Mind the Gap

~ jtimothyhoward

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.

157 thoughts on “Mind the Gap”

    1. I’m not a WSJ subscriber on principle, due to its historical role in creating the fictional versions of Fannie and Freddie’s business and risks that dominate today’s media (and policymaking). But I’m happy to hear that it’s letting a bit of reality creep in to its analysis of the companies. It would be nice, though, if the Journal, or someone, “connected the dots.” There is no mystery as to what caused the 2008 mortgage crisis: the Federal Reserve and Treasury–wishing to create a “free market” alternative to Fannie and Freddie–declined to regulate subprime lending, then allowed a private-label securitization (PLS) mechanism to flourish in which all participants in the process could make money even if the underlying loans never made a payment and then defaulted. Unqualified borrowers with access to cheap credit drove the prices of new and existing homes to unsustainable levels, and when the PLS market melted down in 2007 and the cheap credit went away, prices crashed. The Fed and Treasury admitted their policy mistake, and Congress passed Dodd-Frank, with its “ability to pay” requirements of borrowers. These were the reforms that were necessary, and they’ve worked.

      That means two things: we’re not going to get a repeat of the boom and bust cycle of the aughts because we’re not going to make the same policy mistakes, and for that reason Fannie and Freddie really don’t need to be capitalized to survive such a scenario. And the companies certainly don’t need to be “reformed” before they can be released from conservatorship. Yet those fictions persist, in spite of the discordance between them and the evident reality of the single-family mortgage market today (epitomized by, but not limited to, the results of the FHFA Dodd-Frank stress tests run on Fannie and Freddie over the past three years).

      Liked by 3 people

      Reply

      1. “Yet those fictions persist…” yes, certainly within the WSJ editorial board, but as a first step, I welcome a rather unbiased WSJ article that makes the case that reform has already achieved its safety and soundness purpose. it would have been beyond the ambit of the article to “connect the dots,” but maybe, just maybe, this acknowledgement of reality will seep within the beltway.

        rolg

        Liked by 1 person

        Reply

      2. Guessing it’s ok to share its first four paragraphs. They agree with you, Tim:

        “Before the financial crisis of 2008, lenders barely bothered to verify mortgage applicants’ income. Today they demand reams of evidence that borrowers can afford their loans.

        Banks once held big pools of shoddy mortgages with little consequence. Now such exotic debt securities hardly exist, and banks would find them too costly to hold anyway.

        Underwater mortgages have given way to hefty cushions of home equity, particularly after a run-up in prices over the past two years.

        A 28% decline in U.S. home prices between 2006 and 2009 sent the value of some 11 million homes below their mortgage balances, triggering widespread defaults, a near-collapse of the financial system and a deep recession. Home prices would have to fall between 40% and 45% from their peak to put the same proportion of mortgaged homes underwater today, according to a CoreLogic analysis”

        Liked by 2 people

        Reply

  2. Tim

    after reviewing the judicial responses to the various claims brought by GSE plaintiffs over the past 8 years, I find it hard to maintain my usual faith in the US judiciary. it seems these claims were decided against the plaintiffs before briefing. to the extent you have posted about the persistence of the Financial Establishment bias contra (or hostile to) the GSEs, perhaps this is all nothing new to you. but it is quite astonishing/disturbing to me.

    I can recall the press conference that accompanied the original filing of Perry in 2014, in which Matthew McGill (counsel for Perry) said that the NWS was “clearly” illegal…and I recall that I absolutely agreed. I cant recall when I have thought myself to be more right only to find out I was proven so wrong…(though I still dont think I was or am wrong, but that and $2.75 gets me downtown on the subway).

    so the fate of a secondary housing finance system, truly unique in the world, that is compatible with a free market/capitalist economic structure all becomes a political situation, and the GSEs are not to be re-privatized until a POTUS wants them to be re-privatized AND has the mental and moral bandwidth to see to it.

    sad, really.

    rolg

    Liked by 1 person

    Reply

    1. ROLG: I’ve followed much the same path as you over the past nine years. I, too, had no doubt that the net worth sweep was illegal, and that all that needed to happen was for the facts behind its creation and implementation to be brought to light, and be introduced into the court cases. Indeed, that’s why I began this blog (almost seven years ago). I excused the early lower court losses by telling myself that once the case got to the Supreme Court the facts WOULD matter, the law WOULD be followed, the net worth sweep would be voided, and Fannie and Freddie could then be recapitalized and released from conservatorship.

