster liquidity in the marketplace?

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    1. I hadn’t realized that the spread between jumbo mortgages (those above the Fannie-Freddie conforming loan limit) had become that wide, in favor of jumbos; historically jumbo rates have been lower than conforming loans. Pricing has to be the main reason. Fannie and Freddie price to the MBS market, and have to include their guaranty fees in their pricing buildup. Portfolio lenders (who hold the large majority of jumbo loans) price to their cost of funds. What appears to be happening is that portfolio lenders are competing against each other for the (relatively small) amount of jumbo loans currently being originated, and that is pulling their yields down.

      Fannie and Freddie pricing, meanwhile, is affected by the factor you note–wider-than normal spreads to Treasury securities. The mortgage-Treasury spread you cited, between the 10-year Treasury and current-coupon MBS, is higher than normal partly because of the current shape of the yield curve, which is essentially flat from 3 to 30 years. (Mortgages are actually priced off the entire curve, so when it has its usual upward slope, that pulls the MBS-to-10 year spread down.) But spreads are also wide because of the supply-demand balance. Since Fannie and Freddie were forced to exit the portfolio investment business (by Treasury) in 2008, commercial banks have picked up about $2 trillion in fixed-rate mortgages, and the Federal Reserve has added $2.7 to its balance sheet (Fannies, Freddies and Ginnies) in its successive “quantitative easing” programs. With short-term interest rates (and banks’ cost of funds) rising, banks are likely stepping back somewhat from the fixed-rate mortgage market, and with the Fed rumored to be soon cutting the size of its agency MBS holdings (it hasn’t yet), that’s probably causing non-bank investors to back up their bids for MBS.

      I would, therefore, expect relatively wide mortgage-Treasury spreads to persist for the foreseeable future. And unfortunately, recapitalizing Fannie and Freddie won’t change this dynamic, unless their capital requirements also are cut significantly. Even when they are recapitalized, Fannie and Freddie won’t return to the portfolio investment business; they will continue to be limited to making credit guarantees on MBS. And because the current mortgage problem is too little demand from fixed-rate MBS investors–and the fear of the Fed running off its portfolio–relative to the envisioned future supply of MBS, recapitalizing Fannie and Freddie won’t really change that.

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      1. @Adam/Tim

        this rather severe spread between conforming rates and 10 year treasuries has developed WITHOUT Fed selling any of its MBS portfolio. it strikes me that the Fed sees this and may very well just go into MBS runoff mode without overt selling…but wont this only extend the time that the MBS purchase market will be dysfunctional (with the biggest MBS buyer out of the market), leading to an increased period of time of excessive conforming mortgage rates?

        rolg

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        1. Although Fannie and Freddie were required to exit the portfolio business beginning in 2008, the impact of this on mortgage-Treasury spreads has never really been felt because just at that time the Fed began buying MBS, and the Fed now holds more MBS ($2.7 trillion) than Fannie and Freddie ever did combined. But when the Fed starts selling–or doesn’t replace all of its runoff–that will be a new and unpredictable dynamic. We don’t have any history of this.

          Even supporters of Fannie and Freddie now talk about their portfolio business as having no benefit other than generating “arb profits” for their shareholders. But that’s not true. The companies’ portfolio purchases served as a cap on how wide mortgage to Treasury spreads could become. Fannie and Freddie’s debt–both bullet and callable–was priced off Treasuries, and those debt spreads were relatively stable. And whenever the investment community favored bullet or callable term debt over prepayment-uncertain MBS, Fannie and Freddie would issue the the bullet and callable debt those investors wanted, and use the proceeds to buy the MBS investors were less interested in. That’s what capped the mortgage-Treasury spreads. Yes, Fannie and Freddie made money from doing this, but it had a significant systemic benefit as well.

          Fannie and Freddie’s historical critics (mainly banks) now have what they always said they wanted–the companies eliminated as investors in mortgages. When the Fed starts selling, or running off, its holdings, we’ll all learn what the companies’ absence as portfolio investors means for the longer-term cost of mortgage credit.

