Mind the Gap

The “dog days” of August are a good time to put up a post on capital, credit pricing and cross-subsidization. It is not topical, so it can be read at people’s leisure. But it should be read, and carefully; its intent is to explain what needs to be done to restore Fannie and Freddie’s role in supporting affordable housing, to prepare for and facilitate their exit from conservatorship.   

For the past half-century, anyone taking the underground metro system (or “the Tube”) in London is likely to have heard a recorded message urging them to “mind the gap” as they disembarked at certain destinations. That gap is the space between the door of the train and the concrete edge of the platform, which varies by station.

Being in London last month caused me to recall that as CFO of Fannie I once was tempted to buy a passle of “Mind the Gap” t-shirts for the staffs of my Credit Finance group and the Single-family Business team, as mementos of our primary metric for balancing the market share, revenue, affordable housing goal and risk management objectives in our credit guaranty business—what we termed the “guaranty fee gap.” And as I thought about this, it occurred to me that a discussion of how the guaranty fee gap concept was used during my time at the company might be an understandable, “real world,” way to explain why the Calabria capital standard is so terribly damaging to the ability of Fannie and Freddie to finance any significant amount of affordable housing loans on reasonable terms, and why that standard must be replaced to restore their ability to do so.

Today, one rarely reads an article about the futures of Fannie or Freddie without hearing about the need to reform their “flawed business model.” Those flaws are never defined, because they are fictitious (as proven by the inability of the companies’ competitors and critics to devise a better model during fourteen years of trying). Fannie’s structure as a “private company with a public mission” in fact was remarkably efficient, and one of the most consequential reasons was its use of the guaranty fee gap as a management tool.

Fannie’s private incentives were to meet its shareholders’ expectations for earnings and growth; its public obligations were to meet (or exceed) its regulatory affordable housing goals and to protect the taxpayer from loss. When I was at Fannie, taxpayer protection was a given; we knew we had a valuable charter, which Congress could amend or revoke if we lost money (or made too much money relative to the volume of affordable housing business we did; it never occurred to any of us that Treasury might nationalize the company while it fully met its capital requirements). Balancing Fannie’s other public responsibility—meeting its affordable housing goals—with shareholder requirements for profits and growth was where our “gap management” came in. It worked then in support of affordable housing the same way it could and should work today, so it’s worth spending a bit of time to review.

We’ll start with credit pricing. To set a guaranty fee for any pool of loans—whatever its risk characteristics—you first must specify two key objectives: the return on capital you wish to earn under the most likely combination of future home prices and interest rates (which will be the central path of your home price model), and the cumulative lifetime loss rate you wish to protect against (or the “stress loss level,” which will be at the extreme, or inside, of the home price and interest rate paths generated by that pricing model). Once you’ve set those objectives, there will be only one combination of initial capital and guaranty fee that simultaneously earns your desired return on capital in the expected scenario, and (through a combination of initial capital and guaranty fees from loans that do not prepay) exactly covers your worst-case losses in the stress scenario you’ve specified. That will be the initial capital you should put up against this pool of loans, and the fee you should try to charge for guaranteeing them—the target guaranty fee.  

We did this when I was at Fannie. For all pools of single-family loans, the Credit Finance group would use its pricing model to determine the fee required to earn the company’s target return on capital, while passing the “loss stress test”. The difference, in basis points, between the fee charged by Single-family and the target fee set by Credit Finance was the guaranty fee gap; a charged fee higher than the target fee produced a positive gap, and a charged fee lower than the target produced a negative gap. The Single-family Business team had wide latitude on the size of the guaranty fee gaps on individual transactions, but we managed the gap at the aggregate level across all transactions each month.

When Single-family set a charged fee on any loan pool, we kept track of whether this fee was “gap positive,” “gap negative,” or neutral relative to its target fee, and by how much. We priced our lower-risk business with the deliberate intent to generate as large a positive guaranty fee gap as we could—without losing that business to a competitor (usually Freddie or a portfolio lender)—so that those excess fees (relative to our target) on a dollar basis could be applied to reduce the negative guaranty fee gap on our higher-risk loans, and thus enable us to do a much larger volume of affordable housing business on a profitable basis than we could have without this cross-subsidization. We set a limit as to how large an overall negative guaranty fee gap we would tolerate at the corporate level (in order to meet our shareholder objectives), then used our gap metrics to allocate the excess guaranty fees from gap positive business to higher-risk loans, in order to finance as many “goals-related” mortgages as we possibly could. It was an extremely efficient, and effective, process.

We all know that post-Financial Crisis, Fannie and Freddie will have to hold substantially more capital against their credit guarantees than before the crisis. But policymakers need to understand that the amount of capital required by the Calabria standard (formally the Enterprise Regulatory Capital Framework, or ERCF)—and equally importantly how this capital standard has been engineered to produce its “bank-like” risk-based percentage requirements—makes it impossible for the companies to use cross-subsidization to finance affordable housing in anything remotely comparable to what they used to be able to do, or could do again under a more reasonably constructed standard. It does so in three ways, none of which are related to risk: (a) ignoring that guaranty fees absorb credit losses; (b) arbitrarily increasing capital on all loans though add-ons, cushions and buffers, and (c) setting capital minimums on lower-risk loans, thus locking up capital that otherwise would be available to reduce the guaranty fees on higher-risk loans. These features combine to make the target fees on higher-risk loans unaffordable to most lower-income borrowers, and at the same time deprive Fannie and Freddie of the ability to use cross-subsidization to lower those fees by any meaningful amount.

We can gain insight into the limits of cross-subsidization from data Fannie and Freddie’s regulator, FHFA, published on the companies’ combined book of business in the spring of 2014, disclosing their required capital, target guaranty fees and charged fees by risk segment for the first quarter of that year. (This was at a time when former FHFA director Ed DeMarco had been raising Fannie and Freddie’s guaranty fees to “reduce [their] market share” and “encourage more private sector participation”; incoming director Mel Watt stopped those increases, but did not reverse them.) In the first quarter of 2014, FHFA was requiring the companies to price to average capital of a little over 300 basis points, and they set their target guaranty fees to achieve a return on capital of 11 percent after-tax (at what then was a 35 percent marginal tax rate). This made their average target guaranty fee for all business 72 basis points (including the 10 basis points they were required to charge and remit to Treasury, and still are), but they were able to charge “only” 60 basis points, leaving them with a negative guaranty fee gap of 12 basis points, and an expected after-tax return on capital of just 8.5 percent.

There are two aspects of these data that are instructive. The first is that there appears to be market resistance to average guaranty fees much above 60 basis points. (Fannie raised its average guaranty fee on new business from 57.4 basis points—again including the 10 basis points remitted to Treasury—in 2013 to 62.9 basis points in 2104, but its business growth stalled, and it dropped that average fee to 60.5 basis points in 2015.) The second is that with the 307 basis-point average capital required on Fannie and Freddie’s total new business in the first quarter of 2104, there was a large difference between the capital required on the lowest-risk quarter of that business, at 110 basis points, and the highest-risk quarter, at 570 basis points. (The middle fifty percent was capitalized at 275 basis points.) Because of these large capital differentials, there were comparably large differences in target guaranty fees, creating challenges for the companies’ cross-subsidization efforts.

Let’s assume that the 307 basis points of capital FHFA required of Fannie and Freddie’s first quarter 2014 books of business are the stress losses the companies must cover on today’s books (which are somewhat less risky), and that their target after-tax return on capital is not 11 percent, but 9 percent, at today’s marginal corporate tax rate of 21 percent. In these circumstances, the companies still could employ cross-subsidization reasonably effectively, if guaranty fees are counted as offsets to stress credit losses.

To cover 110 basis points of stress credit losses and earn a 9 percent after-tax return on the least-risky quarter of their business, they would need to put up 78 basis points of initial capital, and set a target guaranty fee of 30 basis points—composed of 10 basis points for Treasury, 8 basis points for administrative expenses, 4 basis points for expected credit losses, and another 8 basis points to absorb the 32 basis points of stress losses not covered by initial capital (using a multiple of 4 times the initial annual net guaranty fee—less than Fannie actually experienced on its December 2007 book that went through the financial crisis). For the middle 50 percent of their business, they would put up initial capital of 195 basis points and set a target guaranty fee of 42 basis points (to cover 80 basis points of stress losses), and for the riskiest quarter of business put up initial capital of 402 basis points and set a target fee of 64 basis points (to cover 168 basis points of losses). Even with target fees this high, charging an average of 38 basis points for the lowest-risk business would generate a positive guaranty fee gap of 8 basis points, and charging 44 basis points on the middle 50 percent would generate a positive gap of 2 basis points (on twice as many loans). This would enable the companies to charge as little as 52 basis points on their highest-risk loans (a negative gap of 12 basis points), making them much more affordable with no sacrifice to shareholder returns.

But note what happens when the three critical features of the Calabria standard get layered in. Not considering guaranty fees as offsets to credit losses—and requiring all of them to be covered by initial capital—increases the target guaranty fees on the lowest-, medium- and highest-risk business to 33 basis points, 51 basis points, and 81 basis points, respectively. And we still haven’t added the effects of the larger cushions and add-ons built into the risk-based capital standard, the stress and stability capital buffers, and the 20 percent minimum “risk-weight” (or 1.2 percent minimum capital requirement) on the lowest-risk loans. At June 30, 2022, these combined to raise Fannie and Freddie’s average required capital to more than 4 percent of total assets, a percentage that would have been higher were it not for credits for credit-risk transfer (CRT) securities issued, which cost the companies the equivalent of 4 basis points of foregone guaranty fees (3 for Fannie and 5 for Freddie).