      I therefore was profoundly disappointed to read Justice Alito’s opinion when it came out in June of last year. As I wrote in “An Unexpected Ruling,” it was so obviously written to justify an opinion already decided upon–I speculated as long ago as when the Court agreed to accept cert on an interlocutory appeal–that there was no doubt (to me) that “the fix was in.” Call me naive, but I never thought the highest court in the land would do that. But shortly afterwards I read a book called “Evil Geniuses,” by Kurt Andersen. Its theme is how the ultra wealthy, big business and libertarian economists and lawyers devised and then executed a multi-faceted, sophisticated long-term plan (beginning in the 1970s) to reverse the New Deal and re-engineer society, economics and the law to favor themselves at the expense of everyone else, and how they succeeded beyond what even they ever could have wished for. The Federalist Society, created in 1982 and an implacable foe of Fannie and Freddie since its inception, plays a prominent role in this narrative.

      I now have concluded that while some plaintiffs may be awarded a modest amount of money for breach of contract or regulatory takings as a result of the net worth sweep–and even that’s not going to be easy–there is no chance that the net worth sweep will be reversed by a judicial decision upheld by the Roberts Supreme Court. And with the net worth sweep remaining legal and Treasury’s liquidation preference in Fannie and Freddie at $289 billion and growing every quarter, the only way they can emerge from conservatorship is for the current or a future administration to make a policy decision to let them out. I’ll be doing a new post about this over the next few weeks, for publication shortly after the beginning of the new year.

      Liked by 2 people

      Reply

      1. Tim

        except federally owned and dominated GSEs are more rather than less New Deal, by my estimation. to the extent the Financial Establishment/Federalist Society is pleased with the GSE status quo, perhaps they should revisit their Milton Friedman/Frederick Hayek texts. in any event I look forward to your next piece.

        rolg

        Liked by 1 person

        Reply

        1. Federally chartered Fannie WAS a New Deal company, and Freddie was given the same charter in 1970 to act as a Fannie Mae for the S & L industry. It was the “public mission/private ownership” aspect of these companies (competing with “fully private” banks) that the Federalist Society found so abhorrent. Having gotten control of Fannie and Freddie in 2008–and having failed to come up with a legislative replacement for them–I don’t think the Financial Establishment knows what it wants to do with them now. But having them grossly overcapitalized and over-regulated to the point that they pose no competitive threat at all to banks is, for the FE, not a bad resting place.

          Liked by 1 person

          Reply

          1. I concur w/Tim……read the same book and am now reading “The Destructionists”. Any thought that the SCOTUS isn’t now political was out the window a long time ago. Alito twisted whatever so-called logic he could muster eleven ways to Sunday to come up with that opinion.

            There are just too many “intersections” b/n some Supreme Court members and folks with the big agenda AGAINST F&F. Power, money, etc……it’s all there on display and we’re seeing the results of it all.

            Liked by 1 person

          2. I’m now reading the same book (“The Destructionists,” by Dana Milbank). So far it’s nothing I didn’t already know, but then I was in DC and right in the middle of the events he’s recounting, beginning around the time I became Fannie’s CFO in 1990.