          Liked by 3 people

          1. Tim

            I wonder whether F/F could set up a pass-through platform, so that the trust holders of the pass-through trusts would bear the risk/reward (and the credit arb opportunity), and I suppose F/F could scrape an origination fee and perhaps an on-going supervision fee. in my mind, these pass-throughs would not be guaranteed by F/F, so they “should” bear a higher rate than MBS, but if done in large enough quantity, they might bring down the mortgage/treasuries spread. have these pass-throughs act in stead of the whole loan portfolios that F/F had pre 2008.

            rolg

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          2. In a word, no, for a couple of reasons. First, while in conservatorship “F/F” don’t do anything without FHFA approval (or initiation), and I don’t see FHFA approving (or proposing) anything like what you suggest. Second, even if it did, the market for agency-issued securities without an agency guarantee would not be deep enough to have any noticeable impact on overall mortgage rates. When I was Fannie’s CFO the company had a program it called “Wisconsin Avenue Securities,” which were senior-subordinated tranched securities issued but not guaranteed by Fannie. We never did more than a token amount of business with these.

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  2. Tim

    I quote a recent tweet: “Last year a 30-year mortgage under 3% meant your payment on a $500,000 home was $2,100/month (not including down payment, taxes and fees) but now a 6% mortgage only gets you a $352,000 home for $2,100/month. Unless rates come down, how do we not get 20-30% correction in prices?”

    this seems intuitively correct. and if it is, then shouldn’t we see a “stress test” environment for the GSEs over the next year or so? given the favorable results of the latest regulatory GSE stress test conducted by FHFA (and belatedly disclosed without any read over to the capital rule), one might expect the GSEs to fare quite well during this next year, as they did during the covid pandemic. perhaps this will be necessary to prove to even the ideologically pure federalist types that the GSEs dont need “bank like” capital….especially if there is no treasury secretary who imposes massive fictitious reserves/losses this time around.

    rolg

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    1. The tweet may seem “intuitively correct,” but it’s simplistic to the point of inaccuracy. One can argue that the availability of cheap (3%) mortgage credit was a major factor in driving average single-family home prices up by 33 percent since the end of 2019, but the people who were paying those prices did so with monthly payments they’ve locked in for as much as 30 years. Over the last nine quarters, there was a large imbalance between those who wanted a home at prevailing prices and the supply of homes available; that’s why prices rose so much. Now that mortgage rates have gone up, there are fewer buyers on the demand side, which will take much of the pressure off prices. But even today there still seems to be an imbalance favoring the demand side (because supply is so constrained, and building costs have risen so much), and that’s why home prices are continuing to rise. Before home prices could fall 20-30 percent, they first will have to stop rising. I think they WILL stop rising, but I don’t believe they will fall significantly in the foreseeable future. This is not 2008, when home prices were driven up by four years of irresponsible lending to people who couldn’t afford the loans they were taking on; once lending practices tightened (after the subprime and PLS markets imploded), many who had taken out loans in the prior four years found they couldn’t afford them, and either defaulted or walked away. That put more (foreclosed) homes on the market just at the time demand was collapsing as well, triggering the downward spiral in home prices we experienced then.

      Today’s environment is fundamentally different. Those who bought homes recently did so with sizable down payments, and now have below-market-rate mortgages. They are highly unlikely to default in significant numbers. My expectation, therefore, is for a “soft landing” in home prices, in which Fannie and Freddie’s credit losses don’t rise much either this year or next.

      Liked by 1 person

      1. I also believe the increase to the conforming loan limits Coupled with sub 3% rates was a contributing factor. In 2020 the limit was $510,400, 2021 ($548,250) and in 2022 ($647,200). Prior to 2020 these loan amounts were considered JUMBO so these would have been based on higher purchase prices that required a 20% down payment. After 2020 these loan amounts were available with purchase prices only requiring a 5% down payment. Not all new homebuyers are constrained by monthly affordability, many were constrained by higher down payment requirements for higher price homes. Consumers incentive was not quite as high to save more toward the down payment when rates were sub 3% because the payment reduction was not as significant. Ex. Additional $10,000 down payment lowered your payment $42.16 @ a 3% rate 30 yr fixed. Tim, I know you already know this. The comment is more for your readers.

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        1. @Eric

          having more expensive homes financed with lower down payments seems to me to cut the other way for the
          GSEs moving forward, to increase the risk of adverse future credit losses. I suppose this all comes down to future unemployment. we may be in the early innings of a rising unemployment picture.

          rolg

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          1. Fannie and Freddie each publish the LTV and credit score breakdowns of the loans they purchase or guarantee each quarter.