We don’t have actual breakdowns of the companies’ June 30, 2022 capital requirements by risk segment, but we can approximate them. I estimate that the 1.2 percent minimum and the two buffers raise the required capital on the least-risky quarter of Fannie and Freddie’s business to around 225 basis points, which leads to a target guaranty fee of 50 basis points (including the 4 basis points for the CRTs issued to keep that capital amount from being even higher) for those loans. I also estimate required capital under the Calabria standard for the middle 50 percent of their business to be about 370 basis points—resulting in a target guaranty fee of 63 basis points—and the capital for the riskiest quarter to be about 660 basis points, leading to a target fee of 95 basis points.  

At these guaranty fee levels, cross-subsidization simply ceases to function. The most Fannie and Freddie were able to charge on the least-risky quarter of their business in early 2014, when their average total target fee was 72 basis points, was 50 basis points. Intuitively, it makes sense that there would be price resistance at this level. Charging more than that to insure the credit of loans with loan-to-value ratios of 65 percent or less—whose lifetime stress losses are less than one year’s worth of guaranty fee payments—risks this business being lost to portfolio lenders, who can earn 300 basis points of spread income on it while holding less capital than is required of the companies. But 50 basis points is now the target fee for Fannie and Freddie’s lowest-risk business under the Calabria standard. Without the ability to generate a positive gap on either this or their medium-risk business (which under the Calabria standard now has a 63 basis-point target fee), the companies have no way to reduce the average 95 basis-point fee on their riskiest loans, predominantly to affordable housing borrowers. What inevitably will happen, therefore, is that this riskier quarter will shrink to become far less than that, as borrowers can’t afford the full fee and the companies aren’t able to subsidize it.

Of course, all of this is an artificial problem. There is no economic need for Fannie and Freddie to have to hold anywhere close to 400 basis points of capital against their current books of business, with no consideration given to their charged guaranty fees. In its June 2018 capital proposal, FHFA said that the credit loss rate of Fannie’s 2007 book of business “using current acquisition criteria”—that is, without the Alt A loans, interest-only ARMs and risk layering that resulted in over half of that book’s losses—through September 30, 2017 only would have been 150 basis points, which projects to lifetime credit losses of around 165 basis points. Even if Fannie were to stop operating tomorrow, its 45.9 basis-point average charged guaranty fee (net of the fee paid to Treasury) in the second quarter of this year would, after deducting administrative costs and the provision for loss, and at a four-times multiple, cover 136 basis points of those losses, leaving the need for just 29 basis points of initial capital. This is the reality of both companies’ current business, and it was confirmed by the results of the Dodd-Frank stress tests run on them by FHFA in 2020 and 2021.

Calabria’s capital requirement for Fannie and Freddie is not an economic standard; it’s a political one. Calabria was, and is, an ideological opponent of the companies. His capital standard was designed to do precisely what it does do: use gross overcapitalization to cripple Fannie and Freddie’s gap management and cross-subsidization processes, since he believes the government should not be intervening to make housing more affordable to lower-income borrowers. Unless the senior economic team of the Biden administration shares this view—which I doubt it does—it must scrap the Calabria capital standard entirely. Its structure has too many minimums, cushions and buffers that immobilize the excess capital on lower-risk loans, and also unduly penalizes higher-risk loans by not giving any value to their higher guaranty fees (which also prepay more slowly during periods of stress) as offsets to credit losses. For these and other reasons, the Calabria standard cannot be fixed.

And there is no need to try to fix it. In Capital Fact and Fiction, I say, “A rigorous and highly effective capital regime for Fannie and Freddie can be built with just three elements: (a) a true risk-based capital requirement based on a stress test run on each company’s book of business every quarter, with no cushions or add-ons; (b) a single ‘all purpose’ capital cushion, calculated as a percentage of this true risk-based requirement, and (c) a minimum capital percentage. Fannie and Freddie’s required capital would be the greater of the risk-based amount (plus the capital cushion) and the minimum percentage.” In the same piece I also point out that there is an obvious minimum capital percentage for the companies: 2.5 percent. This is the minimum requirement already in the Housing and Economic Recovery Act of 2008 for the companies’ on-balance sheet assets, and also is the minimum in the Calabria standard—without his (excessive and unjustified) “prescribed leverage buffer”.

Given the credit quality of Fannie and Freddie’s current books of business, a true-risk based capital standard would result in required stress capital of far less than 2.5 percent, making that percentage the companies’ binding capital requirement for the foreseeable future. At this amount of capital, they again would be able to “mind the gap,” and use their positive guaranty fee gaps from lower-risk business to significantly reduce charged fees on higher-risk loans, thereby allowing many more underserved borrowers to afford homes, without falling short of shareholders’ return objectives.

Also, a known 2.5 percent minimum capital requirement would open up, and facilitate, a path for the companies out of conservatorship. At June 30, 2022, 2.5 percent of Fannie and Freddie’s total assets (not “adjusted total assets,” a concept contrived by Calabria) was $185.9 billion. Were Treasury to cancel its senior preferred stock and eliminate its liquidation preference (as it should do), the companies’ core capital as of that date would be $90.4 billion. That is only a $95.5 billion shortfall to full capitalization—not too large to overcome with a combination of retained earnings and new equity issues in a relatively short time.

Fannie Mae and Freddie Mac have been in conservatorship for nearly fourteen years. They have been “conserved,” but remain constrained and captive by the misguided policies of previous administrations. Freeing them by revising their capital standards, canceling their (fully repaid) senior preferred stock, and returning them to private ownership will not be difficult for the Biden administration to do, and would be an unmistakable affirmation of its commitment to affordable housing. It must not allow that opportunity to go to waste.

78 thoughts on “Mind the Gap

  1. @ROLG

    Any insights on the redacted opinion released today in Lamberth’s court?

    Click to access 13-mc-01288-0198.pdf

    It appears the lost value of the shares as a result of never being able to get dividends again is what shareholders can argue for damages. That lost value is evident as a result in a drop in share prices when 3rd amendment was announced and Lamberth emphasized that an expert indicated that share drop underestimated the “lost value” of the shares. Will this be a a case of determining “what was the lost value?”


    1. @juice

      thanks for the opinion cite.

      yes, Lamberth states that Ps (i) cannot claim damages for the lost stream of dividends that the NWS barred, as that would be too speculative to assess, as of the date of the NWS, what that might be, but (ii) can claim damages for the lost value of the preferred shares, if Ps can convince a jury by a preponderance (ie >50%) of the evidence that the NWS was unreasonable, given the reasonable expectations of the P shareholders at the time of contracting to buy the preferred shares.

      since this is both an individual action and a class action, all preferred shareholders, assuming a win on the merits as to the breach of implied covenant, as of the date of NWS adoption would be entitled to damages. the opinion doesn’t address whether the shareholder claims for lost value “travel” with the shares, though as a matter of Delaware corporate law, I would argue that it has to (shares represent a “bundle of rights” and, as of date of NWS, one of the share’s rights was an inchoate claim for damages for breach of implied covenant that has now matured into this lawsuit).

      what will be that lost value determination? that will be for a jury to determine. just looking at FNMAS, for example, a share went from >$2/sh to <$1/share at around the time of the NWS. Will this be the limit to the potential scope of damages with respect to each preferred share? dont forget that prejudgment interest should run from the breach date (ie 10 years). Delaware law refers to a "legal rate", which I believe is 5% over the Federal Reserve discount date including any surcharge as of the time from which interest is due, or the rate identified in the contract if less than 5% over the Federal Reserve Discount Rate. Del. Code Ann. tit. 6, § 2301.

      so there will be a trial, since Lamberth denied the government's theories (Collins SCOTUS opinion and HERA, alternatively, authorize NWS, so NWS can't be unreasonable, and hence cant be an implied breach of covenant of fair dealing) that would have thrown case out. Ps will have an opportunity to have a jury find that the NWS was unreasonable given Ps reasonable investment expectations, and if the jury so finds, determine how much value in their shares Ps suffered. and Ps will have an opportunity to appeal Lamberth's decision that Ps did not suffer damages for lost dividends, as well as lost share value.



      1. [Comment edited for tone.]

        did you read the legal opinions or understand what is being argued?

        1. lamberth ruled in the past that the claims travel with the shares
        2. if you read the opinion you will see that this is more than just price of shares lost, but the future value that would accrue to them absent the net worth sweep.