            One of my enduring memories from this period were the senators who came to speak at meetings of Fannie’s National Advisory Council–a group of prominent people from the housing and mortgage finance industries, who met two or three times a year at our palatial former headquarters on Wisconsin Avenue. We could get any senator we wanted to come speak to this group, because we gave them good food (and wine) and put them in front of opinion leaders (and potential contributors). My vivid memory is how, over a 20-year period from the mid-1980s to the mid-2000s, the personal characteristics and attitudes of the prominent senators we invited to Advisory Council meetings changed. In the late 80s and early 90s, the leading senators of both parties were true statesmen, who worked across the aisle to try to find solutions to issues that affected all of their constituents, irrespective of party. That began to change with what Milbank calls the “Gingrich revolution” at the beginning of the Clinton administration. The newer generation of Republican congressmen (and women)–particularly those who came in during the 1994 mid-term election, which went heavily against the Democrats–took to heart Gingrich’s message that they weren’t “nasty enough,” and that to win and stay in power they had to delegitimize and even demonize their opponents. The notion that “compromise is weakness” took hold quickly in the House, and it soon spilled over into the Senate. I saw first-hand the effect that had on the old guard, patrician senators (again, of both parties). They spoke openly about it at Advisory Council meetings, lamenting the loss of comity and its replacement with vitriol and enmity. And one by one, these true public servant, statesmanlike senators simply declined to run again when their current terms expired. They’d had enough.

            Liked by 5 people

    1. This is another theoretical piece by CBO (which has done countless numbers of them on Fannie and Freddie over the past four decades), and it will meet the same fate as the others: consignment to oblivion.

      There are a couple of interesting aspects to it, though. First–and I didn’t know this–CBO apparently concluded after the 2008 conservatorships that “the institutions effectively became governmental entities whose operations should be reflected in the federal budget.” (They are not.) Second, “CBO projects that under current law, the mortgage guarantees issued by the GSEs will have a budgetary cost—that is, the cost of the guarantees is expected to exceed the fees received by the GSEs.” This is a theoretical cost, based on the notion CBO has insisted upon since the late 1980s that Fannie and Freddie receive an implicit government subsidy that properly should be considered as a cost, and put on budget. CBO doesn’t say in this document how it calculates that “subsidy,” but it must think it’s massive. This year Fannie and Freddie’s combined pre-tax net incomes are running at a rate of over $30 billion a year; that’s a lot of income that has to be run through to get to a net cost.

      The CBO’s recommendation is that the government can reduce its alleged subsidy cost by raising the companies’ guaranty fees (adding more revenues), and lowering their loan limits (reducing the “subsidy”). Quite apart from the fact that lowering the loan limits would require legislation–which won’t happen–the whole idea of taking actions with respect to Fannie and Freddie intended to reduce a subsidy that isn’t real, in order to show a budget “saving” that only would count were the companies to actually BE on the budget, isn’t going to have any impact at all on what the administration decides to do about Fannie and Freddie’s conservatorship prior to the next presidential election.

      Liked by 5 people

      Reply

    1. These very likely are older CAS issues with near-zero probability of ever transferring any credit losses, and Fannie has calculated that the dollar cost of the premium PLUS the economic value of the capital credit FHFA gives to these CRT tranches is less than the present value of the interest payments Fannie would have to pay if it left them outstanding until they paid off.

      Liked by 1 person

      Reply

  5. Tim,

    I don’t recall having seen this piece by Layton written in October. It’s somewhat typical Layton, though in this much briefer and more recent installment (as compared to July’s article in two parts) he dialed back the 2030 or later timeline for release of the GSEs to 2027. So, in three months he cut off at least three years. Given it’s been nearly two months since the more recent piece, we could now be at a target year of 2025. So, by this coming February, we could be ready for recap and release in 2023.

    Sorry, I’m getting punchy. But seriously, do you see a different tone?

    Beyond weary,

    Ron

    https://thehill.com/opinion/finance/3694135-the-fannie-mae-and-freddie-mac-endgame/

    Like

    Reply

    1. I commented on this piece by Layton shortly after it came out. (That comment is here: https://howardonmortgagefinance.com/2022/08/08/mind-the-gap/#comment-28485)

      It’s important to distinguish which form of “recap and release” Layton is talking about. There are two. The first is the track we were put on by the January 14, 2021 letter agreements between former FHFA Director Calabria and former Treasury Secretary Mnuchin, which would keep Fannie and Freddie in conservatorship until each has retained “common equity tier 1 capital” equal to at least 3 percent of adjusted total assets for two consecutive quarters. As of September 30, 2022, the two companies combined were $398 billion short of achieving that status, and given their lack of access to the capital markets would be unlikely to do so until close to 2040, if not later. The second form of recap and release could occur much sooner, if the administration follows the advice that I and many others have been giving, which is to (a) admit that Treasury’s senior preferred stock has been repaid in full and cancel it along with the liquidation preference, and (b) replace Calabria’s bank-like ERCF standard with something that more closely reflects the risks of the credit guarantees Fannie and Freddie are making today.