            I have the Fannie data at hand, and its first quarter 2022 loan acquisition profile shows 15 percent of its acquired loans with LTVs above 90 percent, compared with 10 percent above 90 percent in the first quarter of 2021. But most of that mix change reflects the absence of the large number of refinances that pushed up the lower-LTV totals in the first quarter of 2021. Fannie’s first quarter 2022 acquisition profile is still slightly better than the original LTV profile of its December 31, 2021 book, so there is little evidence that the company is doing more low-LTV purchase money credit guarantees than it typically does.

            Where there IS a difference is in credit scores. The weighted average credit score of Fannie’s first quarter 2022 acquisitions was 748, lower than not just the average of the first quarter of 2021 (761) but also the 753 average of the December 31, 2021 book. This is something to watch going forward.

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    1. I listened to this live, and thought it went as well for the plaintiffs as could have been expected. The government had no good answer to why having Ed DeMarco serve for three years as an acting director of FHFA (before he approved the net worth sweep)–without having either been confirmed by the Senate or given a recess appointment–wasn’t in violation of the constitution. And I thought counsel for the plaintiffs (Pete Patterson of Cooper & Kirk) was effective in making the case for why the court should grant plaintiffs the remedy they seek of voiding the net worth sweep, in spite of the alleged “sweeping consequences” of doing so, noting first that the Supreme Court has made clear in other cases that remedies are the incentives offered to plaintiffs for bringing cases of unconstitutionality to the Court’s attention, then closing the oral argument by telling the three appellate judges that “the only practical consequences [of a decision voiding the net worth sweep] would be putting Fannie and Freddie in a stronger position.”

      I’ve given up on predicting the outcomes of court cases, but based on what I heard I wouldn’t be shocked if the Sixth Circuit Court of Appeals were to rule in favor of the plaintiffs and void the net worth sweep, leaving it to the government to appeal this decision to the Supreme Court.

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      1. none of the three circuit court judges wanted to affirm on the basis that the district court judge held, that the question as to whether DeMarco was validly acting as acting FHFA director was a political question. the de facto officer argument wasn’t winning the day for the govt either. there was some hesitancy as to whether the appointments clause holdings in Administrative Law Judge cases, such as Lucia, should be extended outside that adjudicatory context to a contracting context such as the NWS, and Patterson’s rebuttal point that the GSEs would be stronger was helpful in that regard (and there is the notion that if SCOTUS wants to limit appointments clause remedies to the adjudicatory setting, then they should do it, not an appellate court)…but if the 6th C does not distinguish agency adjudications from agency contracting, it is hard to see how this panel, based upon this oral argument (and the briefing, which Judge Thurpar commented on in a fashion favorable to plaintiffs), doesn’t rule in favor of Rop. still plenty of time between oral argument and decision for Federalist Society members such as Wallison to try to put the fix in however.

        rolg

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          1. more likely 3-6 months. no appeal as of right, SCOTUS decides (4 justices) whether to grant certiorari, which it will likely do if govt loses and not do if plaintiff loses

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          1. to be clear, a Rop win shouldn’t be expected simply because of superior briefing and oral argument. the only govt argument that seemed to resonate with the judges was not a legal argument but the practical argument, that things would get messy invalidating a contract entered into 10 years ago involving billions of dollars…and that is usually enough for judges to walk humbly back their initial analytic conclusions. Judge Thapar is a strong conservative legal theorist, and a Federalist Society member, as was Judge Ginsburg in Perry, and that alone should give one pause. the notion is that it is one thing to say some individual plaintiff like Lucia should get a rehearing in front of a properly appointed ALJ, and another to invalidate an important financial contract affecting a very large financial market…though Patterson did well to point out that the Lucia decision affected thousands of similarly situated plaintiffs as well as Mr. Lucia, so Lucia invalidated many plaintiffs’ ALJ decisions. but simply based on the legal merits, plaintiffs won the day in my opinion

            rolg

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  3. Tim,

    What are we to make of these statements?

    Thank you.