        1. @donotlose

          in this opinion, Lamberth did not address the claim-transfer-with-share question. that is all I wrote. I certainly dont remember Lamberth addressing this point previously in a manner that would be dispositive at this trial. as for what is lost share value, Lamberth does state that the Ps expert present expert testimony that the drop in value that he is going to let the jury assess, if their is a finding on the merits for Ps, is greater than the drop in the share trading price at the time of the NWS. This is a jury question as to what the “real” share value damages are that have been incurred by preferred shareholders, though Lamberth can always step in and limit a jury determination if he thinks it is unreasonable. all of this should be further addressed when Lamberth issues his jury instructions.

          you have to appreciate how uncertain trials are. is there a pathway to a trial damage calculation that would entitle preferred shareholders to par? sure, if Ps can present expert testimony that absent the NWS, the senior preferred would have been paid off at the “10% moment”, and the junior preferred would certainly be worth par from and after the 10% moment, and then you discount that par value back to the date of the NWS at some discount rate, and then add back prejudgment interest from the NWS date, etc. Will Ps present this testimony? If Ps are ready to present this testimony, will Lamberth allow it? If Lamberth allows it, will the jury buy it? This is all uncertain, especially given the extent to which filings have been sealed.

          one other point, It is not clear to me that HERA bars restitution damages, as Lamberth held. there is a difference between barring an injunction/restraining FHFA (per HERA) and using restitution as a theory to calculate contractual damages. While this should be another ground for appeal by Ps, it is a federal question and I dont see the DC Circuit being favorably disposed to Ps.



          1. I’ve now read Judge Lamberth’s unredacted Memorandum Opinion released yesterday, and my main reaction to it is that his grant of summary judgment on the defendants’ claim that plaintiffs “lost dividends” theory is “speculative and conjectural” and thus “cannot be the basis for recovery” will make it very difficult for plaintiffs to win more than a token award from the damage theory that survived the summary judgment motion–for the “lost value” suffered by Fannie and Freddie junior preferred and Freddie common stock as a result of the net worth sweep.

            The simple reason is that the main driver of the value of junior preferred shares (and, to a lesser extent, common stock) IS the fact that they pay dividends. Plaintiffs’ expert, Professor Joseph Mason, made four arguments for why his clients should receive lost dividends caused by the net worth sweep. As summarized by Judge Lamberth, they were: “First, the federal government has historically allowed prompt repayment of emergency financial assistance it has given to companies in times of financial crisis; second, allowing a paydown would have served the conservatorship’s goal of returning the GSEs to stability and normal operations; third, a paydown would serve Treasury’s financial interests by resulting in the prompt return of the money it loaned to the GSEs and maximizing the value of its stock warrants; and fourth, continuing to prohibit a paydown would have been politically unpopular because the GSEs would have built up substantial capital while still owing taxpayers billions of dollars.” Lamberth dismissed all of these, saying, “The flaw in plaintiffs’ argument is that it requires the jury simply to GUESS how Treasury and FHFA would have balanced their obligations to different stakeholders and responded to financial and political incentives in a counterfactual world,” adding, “Even a good guess would require an inherently speculative logical leap that could not result in the reasonable certainty that Delaware and Virginia law require as to damages.”

            I find it difficult to see why Lamberth’s skepticism about the validity of plaintiffs’ arguments for historical dividends also wouldn’t apply to the same arguments made for dividends being turned on at some point in the future. And without credible prospects for future dividends, it’s hard to claim very much in damages on either the junior preferred or the common as a result of the net worth sweep. The real harm to both shares, following this line of reasoning, was caused by the original and highly onerous terms of the Senior Preferred Stock Purchase Agreements with Treasury, which aren’t being challenged in the Lamberth court.

            The one silver lining in this dark cloud is that the facts behind the imposition of the net worth sweep by Treasury and FHFA still would be put forth by plaintiffs in Lamberth’s court, as the basis for why there WAS harm to Fannie and Freddie shareholders, however defined and valued. That will be a positive development, with implications for other cases, and perhaps administrative reform that would include a voluntary cancellation of the sweep and the liquidation preference by Treasury.

            Liked by 2 people

      2. Tim / ROLG

        Seems to me that although we’re not entitled to lost dividends that were effected by NWS, we are entitled to pursue damages as a function of loss of share price. Share price (as Tim observes) is affected by loss of dividend potential, (which was effected by NWS). Yes, our claim to loss of share price is *related* to dividend loss, but it is not obvious to me that such a claim for loss of share price should be disallowed due to it being merely related to dividends. After all, to recognize our loss of share price on that basis is not to seek loss of dividends, which is what is disallowed. Thoughts?


        1. Ron–Judge Lamberth explicitly HAS allowed loss of value damages to be claimed (assuming plaintiffs can show that FHFA and Treasury unreasonably violated shareholder expectations by agreeing to the net worth sweep); the question is, how does one define those damages if one can’t argue successfully that dividends would be turned on at some point absent the sweep? That will be up to the jury to decide (guided by instructions from Lamberth), but without dividends I can’t see how it would conclude that Fannie and Freddie junior preferred are worth too much more than they’re trading at now.


          1. Based on ROLG and Tim’s thoughts above, it appears Lamberth’s instructions to the Jury at trial will be highly informative.


          2. Tim

            Lamberth distinguishes between loss of dividends and loss of value, which is a somewhat curious distinction since as you point out the former affects the latter. the main reason he gives for not allowing the jury to decide the former is that the jury would then have to read the minds of FHFA/Treasury actors regarding what they would do re junior preferred dividends at various points in time, and this was too speculative for him to allow the jury to consider. of course, presenting evidence as to future value is also speculative but Lamberth has permitted this…it may just be that Lamberth is somewhat at sea when it comes to financial matters, as I suspect the jurors will be too.

            but the future value door has been left open by Lamberth and Ps should march smartly right through it. I believe Ps will put Fannie CFO Ms. MacFarland on the stand to testify as to the GSEs being about to enter their golden era of profitability, which should help to convince the jurors that there was bad faith at play at the time of the adoption of the NWS by FHFA/Treasury. but sometimes testimony can play a doubleheader, as it were, and help the jurors to see that the expectations of future value were significant, because of this golden era prospect. if Ps can get jurors to see Ps as the good guys and FHFA/Treasury as the bad guys, then juror calculation of future value may take on aspects more of a morality play than precise financial analysis.



          3. Tim – you are correctly pointing out the conundrum: How to define the “lost value” without speculatively referring to dividends turning back on?
            I would like to offer one possible approach:
            1. before the NWS, there was the reasonable expectancy that, at some point, the companies would exit conservatorship, recapitalized. For Preferred Shareholders, this means that EVENTUALLY dividends would resume and shares would be worth roughly par value.
            2. after the NWS, any such chance is gone forever.
            3. it results for FNMAS specifically, that eventually shares eventually would be worth 25$, but are 0 after the NWS.
            4. we know for a fact that Treasury knew that the companies would turn profitable just before the NWS, so that is not speculation. And Treasury even had its own projections at that time, showing the companies would be recapped by like 2029 if I remember correctly?

            5. discounting @5% p.a., 25$ by 17 years, from 2012-2029 gives us roughly 42% of par value, or around 10$ per FNMAS.

            note, this method does not need to speculate when dividends would turn back on, but it just says “this is Treasury’s own best guess at the time of the NWS, so this is what they KNOWINGLY took from us”. value lost = value taken by Treasury

            add judgement interest @6% p.a. for 10 years 2012-2022 gives us a total of around 18-19 $ per FNMAS, or roughly 75% of par. sounds around fair?

            Liked by 1 person

          4. Tim,

            Thank you for sharing your thoughts and if I may challenge your main point that plaintiffs will only be entitled to minimal damages based of your comments in your 2 recent posts. First recall this contracts case is about both our dividend and liquidation rights (not just dividends).

            Re: dividend rights: I read Lamberth’s ruling to mean that while shareholders cannot speculate with any reasonable certainty that they would have been DEFINITELY receiving dividends, that is a big difference vs there being SOME POSSIBILITY at some point in the future that shareholders would have expected to be receiving dividends. Plaintiffs dividend model presented by Dr. Mason relied on shareholders actually RECEIVING dividends, which is where Lamberth draws the line because they can’t prove that with any certainty. You can infer this by reading the opening passage of the section that allows shareholders lost-value theory to proceed, “… plaintiffs suggest an alternative theory of harm: that the Third Amendment, by eliminating any possibility of future dividends for non-Treasury shareholders, deprived plaintiffs’ shares of much of their value, even if such dividends were not reasonably certain to occur in the foreseeable future.” The key here is “any possibility of future dividends”, so while plaintiffs can’t speculate they would have received dividends with certainty like the dividend model presented, they are allowed to speculate that there is a possibility at some point in the future to receive dividends, and that’s well within their reasonable expectations. This is where Lamberth draws the line, and if your interpretation was correct, he would have simply tossed this damage model out for the same reason he tossed the dividend model out as you allude to.

            Re: Liquidation rights: You bring up a good point, what are the shares really worth without any possibility of future dividends assuming you disagree with the above? The answer is liquidation rights. The NWS not only eliminated shareholders dividend rights, but their liquidation rights as well because all the net worth was being swept to the Treasury leaving no cash for anyone else (there are actually examples in the market today of pfd shares trading at 70-80% of par while dividends are turned off because if its liquidation value). Lamberth elegantly discussed this in his Sept. 2018 motion to dismiss ruling, “The Net Worth Sweep -however- is fundamentally different than Treasury’s right to veto capital distributions. For one thing, if Treasury withheld approval for a dividend to plaintiffs under the original terms of the PSPAs, that available cash on hand would not simply be handed out to Treasury. One would expect that cash to increase the value of Plaintiff’s underlying securities either by way of reinvestment into the company or reduction of debt. The Net Worth Sweep does exactly the opposite. It decreases the value of all securities other than the PSPAs by eliminating the possibility of profits accruing in any way to their benefit.” This is Lamberth discussing your main point (what value would plaintiffs securities have without any dividends? and he lays it out for us, that cash would have still been accruing to shareholders benefit, instead it was being swept away to only treasury’s benefit, and he says that fact “decreased the value of all other securities other than the PSPAs”

            To recap- The only speculation off-limits according to Lamberth because neither of them could have been concluded using reasonable certainty is 1) senior pfds would have been paid down and 2) dividends would have DEFINITELY been paid. But according to Lamberth, we can still speculate on other things in damages, as he explains in the summary judgement ruling, “The amount of damages can be an estimate … When it is certain that substantial damages have been caused by the breach of a contract, and the uncertainty is not whether there have been any damages, but only an uncertainty as to their true amount, then there can rarely be any good reason for refusing all damages due to the breach merely because of that uncertainty.”