      It’s this second form of recap and release that Layton is talking about in his October piece. And of course, he’s “assuming away the problem.” To date the senior officials in the Biden administration have shown no signs that they have given any thought to canceling the senior preferred, and the Director of FHFA has made very clear that she believes the “tweaks” she made to Calabria’s ERCF–the most important of which was to increase the capital credit the companies are given for issuing non-economic credit risk transfer securities–is the only change to the ERCF that FHFA needs to make. (Now that the mid-term elections are over and we know that for the next two years Republicans will control the House and Democrats will control the Senate, the focus will be on key members of the Biden economic team, to see if they do come to the realization that they have an opportunity in the next two years to put their stamp on what Fannie and Freddie look like and how they operate for the foreseeable future, which will require them to undo the damage to them inflicted by prior administrations with the net worth sweep and the ERCF).

      I have long believed, and said, that it should be almost as easy for the Biden administration to get Fannie and Freddie out of conservatorship as it was for the Bush administration to put them into it–should the former decide to do so. I’ve never understood why Layton once said that administrative recap and release would take until 2030 to accomplish, so the fact that he reduced that in his October piece by three years, to 2027, is to me of no consequence. Both are made up dates, and importantly extend beyond January 2025, when the Biden administration would have to complete administrative reform to ensure its key elements stick (and could only be overturned by a subsequent Congress).

      Like

      Reply

        1. Yes, I do agree with ROLG. If we get to September 7, 2028 and Treasury has not yet exercised the warrants, I believe that if Treasury wants to extend their exercise period and asks FHFA to agree to do that, it would be legal, and also that FHFA would do what Treasury asks (as it always has).

          Like

          Reply

    1. IV. CONCLUSION
      The Supreme Court provided Plaintiffs with an opportunity to allege that they were concretely harmed by the unconstitutional provisions restricting President Trump’s ability to appoint a new FHFA director in the first two years of his administration. Plaintiffs’ Amended Complaint fails to plead that any harm was more than speculative. Their new Appropriations Clause claims exceed the scope of the remand. For these reasons, Defendants’ Motions to Dismiss are GRANTED, and Plaintiffs claims are DISMISSED WITH PREJUDICE. IT IS SO ORDERED.

      Signed at Houston, Texas on November 21, 2022.
      Keith P. Elison

      Like

      Reply

        1. I now have read the ruling. In explaining his decision, Judge Ellison began by repeating the government’s fictional tale of how the net worth sweep came about–which plaintiffs’ counsel has not been able to successfully challenge in any of a multitude of court cases. (This also seemed to be the problem that led to the mistrial declared in the jury trial before Judge Lamberth.) He then referred back to the Supreme Court’s June 2021 ruling in the Collins case, noting that “Three concurrences [by Thomas, Gorsuch and Kagan], reflecting the opinions of five justices, suggested that Plaintiffs would struggle to establish cognizable harm on remand.” After that, all Ellison had to do was explain why that was so, which he did. And he made short work of former President Trump’s letter to Rand Paul, saying, “President Trump’s post-hoc letter–written after the Collins decision was released–should not be given significant weight,” quoting legal precedents that suggested it was a “convenient litigating position” not consistent with “contemporaneous explanations,” and using phrases like “belated justifications”,”after-the-fact claims” and “post-hoc affidavits” to leave little doubt about his reaction to the letter.

          The one ray of sunshine–although it’s not clear how long it will last–was that Ellison did not dismiss plaintiffs’ claim that the Third Amendment should be vacated based on the theory that FHFA’s self-funding structure violates the Appropriations Clause. But his reason for not doing so was purely procedural, finding that “Plaintiffs’ Appropriations Clause claims exceed the scope of its mandate,” and for that reason “the Court does not reach the merits [on it].” That will be for another time and place.