    The Enterprises will publish their first public disclosure reports under the final rule in the first quarter of 2023.

    https://www.fhfa.gov/mobile/Pages/public-affairs-detail.aspx?PageName=FHFA-Announces-Final-Rule-Introducing-New-Public-Disclosure-Requirements-to-the-Enterprise-Regulatory-Capital-Framework.aspx

    Under the final rule, each Enterprise will submit its first capital plan by May 20, 2023.

    https://www.fhfa.gov/mobile/Pages/public-affairs-detail.aspx?PageName=FHFA-Announces-Final-Rule-Requiring-Fannie-Mae-and-Freddie-Mac-to-Submit-Annual-Capital-Plans.aspx

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    1. The public disclosure announcement is consistent with the final rule FHFA issued a couple of weeks ago titled “Enterprise Regulatory Capital Framework–Public Disclosures for the Standardized Approach.” The new piece of information is that FHFA would like Fannie and Freddie to make their first public disclosures under this rule “in the first quarter of 2023.”

      I am less certain what to make of FHFA’s June 1 announcement about Fannie and Freddie’s annual capital plans, which says, “each Enterprise will submit its first capital plan by May 20, 2023.” FHFA’s December 2021 proposal on “Capital Planning and Stress Buffer Determination” said, “An Enterprise must submit its complete capital plan to FHFA by May 20 of each calendar year, or such later date as determined by the agency, and in the “Legislation and Regulation” section of its first quarter 2022 10Q, Fannie said, “The enterprise regulatory capital framework requires that we provide our initial quarterly capital reports to FHFA by May 30, 2022. ” I took Fannie’s statement in its 10Q to mean the company’s first capital plan would be submitted to FHFA at the end of last month (with the extra ten days having been “determined by the agency”). But this latest announcement from FHFA makes me wonder if there is a distinction between a capital “report” and a capital plan.

      If the two ARE different, then I’m not sure what will have been in the “reports” Fannie and Freddie submitted to FHFA last month. If it was just a recap of their capital numbers (which come from FHFA, so it already knows them), that would be disappointing. As I said in the current post, we already know what Fannie and Freddie’s capital problem is. Adding a year to the timeline for the companies to be required to produce a “plan” for dealing with it–when FHFA should know that no such plan is within the power of Fannie and Freddie to execute–just adds more bureaucratic delay to a process that instead should be sped up. The companies’ (obvious) capital problem is not going to get better by itself.

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      1. Tim,

        Thanks for that. Maybe the annual capital plan and report are indeed the same thing, and hopefully the June 1 remark was a typo on the year. Or else 5/2023 could be the second plan / report, not the first. *shrug*

        Like

  4. Tim,
    Have you had an opportunity to look into the Collins refiling? Apparenty, it is asking the district court to eliminate the liquidation preference and restore FnF to their position before the net worth sweep. What is your assessment? Is there any reality in this new request? I believe the story came from Inside Mortgage Finance.

    Like

    1. It’s not really a “new request”; the plaintiffs opening brief to the Fifth Circuit Court of Appeals asked it to “remand this case to the district court with instructions to enter a permanent injunction requiring, at a minimum, that Defendants amend the purchase agreements to either: (1) reduce the liquidation preference on Treasury’s senior preferred stock to zero and end further increases to the liquidation preference except as necessary to offset further draws on Treasury’s funding commitment, or (2) convert Treasury’s senior preferred stock to common stock.”

      And as I believe I’ve said before, I don’t assign a very high probability to the district court’s reaching the verdict plaintiffs are asking for.

      Like

      1. There is a promising new argument in Collins based on last months CFPB vs All-American Check Cashing decision (5th Circuit en banc)

        In a scholarly concurring opinion in which four other Fifth Circuit judges joined, Judge Edith Jones agreed with All American’s argument, writing that “[t]he CFPB’s budgetary independence makes it unaccountable to Congress and the people.”

        Judge Edith Jones also concluded that there was “no other option” for remedying the separation of powers violation arising from the CFPB’s budgetary independence than dismissing the enforcement action against All American. She distinguished cases involving an improper removal restriction because, as the Supreme Court indicated in Collins, an unlawful removal provision does not take away an officer’s power to exercise his or her authority. As a result, for a party challenging a removal provision to establish a right to a remedy, it must show that the unconstitutional provision caused compensable harm. In the case of an Appropriations Clause violation however, Judge Jones concluded that “a government actor cannot exercise even its lawful authority using money the actor cannot spend.” She stated that “a constitutionally proper appropriation is as much a precondition to every exercise of executive authority by an administrative agent as a constitutionally proper appointment or delegation of authority.” Because the separation of powers violation at issue impaired the CFPB Director’s authority to act, she concluded that “the proper remedy is to disregard the government action.”