            Bringing this all together, what can plaintiffs possibly ask for in damages? I’m only speculating and I’m guessing the class action lawyers will be able to put together a much more compelling case than this simple example, but I believe based off everything discussed above Plaintiffs will be able to argue that the NWS eliminated and extinguished the possibility of any possible dividend and liquidation value going forward, and you can reasonably speculate that by just looking at the position the GSEs would be in today if the NWS wasn’t in place. The GSEs would have roughly ~$160b in net worth today, and growing $5b-10b a year accruing to shareholder’s benefit net of paying Treasury their $19b 10% dividend, placing shareholders on a path to one day reap the benefits of our contracts that were breached (which extinguished that possibility). The key here again is this makes no assumptions about what Treasury would have done with re: 1) its senior pfds or 2) approving dividends to other shareholders, which is where he draws the line.

            Apologies for the long length!


          5. Michael and “Unfortunate SCOTUS”–We’ll see what plaintiffs’ counsel comes up with as a rationale for damages under the framework adopted by Judge Lamberth, but there are some parameters that will govern what can reasonably be claimed. Had there been no net worth sweep, both Fannie and Freddie would have continued to pay 10 percent after-tax on their $187 billion of senior preferred stock though 2015, and $190 billion of senior preferred after that. Between 2012 and 2014 both companies would have seen a very large jump in retained earnings when most of their FHFA-induced book losses from 2008 to 2011 reversed and came back into income (I don’t have the exact amount at my fingertips), but after that the $19 billion per year in net worth sweep payments would have eaten up most of their retained earnings. Only recently–now that the companies’ combined annual net income is consistently exceeding $20 billion after-tax per year–would they have begun adding (very modestly) to their retained earnings. But with their $190 billion in Treasury senior preferred not counting as regulatory capital, their actual core capital would still be negative, and they would be over $400 billion short of the capital requirements set for them by Director Calabria. Neither the junior preferred nor the common dividends could be turned on until the companies were adequately capitalized, and without access to the capital markets and a $19 billion annual SPS dividend payment this would take literally decades to accomplish. As I noted earlier, this damage was inflicted upon the companies by the SPSPAs, which are not being challenged. Defendants know this, and they will argue accordingly.

            I don’t mean to appear negative, but it’s important to be realistic about the hurdles plaintiffs’ counsel face if they can’t argue that the SPSPAs could be cancelled, repaid or unwound at some point.


          6. ” Had there been no net worth sweep, both Fannie and Freddie would have continued to pay 10 percent after-tax on their $187 billion of senior preferred stock though 2015, and $190 billion of senior preferred after that. Between 2012 and 2014 both companies would have seen a very large jump in retained earnings when most of their FHFA-induced book losses from 2008 to 2011 reversed and came back into income (I don’t have the exact amount at my fingertips), but after that the $19 billion per year in net worth sweep payments would have eaten up most of their retained earnings.”

            Hamish Humes (part of the class action legal counsel), ran the math on this in the takings SCOTUS petition earlier this year. He calculated the GSEs retaining $149.4b in total as of Q1 ’22, “Accordingly, one approximation of the excess value transferred thus far to Treasury as a result of the Net Worth Sweep is $149.4 billion ($324.2 billion received under the Sweep minus $174.8 billion of 10% dividends payable absent the Sweep).” In this scenario the senior preferred liquidation preference would have remained at $187.4b through out since they would have cash on the balance sheet at the time they had to draw an extra $3b in 2018, so the GSEs would owe $18.9b a year in dividends to the Treasury.

            This is where the liquidation value comes into play, even absent future dividends, assuming ~$27.5b/yr in earnings going forward, the GSEs pfd shares would start being covered by the net worth retained in 2026 and fully covered approximately 6 years from now by the end of 2028 (>$220.6b which is $187.4b of senior pfds + $33.2b of jr pfds). The NWS extinguished the possibility of having any liquidation value and a damage expert can model out what the value of jr pfd shares that would be fully covered in liquidation but don’t currently pay dividends are worth in the market, but its surely worth more than 10% of par (there are actually examples in the market today of pfd shares trading at 70-80% of par while dividends are turned off because if its liquidation value). One could simply discount that figure back to present value using an appropriate discount rate, apply interest penalty on top, and voila, there are your damages ex dividends.


    2. I believe the Rop verdict was just released.


      “We reverse the district court’s holding that shareholders’ Appointments Clause claim poses a nonjusticiable political question. Addressing the merits of that claim, we hold that Acting Director DeMarco was not serving in violation of the Appointments Clause when he signed the third amendment, so dismissal of this claim was appropriate. We remand to the district court to determine whether the unconstitutional removal restriction inflicted harm on shareholders.”


      1. The Sixth Circuit Court of Appeals has ruled that “Ed DeMarco was not serving in violation of the Appointments Clause when he signed the third amendment” because “Congress vested the President with the authority to unilaterally designate an Acting Director in the Recovery Act. President Obama designated DeMarco as Acting Director in compliance with the Recovery Act. DeMarco’s service terminated, in accordance with the Recovery Act, upon the appointment of the new Director. Therefore, we find no violation of the Appointments Clause.”

        The “bottom line” impact of this ruling is that the net worth sweep will not be unwound, because DeMarco was not serving in violation of the Appointments Clause when he agreed to it. The remand to the district court “to determine whether the unconstitutional removal restriction [found by the Supreme Court in the Collins case] inflicted harm on shareholders” is substantively identical to the remand by SCOTUS to the Fifth Circuit District Court for the same purpose.

        Liked by 1 person

        1. Tim

          I have not read the opinion, but it is not clear to me why congress’s vesting in POTUS the power to designate an acting director under the recovery act doesnt violate the US Constitution, which requires principal officers to be nominated by POTUS and consented to by Senate. if the recovery act is inconsistent with the constitution, why should the recovery act prevail? I dont remember this reasoning being argued by government in oral argument.



          1. ROLG–It may not make sense to you, and the government may not have argued it, but that was the ruling of the appellate court. And in response to the question by “Big Bruce”, I believe there is no chance the Supreme Court would grant cert on an appeal of this ruling. As I noted in my post about its ruling in Collins (“An Unexpected Ruling”), I believe the six conservatives on the Court have fully bought into the Federalist Society’s animus against Fannie and Freddie (and the three liberals don’t challenge it), and that this explains not only the contorted ruling on the APA claim in Collins but also why the Court will be very happy to let this ruling by the Sixth Circuit Court of Appeals on the Appointments Clause stand, whatever its flaws.


  2. Tim

    Fannie’s book grew 1.1% annualized as of 8/22. I wonder whether the GSEs are entering a period where capital requirements can be expected not to grow substantially, as total guarantee liabilities will not grow substantially in near term given high mortgage rates, but that net income will remain robust (absent credit losses from a serious recession), permitting capital to accumulate steadily to get the GSEs closer to the capital requirement (putting aside for the moment that the capital requirement is improperly excessive). The downside to a rapidly growing book is the commensurate rapidly growing capital required, exacerbated by the GSEs being shut out of the equity markets and unable to raise equity capital. perhaps the GSEs will be able to take a temporary breather from this business book/capital increase conundrum.



    1. While Fannie’s annualized book growth in August was 1.1 percent, Freddie’s was 7.2 percent, and since June the compound annual growth rates of the two companies’ books have been 0.9 percent and 5.4 percent, respectively. That’s an unusually wide growth differential, and a likely explanation for it is that Fannie is charging a fee for loans originated by brokers (which historically have performed notably worse than loans made by institutional lenders) whereas Freddie is not. Freddie’s less defensive pricing for brokered loans may have been because it intended to offload their risk to CRT buyers. If so, that pricing soon should change, since the CRT market has gone into hibernation (as Freddie’s executives almost certainly are aware).

      That said, Fannie and Freddie’s combined business growth since June, at 2.7 percent, IS much slower than it had been, and I suspect it will slow even further (if not decline) due to falling home prices in many regions and a much less healthy home purchase market. This, as you point out, will keep Fannie and Freddie’s required capital from increasing much because of business growth. Yet as I noted in a comment made on September 13 (below), their required capital may now start rising for two other reasons: rising mark-to-market LTVs because of flat to falling home prices, and less credit for CRT coverage because the pricing for new issues has deteriorated dramatically. And now there is a third factor that could impede capital retention in the near term: the potential for both companies, under current expected credit loss (CECL) accounting, to make significant additions to their loss reserves to cover possible credit losses from Hurricane Ian (we should know this when they release their third quarter earnings at the end of this month).


  3. Dear ROLG or Tim: Any thoughts on the progress in Lamberth court? He recently put in his order on summary judgement denial and grants. It looks like we will be proceeding to trial, which is great. But the damages are what is in question. It seems the model which will be used for damages is under seal. Any thoughts on how that would be calculated if we prevail?