          Like

          Reply

          1. Does the last sentence of footnote 2 on page 13 mean he would grant the plaintiffs the relief requested for the appointments clause claim if the remanded mandate allowed for expanded view? Or is he just indicating this is what plaintiffs are asking for?

            “Plaintiffs’ arguments would void all actions FHFA has taken since it began its work in 2008.”

            Like

          2. No to your first question. The final sentence you quote follows the statement, “While the Collins court did not consider an Appropriations Clause question, it found that the Third Amendment ‘bore no constitutional infirmity in its inception’.” I view the two sentences in conjunction as being Ellison’s way of telling the Fifth Circuit Court of Appeals that he views the remedy requested by plaintiffs for the alleged violation of the Appointments Clause to be extreme, and thus unlikely to be upheld by the Supreme Court should the Appellate Court rule in plaintiffs’ favor an the Appropriations Clause.

            Like

          3. “In explaining his decision, Judge Ellison began by repeating the government’s fictional tale of how the net worth sweep came about–which plaintiffs’ counsel has not been able to successfully challenge in any of a multitude of court cases. (This also seemed to be the problem that led to the mistrial declared in the jury trial before Judge Lamberth.)”

            Agree that the inability to overcome the “fictional tale” about the Government having to come to the rescue and all their actions afterward resulted in some definitely strong jurors’ opinions against the Ps. I’ve always felt that it would be very hard to get a unanimous verdict in the the company town against the company. Now I don’t think its possible – at least in Lamberth’s court.

            Like

  7. Tim,
    With respect to FNMA’s recent 3Q22 earnings, I was expecting (as I’m sure most were) an increase in the credit-related expense due to decreasing home values and rising rates. Was the $(2.5) billion expense about in line with what you would have expected? I’d be curious as to your impressions.

    Like

    Reply

    1. Yes, I was expecting an increase in Fannie’s credit-related expenses in the third quarter because of the flattening to modest declines in home prices nationwide, and I also was expecting a further decline in guaranty fee income stemming from the reduced amount of amortization of upfront guaranty fees because of higher mortgage rates.

      I did not attempt to estimate the exact size of the increase in the loss reserve, because I don’t yet have a good handle on how the new Current Expected Credit Loss (or CECL) accounting standard is going to work quarter-to-quarter; I’d like to see a few more quarters of actuals before trying to figure that out. But I doubt we’ll see anything close to a $2.5 billion credit-related expense number in the fourth quarter, and with these expenses back closer to zero Fannie’s fourth quarter net income should rebound to over $4 billion, pushing full year 2022 after-tax net income into the $15- 16 billion range.

      Fannie’s total net interest income in the third quarter was $7.12 billion, down about $700 million from the $7.81 billion recorded in the second quarter. Going forward, though, I would expect Fannie’s net income to begin rising again, as book growth, an increasing average guaranty fee rate and the effect of higher interest rates on portfolio income all combine to push net interest income higher.

      A modest surprise in both Fannie and Freddie’s third quarter results was that their credit risk transfer (CRT) amounts continued to rise, despite the much higher interest rates and the dramatic rise in CRT spreads to Treasuries recently. Freddie didn’t say anything about this, but Fannie pointed out that virtually all of the CRTs they’ve done this year (both the securities issued through their CAS program and the reinsurance they do in their CIRT program with mortgage insurers) were on 2021 originations. Those loans would be much more attractive to investors or insurers than the 2022 vintage, because they have a large component of refinances and still have significant post-origination price appreciation. Loans originated this year have notably higher LTVs, lower credit scores, and will face powerful headwinds from continued sluggishness, and more likely declines, in home prices, and thus will be much harder to put into CRTs. So it would not surprise me at all if we see both Fannie and Freddie’s CRT coverage fall in the fourth quarter, and their risk-based capital requirements rise as a result.