        Liked by 2 people

        1. @John D

          the problem is that SCOTUS in Collins found [erroneously in my opinion] that the acting FHFA director who signed the NWS was not subject to removal only with cause. so this All American case doesnt apply to Collins.

          rolg

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  5. Judge Lamberth entered two orders yesterday afternoon (5/31):

    (A) pushing the date for commencement of a jury trial to Mon., Sept. 19, 2022; and

    (B) allowing Berkley to participate in the jury trial and Fairholme to sit on the sidelines

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    1. The second order is not a surprise; both classes of plaintiff (represented by Berkeley and Fairholme) had requested it, and seemed to have had solid arguments for doing so.

      I also can’t say I’m surprised that the timing for the jury trial has been pushed from July 11 to September 19. There had been several delays at the pre-trial stage, and something had to give.

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    2. the sever and stay lets Lamberth impanel a jury to decide facts for both cases essentially, the class action and the separate opt out plaintiffs. there may have been some trial strategy involved in asking for a jury trial in one and not in the other, but that question has been answered by the plaintiffs agreeing to ask for the jury trial to proceed first, and Lamberth appeared more than happy to let a jury handle the facts. the trial rescheduling was expected, and it seems to me that the govt’s motion for summary judgment will not be granted with the pretrial scheduling order…but I want to see that order first before I make book on it.

      rolg

      Liked by 1 person

      1. rolg,

        Can you expand a bit when you say, “impanel a jury”? What is the significance of that, are there alternative ways? Thanks!

        Like

        1. @jb

          it was just that Ps had two parallel cases going in front of Lamberth, one which specifically asked for jury trial and one which did not. jurors have a way of reaching determinations of facts that are different than judges…not better, just different. so is a bench (judge) or jury trial better in this case?

          since the briefing has been sealed, it is hard to assess what facts will be presented at trial, but one surmises that Ps may be able to summon sympathy from jurors more easily than from crusty old Lamberth, given what has appeared in the public domain relating to the adoption of the NWS…and the case is all about whether the govt breached a covenant of fair dealing…so while Lamberth’s instruction to the jury on the Delaware law of the implied covenant of fair dealing will be important, there should be room for jurors to view the testimony In light of their own commercial dealings and sense of what is fair and in commercial good faith.

          it seems to me that there was trial strategy that led to this split choice on fact finder initially, and a resolution between the class and opt out Ps recently as to preferring a jury trial…and Lamberth was happy to let the case requesting a jury to proceed first. same case, esentially, so whatever jury finds in first trial as to the facts will be determinative for second case. plaintiff lawyers have a sense of what a personal injury case is worth in bronx vs queens vs Manhattan, based upon their expected jury pools, and I would dare say that those cases are all worth more than what they would be worth in front of a judge as fact finder.

          rolg

          Liked by 1 person

  6. Hi Tim,

    [Edited] Having been a long-term reader of your blog, thanks for all the input you have given from a justice/legal point of view, and also from a shareholder’s perspective.

    Having seen a lot of the ‘how’, and ‘what needs to be done’, ‘who should do what’, to do with getting both out of conservatorship, I now wonder, WHY? What’s the benefit, for the US gov, Treasury, or even the US people, to have FNMA and FMCC released? Why not the current model, with both entities building capital perpetually because of the 4.5% (roughly) capital requirement, and thus safe to keep the Treasury from another draw, and also maintaining the unique 30-year pre-payable mortgage, and MBS also keeping their price stable assuming implicit government guarantee. Isn’t that exactly what the GOV wanted? Looks like this is the perfect, controllable, no cost (unless you are a shareholder), self-sustaining model to keeping all the priority satisfied.

    So I wonder, why would the US do anything anymore?

    Like

    1. I attempted to address the “why do anything further with Fannie and Freddie” in my latest post, although very indirectly.

      Right now, FHFA is on the path set for it by former director Calabria, which was, “You [Fannie and Freddie] can come out of conservatorship, but only on the terms I’ve set.” What I tried to point out in this post–using data from the ERCF capital tables in the companies’ first quarter 10Qs–is that without a change in either the net worth sweep or the excessive conservatism of the ERCF risk-based capital requirements, it will take both Fannie and Freddie close to three decades to accumulate through retained earnings the amount of capital Calabria insists that they hold.