    Liked by 1 person

      1. @Tony/JB

        right now there is a lot of motion practice going on as to what witnesses may be put on the stand and what the parties can introduce into evidence. so Lamberth will have a great deal of influence on the manner in which the trial unfolds, based upon his decisions with respect to the pretrial motion practice. so before the trial starts, Lamberth will have a great influence on how the trial can be conducted by the parties.

        once the trial starts, assuming it is 10/17, I would expect it to take two weeks or so…but once the trial starts, much of the work is out of Lamberth’s hands. this is a jury trial and it is up to the jury to decide, and how long it takes for them to decide. Lamberth can always issue a “directed verdict”, deciding the case himself and taking it out of the jury’s hands, but that would be very unusual.


        Liked by 1 person

    1. @Tony

      almost all filings have been under seal, so there is not much anyone can say, other than Lamberth’s order today states that, as to remedies, recession and restitution are barred “as a matter of law”…these remedies would be preferred imo, and why he found them barred is sealed. I can say that FHFA’s motion for summary judgment, on the theory that SCOTUS’s opinion in Collins authorizes the NWS so that there can be no breach of implied covenant of fair dealing, apparently was denied…which is a big win for plaintiffs in being able to argue the merits…as to what damages a win on the merits will entitle plaintiffs, I simply cant tell from the filings and docket.


      Liked by 1 person

      1. ROLG,
        I am no expert, and certainly no attorney, but you used the terms “recession” and “restitution” in terms of remedies. Understand the “restitution” model. Do NOT know “recession”.

        Did you mean: What Are Rescission Damages? A judge may rule that a contract was unfair or misrepresented certain facts but choose not to nullify it. Instead, the judge may award monetary damages that must be paid by the offending party to the injured party.

        Thought is was either “expectation(ary)” or “restitution” damage models.

        Briefly what is “recession” model of damages, and if EITHER of these models are barred “as a matter of law” what damages model COULD be calculated IYO? If ‘Rescission” who would be the offending party? Fannie & Freddie or FHFA &/or Treasury?

        TIA, VM


        1. in short, rescission would invalidate the NWS. restitution would put Ps (all shareholders as well) where they would have been if no NWS had been adopted. this has been ruled out. the question I have is what if these named Ps win? I believe they get a personal award of money, forget for a moment how much, how calculated and who pays. what happens to the rest of the shareholders? well, perhaps they can bring some sort of class action claiming collateral estoppel (saying we should win too since were are similarly situated, same facts, same questions of law, no need for a full trial), and seek the same damage award for themselves as well…but there is such a thing as the statute of limitations (S/L) which has lapsed on this claim…but could a follow on action be brought by all of the other shareholders based upon a win in this Fairholme action? can all other shareholders follow on notwithstanding the S/L? not sure



          1. Be-Jesus. This has been addressed b4 and is somewhat of a ‘nightmare scenario.’

            IYO is there a chance ONLY the NAMED Plaintiffs get ‘relief’, and everyone else is shafted b/c the S/L has expired? There are many who would jump off a bridge at such a prospect. There has been speculation that there were some very creative and well-versed lawsuits already brought and ‘paid off’ due to the Named-Plaintiff issue. Say it ain’t so……..

            Was originally referring to speculation that damages would come from F&F, and not from FHFA/Treasury thereby actually making F&F ‘weaker’ through a direct hit to the Corporations’ Capital. That would be unfortunate since that would directly weaken F&F itself and by extension any Commons claim and the future stability of F&F. Again, say it ain’t so……



          2. This is a class action. I don’t understand why you think that only the named P’s win something. the “genuine dispute of material fact remains on the fact of harm on the theory that plaintiffs’ shares lost much of their value, and in all other respects”

            this stems from/ties to lamberth’s 2018 ruling: “For one thing, if Treasury withheld approval for a dividend to Plaintiffs under the original terms of the PSPAs, that available cash on hand would not simply be handed out to Treasury. One would expect that cash to increase the value of Plaintiffs’ underlying securities either by way of reinvestment into the company or reduction of debt. The Net Worth Sweep does exactly the opposite. It decreases the value of all securities other than the PSPAs by eliminating the possibility of profits accruing in any way to their benefit.”

            I think that there are still compensatory / punitive damages on the table, but you’re the lawyer here.

            Liked by 1 person

          3. I have a more basic question for ROLG or anyone similarly situated. When Lamberth uses the word “value” as in “shares lost much of their value”, is he referencing a specific and limited instance of transient share price (e.g., shares went from $x price to $y price and lost value)? Or, is he referring to a more general concept of the value of what the shares (i.e., contracts) represent, such as liquidation preference, place in the capital structure, etc.? Alternatively, perhaps it’s not so clear and this is something for the jury to decide. Thanks


          4. @donotlose

            ok, 13-1288 is the class action, and it is consolidated with 13-1053 and 13-1349 (individual plaintiff cases). I had thought the class action was severed, but I now see that Lamberth’s order denying summary judgment applies to all three actions. so all three cases, including the class action, are consolidated and going to trial. sorry for the confusion.

            so all preferred shareholders stand to win damages on a win on the merits.


            again, since so much of what the parties have briefed and what Lamberth has decided and written is under seal, I dont know what Lamberth has held as to available damages.

            Plaintiffs have alleged that the implied covenant breach has denied plaintiffs (all preferred shareholders) their ability to receive dividends and their liquidation preference, causing billions of dollars of damages.


            Liked by 2 people

    1. I found one aspect of this article particularly “interesting.” I’ve been reading articles about Fannie and Freddie in The Washington Post (and The Wall Street Journal) for over four decades, and I cannot recall a single one that reported on the facts of their business objectively. This one does. And I think there is a very simple reason for that: the beneficiaries of this journalistic objectivity are not the companies themselves, but their shareholders.

      Right after I published my book (which is now close to nine years ago!) I made a number of attempts to get the Post, the Journal and The New York Times to print op-eds whose intent was to make the public aware of key, verifiable facts about the history and business practices of Fannie and Freddie. I was unsuccessful at getting any of them published–even when I asked people who knew the op-ed editors personally to contact them on my behalf. I concluded from this experience that the major media outlets had no interest in giving visibility to facts or opinions that countered the fictions about the companies promulgated by what I call the Financial Establishment, because they did not want to offend the large companies or interests that were major advertisers or sources of information for their business and financial stories. And this hasn’t changed. On more than one occasion in the past few years, I have approached journalists for whom I have great respect (no names offered) with what I pitched as compelling stories related to how Fannie and Freddie were being treated. Each time, the response was “I think this is very interesting, but…”, with the “but” being some version of “old news” or “too complex a story for my readership.”

      The Lamberth case presents none of these obstacles. Here, the “good guys” are shareholders, whom the financial press loves and caters to, while the “bad guys” are the government–Treasury and FHFA, who agreed to the net worth sweep, taking the shareholders’ money. So, for me, the most interesting aspect of today’s WaPo story (which wasn’t in the print edition, since it has a time stamp of 8:55 am) is that reporters CAN write an objective story about Fannie and Freddie-related matters if they want to; they just almost never do.

      Liked by 4 people

      1. That is the most stunning indictment of journalistic integrity I have read in many years. I know the other side of the conservatorship story was being ignored, but I had no idea you had tried so hard to get some resemblance of balance.

        Somehow I think this might well be a one-off. We’ll see. I would also like to know if it makes it into the print edition. Hard to find it in Arkansas.

        Liked by 1 person

        1. To respond to Jeff Wood’s question, this article by a reporter with a Bloomberg byline that appeared electronically under a Washington Post banner yesterday morning was not in today’s print edition of the Post. That’s not to say it may not appear on some later date–this happens on occasion for articles that don’t have a “news peg”–but it wasn’t there today.


  4. Tim

    We seem to be entering a period of rather low unemployment and relatively high interest rates (compared to last 10 years…end of year fed funds rate is expected to be >400bps…https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html).

    it seems to me that as long as the unemployment rate stays relatively low, the GSEs’ credit losses will remain relatively low, and as interest rates rise the GSEs’ refinance activity will trend to nil, reducing earnings but not otherwise resulting in higher credit losses.

    Is this how you see things (understanding that you have a bias against speculation)? this would imply that over the next 24 months, where we experience the most highly anticipated recession in my memory, employment layoffs would be the most important factor to focus on…and job openings are still well in excess of unemployed seeking work, at least currently. assuming we don’t see a systemic financial meltdown, the odds of which I believe to be low, I expect the GSEs to do well enough through this recession at current capital levels.

    all this to say that I anticipate the GSEs’ performance through this recession should put to rest the GSE skeptics’ argument that the GSEs require bank-like capital.



    1. The impacts of higher mortgage rates are interesting. Based on the new disclosure schedules in the 10-Qs, GSE leverage-based requirements are ticking up, but GSE risk-based requirements are actually ticking _down_. Apparently b/c LTVs and risk-based assets are coming down as the mortgages amortize without being replaced by new high LTV originations/refi. A surprising secondary effect of higher rates!