      For the third quarter, Fannie’s risk-based capital requirement actually fell by $2 billion, while Freddie’s rose by only $1 billion. With their combined retained earnings growth of $3.5 billion, they were able to reduce their combined shortfall to full capitalization by $4.5 billion– from $423 billion at June 30 to $418.5 billion at September 30. But if required risk-based capital requirements begin to rise because of falling home prices (and thus rising mark-to-market LTVs) and lesser CRT coverage–both of which I expect–each company will find it harder to reduce their massive shortfalls in required capital through retained earnings for at least the next few quarters. And even at last quarter’s pace of $4.5 billion per quarter, getting to full capitalization through retained earnings alone would take more than 23 years, or until the end of 2045.

      Liked by 2 people

      Reply

      1. Tim

        do I have this right? looking at note 4 to the Fannie B/S for Q3 22, I see $7.488B of credit loss reserve, with a $289MM write off during the Q. This results in a loss reserve balance equal to 26X the actual amount of losses recorded in the Q. is this high or normal in your view? or am I not understanding accounting for the umpteenth time?

        rolg

        Like

        Reply

        1. You’re not understanding the accounting, but you’re certainly not alone.

          Let’s start with the numbers you gave in your example. First of all, they’re one quarter’s numbers; to turn them into a meaningful credit loss ratio you need to annualize them (i.e., multiply them by four). Second, Fannie’s credit gain (loss) ratio isn’t calculated using just the write-off number; it’s write-offs, less recoveries, plus foreclosed property expense. You annualize that total, then divide it by the average book of business for the quarter (not the quarter-end balance)–whether single-family, multifamily or the total. For the third quarter of 2022, Fannie’s reported net credit gain (loss) ratio for its single-family mortgages was a very low (0.4) basis points. [Note: I’m still not used to this reporting convention. When I was Fannie’s CFO we called it a credit loss ratio: if we had losses it was a positive number, and if we ever had credit gains it was a negative number. But Fannie has had credit gains for so long–related to the running down of its ridiculously high December 31, 2011 loss allowance over the past decade–that it’s changed the name of the ratio to “gain (loss),” and it shows credit loss ratios in parenthesis and gain ratios without them.]

          There was a time when many financial institutions set their loss allowances as some multiple of a four-quarter moving average of their most recent credit loss ratio–say, twelve times that amount. I never liked this approach, however, as it caused a company to have a loss allowance that was too low near the peak of a business cycle–when current credit losses were atypically low–and to have a loss allowance that was too high near the trough of a cycle, when credit losses were atypically high. But that’s now moot. Beginning in January 0f 2020, all financial institutions have had to follow the Financial Accounting Standards Board’s Current Expected Credit Loss standard, which requires them to set their loss allowances at a level that reflects their best estimate of the lifetime credit losses they expect they will incur. Fannie and Freddie now do that. As Fannie said in its 2021 10K, “The allowance for loan losses reflects an estimate of expected credit losses on single-family and multifamily HFI [Held for Investment] loans held by Fannie Mae and by consolidated Fannie Mae MBS trusts…Changes to our estimate of expected credit losses, including changes due to the passage of time, are recorded through the benefit (provision) for credit losses.”

          That’s what happened in the third quarter. The sharp deceleration in year-over-year home price growth (heading toward negative territory shortly) caused both Fannie and Freddie to revise their lifetime credit loss estimates significantly upwards, even though, in Fannie’s case, it still has an average mark-to-market (MTM) loan-to-value (LTV) ratio on its total single-family book of 50 percent. Once that MTM LTV starts to rise–as it will–you can expect further significant additions to Fannie’s loss allowance, brought through the current quarter income statement and reducing net income. And that will slow capital accumulation, at the same time as the Calabria capital standard is requiring MORE capital–because it is pro-cyclical (it’s based on MTM LTVs) and because CRT coverage will drop in a less favorable home price environment. Not too many people realize that, and it will come as an unwelcome surprise to them.

          Liked by 3 people

          Reply

    1. Tim

      just a quick thought on the mistrial in the class action before Lamberth. the effect is that there will be a new trial. arguably both Ps and Ds benefit from having the ability to see what worked and what didn’t in the first trial to prepare for the next trial, but I think Ps may be more incentivized to make strategic adjustments, and these adjustments can be made, subject to the local DC federal district court rule set forth below, by interviewing jurors to find out what their reasoning was.