      When Fannie and Freddie file their initial capital reports with FHFA at the end of this month, each will say, in effect, “we can’t get to where you want us to be, using the only tools we have, at any time in the foreseeable future.” It then will be up to FHFA to respond. It will have three basic postures it can take. The first is, “That’s okay; we’ll wait” (your “why do anything further” option). The second is, “Then you have to shrink your business so that the amount capital you’re required to hold is equal to the amount of capital you have.” And the third is, “We get your point; we’ll see what we can do to eliminate the net worth sweep, and take some of the conservatism out of the capital standard.”

      Of the three, I think option two is the least likely, since it would wreak havoc in the residential mortgage mortgage market, for no defensible reason. Between the other two options– doing nothing and fixing the sweep and the standard–my bet is on the latter, because there so obviously ARE problems there than can, and should, be fixed. But inertia is a very powerful force in Washington, so “doing nothing” can’t be ruled out.

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      1. I also believe the option “doing nothing”, isn’t really doing nothing. Doing nothing is tacitly accepting the Calabria capital standards, which should become obviously untenable in due time to all parties. I don’t think they can just ignore the Calabria capital standards. And GSE management will need to emphasize this point. Thus they either implement new capital requirements or go back to the prior risk-based standards. This is when Treasury will be forced to decide how they want to handle them. As of yet, I’m still not convinced Treasury has given the matter serious thought.

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        1. The Treasury department will not bend over backwards to allow Calabria’s capital standards work. It’s a non starter and most people who have any say in the matter are satisfied with the status quo. Unless a scandal really has wings to fly even a shameful outcome from a jury trial will become a moot point.

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    2. A great question, one I have asked myself many times. And you won’t like my current answer.

      In the short run, there is no benefit to the US government. They don’t need the money they would make from selling the GSEs. In a trillion dollar deficit economy that both parties created and which sees no near-term penalties for printing money, the few billion they would make from releasing the GSEs is peanuts. While there are no potential problems in the near term for hanging on to the companies, there are potentially HUGE political problems from releasing them. Whichever party is responsible for releasing the GSEs, and giving the evil hedge funds a huge win, will likely be condemned by their opponents.

      In the long term, government has proven that they cannot handle running a business. Like any business with no competition, it will become bloated with overpaid help, and charge huge fees to pay for it all. The change will come very slowly, like a gradually heated pot. And the frog (the consumer) will not realize there is a problem until it cannot jump out. Banks will capture the cream of the business, and the middle class will be stuck with exorbitant fees. The lower classes will have scant hope of buying a home. In the worst-case scenario, when the little people finally demand change, taxpayers will end up subsidizing the bloated GSEs so poor people can buy a home.

      Expect increasing mortgage costs for the consumer for many years to come.

      Liked by 1 person

  7. TH,
    A very excellent summary. A ‘Call to Arms’ based on reasonable capital standards and actions is warranted. How does Michael Calhoun’s actions, (additional) $100B extraction s-t goal, fit into this scenario?
    Does Lamberth’s upcoming trial, that may be delayed, fit into any of the capital requirements/framework you mention, or are they completely independent?
    TIA
    VM

    Like

    1. The course of action I recommend for Treasury and FHFA would align well with the Calhoun proposal (which, for those who don’t know, is for Treasury to use the proceeds from converting its warrants for 79.9 percent of outstanding common stock in Fannie and Freddie to create a fund to be used to support affordable housing). As I continually like to remind people, however, the $100 billion value attached to the Calhoun proposal is greatly overstated. It may have been realistic at one point, but it’s now unrealistically high. At today’s closing stock prices, Treasury’s warrants for 7.2 billion shares of Fannie and Freddie stock are worth only $4.9 billion. But the key to getting that value up–and way up– is to make the companies more valuable, by freeing them from the bonds Treasury and FHFA (particularly Calabria) have placed them in. In that sense, my proposal very much does fit with Calhoun’s.

      It’s a bit early, in my view, to speculate on how the Lamberth trial might fit into what I’m recommending for Treasury and FHFA; I’m still waiting for his ruling on the motions to dismiss by the government and the plaintiffs. I think there is very little chance that he will grant plaintiffs’ motion to dismiss, but he may well grant the government’s. That motion offers him a easy “off-ramp” for what otherwise would be a very complex and high profile trial: all he has to do is say, in effect, “I agree with Justice Alito that the language in HERA (even though it was taken nearly word-for-word from the FDIC Act, and has never been read to say this before) transforms FHFA into a ‘super regulator’ with unlimited discretion, and plaintiffs in the breach of contract case should have known that when they purchased their shares in the companies.” But Lamberth also may have taken offense at having been lied to by the government in the initial filings in his court, and thus may wish to have the facts that were withheld from him made available to the public. If that’s how he feels–and if the trial goes forward–then that could well put some pressure on the government to settle a case that could be a great embarrassment to it, and this in turn could affect how the government thinks about and approaches the resolution of Fannie and Freddie’s interminable conservatorships.