      1. You are correct that the component of Fannie and Freddie’s required risk-based capital that is derived from FHFA’s calculation of their “risk-weighted assets” has been coming down–modestly for Fannie (from 2.69 percent of total assets at June 30, 2020 to 2.47 percent at June 30, 2022) and quite significantly for Freddie (from 3.13 percent of total assets at June 30, 2020 to 2.16 percent at June 30, 2022). The sharp drop in Freddie’s risk-weighted capital component is hard to believe–particularly when contrasted with what’s happened to Fannie’s over the same period–but unfortunately FHFA gives no explanation of how it derives “risk-weighted assets” for either company, so we’re left to guess. My guess would be that for Fannie, the positive effect on their risk-weighted asset total caused by higher home prices (and thus lower mark-to-market LTVs) has been partly offset by the fact that a lower portion of its book this June was covered with CRTs than was the case two years earlier. For Freddie, their risk-weighted asset total has benefited from both lower mark-to-market LTVs and a continued increase in the portion of their book covered by CRTs.

        Both of these factors, though, are about to start working in the other direction. FHFA’s index of national home prices rose only by 0.1 percent in June (1.2 percent at an annual rate), and in the last few months the pricing spreads on new CRT issues have soared, as investors have become concerned about how flat to declining home prices might affect the loss rates on the new vintages of loans the companies are guaranteeing (investors buy CRTs to receive interest income, not to absorb credit losses). With home prices now likely to be flat at best–and the LTVs on new originations in the mid-70s–the mark-to-market LTV of both companies’ books will now start rising, and will do so for the foreseeable future. And with little or no new CRT issuance, the CRT “coverage rate” for each company will begin falling. Both developments will increase their risk-weighted capital component going forward, causing their required capital to rise faster than their asset growth.

        I also agree with ROLG that we’re likely to see only modest credit losses during the coming mortgage credit cycle, and that as this unfolds it SHOULD have an effect on how policymakers think about the amount of capital required to keep Fannie and Freddie safe and sound. Of course, it shouldn’t take actually going through a credit cycle to make that point. The two factors that will make the next cycle so manageable for Fannie and Freddie are obvious now–the much more favorable dynamics of the mortgage market today compared with leading up to the financial crisis, and the companies’ very strong annual earnings of around $30 billion pre-tax per year.

        In contrast to what happened leading up to the financial crisis–when home prices were driven up to unsustainable levels by borrowers given nearly unrestricted access to mortgages by a private-label securitization system in which none of the participants had any “skin in the game”–the soaring home prices of the past two years were the result of well-qualified borrowers taking advantage of record-low mortgage rates (kept too low too long by the Federal Reserve, I believe) to chase after new and existing homes that better suited their needs (which changed during the pandemic) or that they thought would be good investments. Even if home prices fall from here–which they likely will–very few of those borrowers will default; they’ll ride it out, with the help of their very low-rate 30-year fixed-rate mortgages.

        And it’s also easy to forget how much more profitable Fannie and Freddie are today compared with fifteen years earlier, while many don’t realize how long it takes for the mortgage foreclosure process to play out. As I noted above, Fannie and Freddie are making $30 billion pre-tax per year, and mortgages don’t foreclose quickly. In the financial crisis cycle, home prices peaked in the second quarter of 2006; Fannie and Freddie’s credit losses didn’t peak until four years later, in the second quarter of 2010. In the next cycle, with much more favorable market dynamics, the long-range nature of the foreclosure process, and Fannie and Freddie’s impressive profitability, I can confidently say that there is ZERO chance the companies will come anywhere close to needing to touch their capital bases to cover their credit losses. That should be common knowledge now, but it unfortunately is not.

        Liked by 3 people

    1. Layton concludes, for GSEs combined:

      Stress-based capital requirement = $5 billion modeled stress loss + $77 billion going-concern buffer + $45 billion countercyclical buffer = $1 2 7 billion.


    2. The positive aspect of this Layton piece is that he does call for significantly lower capital requirements for Fannie and Freddie than they currently must hold under the Calabria standard, or ERCF. As he says early on, “I show how the stress test result–i.e, a $4.5 billion loss for the two GSEs combined [in 2022, including an indefensible $20.2 billion write-off of deferred tax assets]–is consistent with a level of required capital for the GSEs that is conservatively calculated to be in the $120-135 billion range.” Using Fannie’s and Freddie’s combined June 30, 2022 total assets of $7.435 trillion, that would be a percentage requirement of between 1.61 and 1.82 percent. This is considerably lower than the 2.5 percent minimum I’ve suggested, so from that standpoint it’s a definite plus.

      But the negative aspects of the piece are that it’s still (despite Layton’s disclaimers) too bank-based, and it’s too disconnected from the actual risks of the companies’ business (that is, there’s too much “this looks about right” in it) to be anything policymakers could use as a basis for recapitalizing Fannie and Freddie.

      Layton gets to his final capital percentages by estimating the appropriate amounts for a “going concern” buffer and a “countercyclical” buffer. He correctly points out that the going concern buffer had its origin in banking regulation, where post-financial crisis regulators realized it wasn’t enough for banks just to be able to withstand stress credit losses, they also had to capitalize against their significant liquidity risk, given that their assets had much longer durations that their consumer deposits and purchased funds, and consequently they were subject to a “run on the bank.” Layton does note that Fannie and Freddie do not have this risk to any significant degree, yet he still uses the bank-based 200 basis points as his starting point for coming up with what he claims should be the right amount for this buffer for the companies. His recommended $77 billion going concern buffer, he says, is the average of banks’ 200 basis points and the 75 basis points in the Calabria standard–except it’s not, even taking into account Layton’s use of “adjusted total assets” as the base of his percentage calculation and my using total assets. As of June 30, 2022, $77 billion would be 104 basis points of the companies’ total assets, and 91 basis points of their “adjusted total assets.” And both percentages are HIGHER than in the Calabria standard, because Layton is giving half weight to the banks’ 200 basis point “run on the bank” requirement that is not applicable to Fannie and Freddie.

      If you look at the capital tables in Fannie and Freddie’s first and second quarter 2022 10Qs, they both have a line labeled “countercyclical capital buffer.” For both companies, the number for that buffer is zero in each of this year’s first two quarters. Layton, though, has HIS view of what a countercyclical buffer should be. I won’t go into its derivation in detail (read the paper if you’re interested), but it’s another idiosyncratic “here’s another way to do this” element, similar to his approach to the going concern buffer. Adding his $45 billion countercyclical buffer to his $77 billion going concern buffer–and the $5 billion in stress losses (which should be a gain of $15 billion, without the $20 billion DTA reserve) gets you to a capital requirement of $127 billion– the center of his $120 to $135 billion range.

      So while I like where Layton ends up, I don’t like how he gets there. And that means I also don’t like his paper. Everyone has been making up capital standards for Fannie and Freddie since they were forced into conservatorship. But as I said in my current post (and in “Capital Fact and Fiction”), there’s no need to do that. Just run an honest stress test–with no add-ons, cushions or buffers–each quarter, add a single percentage cushion for conservatism, and subject this risk-based percentage to an overall minimum percentage. The role of this minimum is to be a countercyclical buffer in good times, such as today; there’s no need to fabricate another one. I personally think 2.5 percent is much higher than Fannie and Freddie’s minimum needs to be, and in fact, the first recommendation I made for it–in an essay I did for the Urban Institute in 2016 titled “Fixing What Works”–was 2.0 percent. But I don’t think that will be acceptable to a broad enough group of opinion leaders to play the role it needs to play now–which is to help break out of the “Calabria capital standard straightjacket” the companies currently are in, and get them out of conservatorship and recapitalized. I believe my approach– a real stress test plus a cushion, and 2.5 percent capital no matter what–could do that. Layton’s, no.

      Liked by 4 people

  5. TH,
    Do you see any possibilities for settlement &/or resolution/restitution specifically due to the ‘imminent’ ROP case decision and Lamberth’s upcoming trial?
    Do either (or both) of these cases provide the best current (legal) possibility to initiate any meaningful change that Congress/FHFA/Treasury/White House would participate & possibly implement any of the recommendations you have mentioned?
    Several detailed Seeking Alpha articles have been touting the possibilities.
    TIA, VM


    1. I can understand why investors or analysts might want to speculate about how the cases relating to the net worth sweep that remain outstanding might be resolved in favor of the plaintiffs, but that’s not something I do, other than state (as I have frequently) that a verdict in one of them favoring the plaintiffs could provide Treasury with useful political cover for canceling the sweep and its liquidation preference, which is a sine qua non for the companies to be able to recapitalize. Having said that, though, I do have some thoughts on how the Rop and Lamberth cases might play into this process.

      The Rop case poses a direct threat to the net worth sweep, by challenging the appointments clause that put acting director DeMarco in a position to agree to it. Depending on the precise nature of the ruling—and any instructions given to the lower court about how to implement it—a finding for the plaintiffs in this case easily could jolt the government into beginning talks on a settlement (and in that event, I would hope my recommendations would be used in structuring it, since they are easy to implement and benefit both sides.) The Lamberth case, in contrast, requests monetary damages. Defendants’ Pretrial Statement states, “The payment of any damages award that you make in this case will be the sole responsibility of Fannie Mae and/or Freddie Mac.” If Judge Lamberth agrees with that (I would have thought that the breach of contract and violation of implied covenant of good faith and fair dealing liabilities in the case would attach to FHFA, not the companies), then the government would have little if any incentive to settle, since it would not be on the hook for the awarded damages. But a ruling by Lamberth that FHFA must pay damages WOULD, in view, likely cause the government to try to settle.

      In either case, though, we really need to wait to read the specific verdicts, with associated details, before we’ll have a good idea as to the role they might play in creating a definite path towards ending Fannie and Freddie’s conservatorships.

      Liked by 1 person

        1. This is why I don’t like analyzing hypotheticals; if there isn’t a way to enforce a judgment that the government must pay for an illegal action committed by an agency of the government–leaving it to the companies supposedly being “conserved” by FHFA to pay the damages–then a plaintiff victory in Lamberth would make junior preferred holders of Fannie and Freddie, and common holders of Freddie, better off by some amount (still to be determined), while putting the companies in a deeper capital hole (Freddie more so than Fannie), and providing no incentive from Rop for Treasury to cancel the sweep and liquidation preference.

          Liked by 1 person

    1. “Given the existing level of capital at the two companies, the probability of taxpayers having to inject more funds into the GSEs is approaching levels that I believe are so small they cannot be statistically measured.”

      Liked by 1 person

      1. “Part 2 of this series will examine how the stress test results are incompatible with the formal regulatory requirement for GSE capital, leading to the conclusion that the regulatory requirement is far too high and needs to be significantly revised lower.”

        Liked by 1 person

      2. I’m glad Layton is publicizing the latest Dodd-Frank stress tests, although his analysis continues to be off-point in (the same) places.

        He cites five reasons for the large drop in the stress losses on Fannie and Freddie’s combined books between December 31, 2013 and December 31, 2021: (1) Working through elevated credit losses on an accelerated basis; (2) banning non-QM products and generally better credit policy; (3) developing and implementing credit risk transfer; (4) the mandated investment portfolio reduction, and (5) the good fortune of rising house prices. Of those, 1, 2, and 5 are indeed causal factors. Adding CRTs to the list, however, is wishful thinking on Layton’s part. As we can read in FHFA’s stress test summary, Fannie and Freddie’s combined provision for credit losses (which represents credit losses during the test plus losses “in the pipeline,” that would be booked after the test’s end date) was only 47 basis points of their total assets. Since the very large majority of companies’ CRTs don’t even begin to pay off until losses exceed 50 basis points of the initial pool balances (and then continue to provide “coverage” up to 350 or 400 basis points of the pool balance), CRTs can’t possibly be the reason Fannie and Freddie’s stress loss rates have fallen to 47 basis points (and they’re not). Similarly, forcing the companies out of the portfolio business hurts their stress resistance, since it deprives them of portfolio spread income that helps absorb credit losses during times of stress (as occurred in the quarters following the financial crisis).

        Liked by 1 person

        1. Tim

          Layton, who should know whereof he speaks as a former CEO of Freddie, states in his essay that “While public disclosure of how much risk has been transferred from the GSEs to investors by such transactions is limited, I roughly calculate that between one-fourth and one-third of the credit losses projected by the stress tests were transferred via CRT”.

          He footnotes this statement with “Risk transfers were also done on an economically efficient basis, i.e. not requiring undue payment to the investors for their taking on the risk. As a result, CRT is a win-win: reduced risk to the GSEs and the taxpayers supporting them, and no higher cost of mortgages.”

          You say “As we can read in FHFA’s stress test summary, Fannie and Freddie’s combined provision for credit losses (which represents credit losses during the test plus losses “in the pipeline,” that would be booked after the test’s end date) was only 47 basis points of their total assets. Since the very large majority of companies’ CRTs don’t even begin to pay off until losses exceed 50 basis points of the initial pool balances (and then continue to provide “coverage” up to 350 or 400 basis points of the pool balance), CRTs can’t possibly be the reason Fannie and Freddie’s stress loss rates have fallen to 47 basis points (and they’re not).”

          my question is not so much “who is right?” as it is, why in the world should Fannie and Freddie be doing very large financial transactions where there is such ambiguity (and lack of transparency) as to its rationality and effectiveness? put another way, isn’t it incumbent upon FHFA, Fannie and Freddie to specifically and transparently answer all questions as to CRT economic utility, so that a former CEO of Freddie doesn’t have to clothe himself in an apology as to the lack of public disclosure before he “calculates roughly”?

          the phrase, “good enough for government work” leaps to my mind.



          1. ROLG– There HAVE been some disclosures made about Fannie and Freddie’s CRTs and their effectiveness– you just have to know where to look for them, and how to analyze them. (And I’m always suspicious of those who make “rough guesses” of things without giving ANY indication of what those guesses are based on.)

            Most importantly, last year FHFA issued a report titled “Performance of Fannie Mae’s and Freddie Mac’s Credit Risk Transfer,” in which it analyzed how the CRTs the companies had on their books as of year-end 2020 would perform in a “2007 replay” scenario. It reported the results as “ultimate costs” of CRTs of $30.7 billion, “ultimate benefits” of $10.1 billion, and a “net cost” of $20.6 billion. These are FHFA’s numbers. Don Layton may say that CRTs “are done on an economically efficient basis,” but FHFA’s own analysis says otherwise. You don’t help yourself in a stress scenario by issuing securities that cost you $3 in interest for every $1 of credit loss transferred.

            It’s also instructive to compare Fannie’s stress test results and CRT use between 2018 (using December 31, 2017 data) and 2022 (using December 31, 2021 data). In the 2018 Dodd-Frank stress test, Fannie’s stress loss provision was $41.1 billion, or 1.29 percent of its average assets, and it reported (in its financial supplement) that at December 31, 2017 30 percent of its single-family book was covered by either a CAS or a CIRT CRT. In the 2022 stress test, Fannie’s stress loss provision had fallen to $19.1 billion, or 44 basis points of its average assets, while at December 31, 2021 only 19 percent of its single-family book was covered by a CAS or CIRT CRT. Again, one can assert that CRTs are the reason for the better loss performance, but the real data of Fannie’s loss rate falling by two-thirds during a time when its CRT coverage was falling by one-third does not support that contention. Nor does the fact that Freddie’s loss provision rate during the 2022 stress test, at 51 basis points, was 7 basis points higher than Fannie’s, in spite of Freddie’s much greater use of CRTs.

            So, if not CRTs, what might be the reasons why Fannie’s (and Freddie’s) stress credit losses have fallen so much in the last four years? For Fannie, my overwhelming favorite for the most important reason would be the fact that at December 31, 2021, 73 percent of the company’s owned or guaranteed loans were originated AFTER the end of 2017. They have very low note rates, and have experienced substantial home price appreciation. At December 31, 2021 the mark-to-market LTV of Fannie’s single-family portfolio was 54 percent (compared with 58 percent four years earlier, and an all-time low of 50 percent at June 30, 2022), while its average credit score was 753 (compared with 745 four years earlier, and 753 last quarter).

            To go back to my earlier comment, then, Layton’s first, second and fifth reasons for the greatly improved stress loss performance (the runoff of the pre-2017 book, much better underwriting on the post-2017 book, and very rapid home price appreciation in the last couple of years) are correct. The influence of CRTs seems to have had minimal if any impact, and the absence of portfolio net interest income clearly has been a negative.

            And a final word of advice: when given the choice between unsupported assertion and verifiable data, go with the data.

            Liked by 2 people

  6. Tim,

    On the subject of capital requirements, the GSEs 2022 stress test results were released this morning.

    The takeaway is that the GSEs combined would EARN $15.6b over the 9-quarter period presented in the stress test. The key assumptions were that unemployment increases to 10%, GDP declines by 3.5%, home prices decline by 29%, commercial real estate declines by 35%, and equities decline by 55%.

    Link: https://www.fhfa.gov/AboutUs/Reports/ReportDocuments/Final_2022-Public-Disclosures-FHFA_SA.pdf

    Why do the GSEs need hundreds of billions of dollars of capital reserve again when even the government’s own stress test doesn’t have them losing a single penny in an extreme adverse scenario?

    Liked by 3 people

    1. @unfortunate

      thanks for that info. you will note the $20B delta between establishing valuation allowance on deferred tax assets and not doing so. it seems one can only in good faith establish the valuation allowance if one thinks the GSEs will go belly up…ie not earn a profit in the future to take the benefit of the future tax loss benefit…or if the government has an ulterior agenda, such as it did with respect to the GSEs in 2009.

      look for the government to refer to the valuation allowance scenario in all of its talking points! of course, the credit losses in each scenario are the same.



      1. As I discussed in my current post, the companies do not need anything close to the amount of capital they’re now being required to hold.

        The Dodd-Frank stress test IS stylized, and probably understates what really would happen to Fannie and Freddie in the scenario described. The very simple example I did in my post–using the updated stress loss numbers from FHFA and my calculation of the value of the companies’ guaranty fee stream on a liquidating book–had them needing about 30 basis points of capital to survive. But still, 30 basis points is a lot less than 4 percent. Even the 2.5 percent minimum I advocate is very conservative, but Fannie and Freddie at least could have a workable business with that; at 4 percent, they really can’t.

        The results of the 2022 Dodd-Frank test actually were not as good as I was expecting. The provision for credit losses in the 2022 test–at a negative $34.9 billion, down $6.7 billion from 2021–was in line with my expectations, but pre-provision net revenues in 2022, at $58.5 billion, were only $1.3 billion, or 2 percent, higher. That seems quite low. The stress tests are run on March 31 balances, and the companies’ total mortgages owned or guaranteed rose by 12 percent between March 31 of 2021 and 2022, while their average guaranty fee rates rose by 2.8 percent. I would have thought that a much larger book and a higher guaranty fee rate would have produced more net revenues than $58.5 billion (strict proportionality would have made them $66 billion, and made the companies’ post-stress total comprehensive income more than $22 billion). Assumed prepayment speeds in the 2022 test had to have been considerably faster than in the 2021 test. The average note rate on Fannie’s owned or guaranteed loans at the end of the first quarter of 2022 (2.70 percent) was higher than a year ago (2.52 percent), but I wouldn’t have thought prepayment speeds would have been that much faster.