      Liked by 1 person

      1. Tim,

        If you read Lamberth’s 2018 ruling denying the governments motion to dismiss, it’s important to note that he already assumed shareholders lost the APA claim for the EXACT reason SCOTUS pointed to, so the SCOTUS ruling in theory shouldn’t change his original ruling in any way.

        Lamberth highlighted that while FHFA as a regulator may act in its own best interest (exactly like SCOTUS used to justify the APA ruling) and that the NWS was a legal action taken, these facts don’t absolve the GSEs themselves (who would be liable for damages here unlike the APA claim) from breaching our implied covenants (it was unreasonable and arbitrary for the GSEs to enter into the NWS, even if it was legal for the government to do so). The government in it’s motion for summary judgement is asking Lamberth to relitigate his ruling from 2018 (that he reinforced in 2019 when he denied the governments motion for reconsideration).

        Let’s hope Lamberth sticks to his guns and doesn’t overrule himself here.

        Liked by 1 person

      2. Tim

        The motion to dismiss briefs are all sealed, so I cant offer any view on the arguments. but in his Perry decision back in 2014 (if I recall the date correctly) Lamberth in the last page of the opinion wrote in effect that while the shareholders got a raw deal with the NWS, it was a deal that FHFA had the power to consummate. I wonder if Lamberth might view the implied covenant case before him as an opportunity to make clear that even though FHFA had the federal statutory power to consummate the NWS, this does not mean that a reasonable junior preferred shareholder would have expected this risk as a result…especially when the GSEs were returning into financial health, their “golden age of profitability” even, a forecast from the Fannie CFO that was totally odds with the government’s affidavit testimony in the original Perry case.

        rolg

        Like

        1. For those and other reasons, I’m not placing any bets on how Lamberth will rule on the summary judgment motions to dismiss. Hopefully we’ll learn of those rulings soon.

          Like

  8. You cite the current average loan-to-value ratio of 53% (and high credit scores) as the highest quality credit book in their history.

    Do the capital requirements make any adjustment for declining LTVs?

    I’m not a mortgage expert, but it seems to me that a 53% LTV mortgage guarantee is far less risky than an 80% LTV. Yet as far as I can tell, GSE capital requirements have increased. I understand incremental assets have increased, but if portfolio-wide LTVs are decreasing then isn’t guarantee risk actually decreasing?

    Liked by 1 person

    1. Patrick–Yes, Calabria’s standard has a “formulaic countercyclical adjustment” for declining mark-to-market LTVs, after a certain degree of home price appreciation. It’s complicated, and requires FHFA to first make an estimate of the “long-term trend of FHFA’s quarterly, not-seasonally-adjusted HPI [Home Price Index] using a prescribed trough-to-trough methodology.” Then, according to the text of the capital rule, “If the deflated all-transactions HPI exceeds the estimated long-term trend by more than 5 percentage points, the Enterprise would adjust upwards the MTMLTV [mark-to-market loan-to-value ratio] of every single-family mortgage exposure by the difference between the deflated all-transactions HPI and 5.0 percent.” Home prices are definitely more than five percent above their long-term trend today (and are likely to be for a while), so Fannie and Freddie are not getting the capital credit for their lower mark-to-market LTVs that they otherwise would. By the same token, however, as home price appreciation slows, the companies will not be penalized for rising mark-to-market LTVs until home price growth comes back within five percent of its long-term trend (which of course will be pushed higher by the recent surge in home prices). Very little about the Calabria capital standard is simple.

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  9. Court hearings, campaign promises, and potential treasury windfall were factors we had hoped would drive change. But with current climate, do you see anything creating a sense of urgency? You’re right – It shouldn’t be a hard call, but I’m not sure how the senior execs at F&F can gain any traction without Treasury having some motivation.

    Like

  10. FHFA seems to be working in the dark. The Biden administration needs to assign some adults to Treasury and FHFA to turn the lights on. Thanks for the update and reality check, Tim.

    Like

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