        There is, however, no excuse for FHFA including a stress scenario that has the establishment of a $20 billion valuation reserve for deferred tax assets. Under GAAP, a company only writes down their deferred tax assets when (a) it’s losing money, AND (b) it doesn’t expect to make money in the future. Fannie and Freddie continue to make money throughout the stress period, so they don’t even meet the first condition for writing down their DTAs. As ROLG implies, FHFA is adding that scenario so there is some version of the test in which the combined companies lose money (although Freddie doesn’t lose money even with a DTA write-down), but it’s not a legitimate methodology.

        Finally, there is one new feature of the 2022 stress test report: FHFA adds the companies’ “CET1” (or common equity tier 1) capital as a memo item. That number, of course, is hugely negative–$159.3 billion without the DTA write-down–because of the net worth sweep. But it does allow FHFA to have one more negative number to point to somewhere on the report.

        Liked by 1 person

  7. Thank you, Tim; this was quite an excellent read. Until now, I really didn’t have a clear understanding of the relationship between capital requirements and the companies’ ability to fulfill their affordable-housing mandates. It’s all very clear now.

    And, I completely agree that the minimum capital requirement of 2.5% of total unadjusted assets is more than adequate to ensure the safety and soundness of the companies. It’s also very straight forward and transparent (anyone would be able to recalculate and forecast that figure).

    With regards to the net worth sweep (“NWS”) and the balance of the senior preferred stock (“SPS”), the only thing I would suggest to those in charge would be a quarterly unwinding of the NWS (beginning January 1, 2013) rather than simply writing down the SPS. Unwinding the NWS would add an additional $26.9 billion to core capital while adhering to the original terms of the senior preferred stock purchase agreements (10% annual dividend rate on the outstanding balance of the SPS).

    With that additional amount, the capital shortfall would only be $73.6 billion, which could easily be reached through retained earnings, the issuance of additional common shares, and the reissuance of each company’s treasury stock. Of course, this could only happen if Treasury extinguishes the liquidation preferences and the warrants; the existence of both would impede the companies’ ability to raise new capital.

    Thank you, again.

    Liked by 1 person

    1. Bryndon–As to the net worth sweep, the unwinding you suggest is what plaintiffs were asking for in the APA case they lost at the Supreme Court. Had the sweep been found to be ultra vires, that would have been the logical remedy (and what the plaintiffs requested)–act as if the sweep never happened, and apply the excess payments to Treasury (above the 10 percent dividend) to reduce the balance of the senior preferred until it was gone, and after that begin an “IOU,” that now would be in the amount you cite. But since SCOTUS said the sweep was legal, and we’re now suggesting to Treasury that it would be in its own best interest to cancel it (as opposed to converting the senior preferred to common), I think it’s a bit of a stretch to ask for an unwinding that would make Treasury a debtor to the companies.

      And I agree with you: whatever Treasury does with the senior preferred, the liquidation preference has to be done away with to get investors to put new equity into the companies.


      1. Thank you for the reply.

        And just to be clear, if we’re successful with our two Fifth Amendment shareholder-derivative cases an unwinding of the NWS in the manner I have illustrated is a likely outcome. It isn’t over yet.

        Liked by 1 person

  8. Though your piece is targeted at a sophisticated readership, I think it’s worth mentioning what often goes unsaid. The Big Lie about the GSEs–pushed by Paulson, Geithner and others–is that their downfall was caused by the cross subsidies that you refer to, which reflect affordable housing goals. But the data shows that most of the post-2008 credit losses were tied to Alt-A and interest-only loans, which were never appropriate for affordable housing borrowers.

    What’s always been true is that the biggest driver in credit losses is home price appreciation (positive or negative). And the primary impetus for the housing bubble and ensuing crash was mortgage fraud in private label securitizations, which was proved by FHFA’s lawyers when they examined hundreds of thousands of loan files for private label deals sold by 18 different investment banks that all admitted their liability.

    Liked by 1 person

    1. David– What you say is correct, although proponents and supporters of the big banks and Wall Street ignore it (in spite of readily available data documenting it) and some do push the “Big Lie” (also readily refutable). Today’s piece, though, is an attempt to look ahead. “Affordable housing” loans generally are those with lower down payments and credit scores. They did not perform any worse than expected during the Great Financial Crisis, given the huge drop in nationwide home prices between 2007 and 2011, but they now are bearing the brunt of the overcapitalization of the Calabria standard. The best way to fix that is the approach I discuss in my post (NOT, as Director Thompson has recently done, giving the companies capital credit for issuing CRTs which–according to FHFA’s own data–cost them $30 in interest payments for every dollar of losses transferred in a normal environment, and $3 for every $1 of losses even in a stress environment).

      Liked by 2 people

    1. Jeff–You’re welcome. That was my goal.

      My prime audience for this, as you might image, are the policymakers in the Biden administration and those who have access to (and perhaps some influence over) them. I doubt they know any of this–not because they’re not smart, or are ill-intended, but because the credit guaranty business is so arcane. If they’re going to be working on releasing Fannie and Freddie after the midterms–as I believe they will be–this will be valuable input for them, and I’d like to get it in front of them (and will work on doing so, but if any readers also are in a position to do so, they shouldn’t be shy).

      Liked by 3 people

      1. Tim

        That was a brilliant exposition of a difficult topic…difficult enough so that too many in policy making positions (looking at you Calabria) dumb it down by simplification into excess safety, since safety sounds good in the financial area, at the expense of the low-income housing finance mandate.

        I have had experience in workouts on Wall Street, going back to the “good bank”/”bad bank” resolution scenarios supervised by the RTC. So my views are colored by my experience. But it seems to me, a non-beltway observer, that a “reform” that would help DC policy folks to see a possible resolution of the GSE conservatorship resolution process would involve maintaining cross-subsidization, while separating guarantor obligations into high credit and low credit guarantors. Simply, there would be two subsidiaries of each of Fannie and Freddie, and each subsidiary would guarantee separate pools of mortgage securities, one subsidiary guaranteeing low risk, the other subsidiary guaranteeing high risk. both subsidiaries would be be publicly held, with Fannie as a holding company holding super-voting stock so as to maintain control of the publicly held subsidiaries. the low risk subsidiary would transfer a cross-subsidization payment to the high risk subsidiary quarterly in a pre-determined amount (depending on credit loss experience, which would fluctuate over time but which would be transparent for institutional investors and, more importantly DC policy makers, to see). each subsidiary would hold differing levels of capital, given their differing risk profiles, and yes the low risk subsidiary would hold a higher level of capital than otherwise needed given its cross-subsidization obligation to the higher risk subsidiary.

        after decades on Wall Street, I firmly believe that investors prefer to see risk separated rather than conglomerated, and for risk to be cabined in a transparent manner. conglomerate holding companies such as LTV in the 1960s and GE more recently have had their day in the sun, but that day has passed. likewise, I believe it would be more efficient for the low risk and high risk parts of the GSE business model to be separated so that their capital levels can appropriately reflect risk.

        in my view, the best evidence supporting a simplification effort such as I propose is the proportion of DC policy makers whose eyes will seriously glass-over after reading your post.

        Treasury’s back stop line of credit would extend only to the high risk subsidiary, and therefor would be smaller than the case if Fannie and Freddie each remains a single conglomerate risk entity…and therefore this would be more palatable for, among others, the Financial Establishment. public risk represented by the treasury line of credit would support only the high risk pools of low income housing.

        This might not be the way I would construct the GSEs out of whole cloth, but this would be the way I would construct an out-of-conservatorship pathway given the current dysfunctional beltway climate.



        1. ROLG–I wouldn’t call creating separate lower-risk and higher-risk subsidiaries at Fannie and Freddie a “simplification effort,” and I also don’t think that “good bank/bad bank” is the right way to think about the companies’ risk segmentation.

          It’s easy to forget that ALL of the mortgages Fannie and Freddie finance are “good” loans; it’s just that some have higher expected credit losses than others. But even a 90 percent LTV loan to a 680 credit score borrower is not a “bad” loan. I don’t have the historical segmented loss rates at my fingertips, but the long-run (non-stress) expected loss rate on Fannie’s entire portfolio of loans is around 4 basis points per year. The lowest-risk segment of that portfolio might have an expected loss rate of about one basis point, so the expected loss rate “highest-risk” segment would be, what…seven basis points? Certainly not much more than that, or the average would go up. Those aren’t bad loans (when I was Fannie’s CFO the average credit loss rate at commercial banks was around 100 basis points year; ours was under 4 basis points).

          There isn’t enough of a performance differential between the high- and low-risk segments of Fannie and Freddie’s portfolio to warrant creating separate subsidiaries for them.

          Liked by 4 people

          1. Exactly, Tim. The business model of every financial company is risk diversification, and every well managed company identifies, discloses and continually tweaks various risk concentrations.

            Liked by 5 people

          2. Tim

            I respect your response, but there is substance and there is appearance, and in the beltway I sense that appearance is substance.



Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s