      Rule 47.2: “After a verdict is rendered or a mistrial is declared but before the jury is discharged, an attorney or party may request leave of Court to speak with members of the jury after their discharge. Upon receiving such a request, the Court shall inform the jury that no juror is required to speak to anyone but that a juror may do so if the juror wishes. If no request to speak with jurors is made before discharge of the jury, no party or attorney shall speak with a juror concerning the case except when permitted by the Court for good cause shown in writing. The Court may grant permission to speak with a juror upon such conditions as it deems appropriate, including but not limited to a requirement that the juror be examined only in the presence of the Court.

      COMMENT TO LCvR 47.2: This Rule gives the Court greater flexibility by stating that where the request to converse with jurors is made after their discharge, the Court may impose such conditions as it deems appropriate.”

      I do not know whether Ps counsel made this request of Lamberth.

      rolg

      Liked by 2 people

      Reply

      1. “I do not know whether Ps counsel made this request of Lamberth.”

        All but one juror said they were willing to be contacted after 72 hours by jury consultants and Lamberth said that info might help with the dispute.

        Liked by 2 people

        Reply

      2. It’s good that all but one juror is willing to be contacted, and that Lamberth is fine with that.

        I was not at the trial, but I did see summary reports on the proceedings put up on Twitter and elsewhere by various people who were there. What surprised me was the apparent effectiveness of the government’s arguments that prior to the net worth sweep Treasury had injected $187 billion into Fannie and Freddie, and that there was no public indication given by anyone that the companies would be able to cover the resultant $18.7 billion in annual after-tax dividends, hence the decision to agree to the net worth sweep was a reasonable judgment by FHFA in order to prevent a cycle of “circular borrowings” (which Treasury did contemporaneously refer to as a “death spiral,” although Judge Lamberth did not permit plaintiffs to use that term, asserting that it was “prejudicial”).

        Seven and a half years ago, counsel for the institutional plaintiffs in this same case (which then was called Perry Capital), Cooper & Kirk, asked me to write an amicus curiae brief for the Court of Appeals for the DC Circuit, after Lamberth had granted the government’s motion to dismiss it on September 30, 2014. In the legal preamble to the factual sections I wrote, we argued that, “In dismissing all of Appellants’ claims, the district court relied on a factual record that was both incomplete and at the same time improperly supplemented by post hoc factual assertions. And the district court improperly made factual determinations on a motion to dismiss based on the defective record and ‘without giving Appellants the opportunity to contest the completeness of that record or to present [contrary] evidence.'” We added, “The district court compounded its error by relying on facts outside of the complaints to resolve factual disputes relating to jurisdiction without ever affording Appellants an opportunity to develop and present evidence relevant to the jurisdictional inquiry.”

        The intent of my amicus brief was to present a more complete, and accurate, version of the prologue to the net worth sweep. I won’t repeat its primary arguments (the body of the brief can be found under the “reference documents” section on the right-hand side of the blog), but I made clear that more than all of the “losses” that resulted in the $187 billion in draws from Treasury were non-cash entries made by FHFA that not only were discretionary but were well in excess of what private companies were doing (e.g., for the loan loss reserve, the creation of a reserve for deferred tax assets, and write-offs or impairments on securities). Moreover, the fact that Treasury required these book losses to be covered by draws of Treasury senior preferred stock that could not be repaid–a feature used in no other financial institution “rescue” (I’ve called it a “concrete life preserver”)– and paid a 10 percent after-tax dividend (which back then was 15.7 percent pre-tax) compared with 5 percent pre-tax charged to the banks it was rescuing was very strong evidence that both Treasury and FHFA knew these book losses would likely reverse in the future, and thus that their post-hoc claim to have been worried about a “death spiral” (or “circular borrowing”) was false.

        I’m now wondering whether counsel for the class plaintiffs–Boies Schiller, represented by Hamish Hume in the most recent case–ever got or read this amicus, or if they did why they didn’t draw more heavily on it in developing their arguments against the defendants’ posture in the case. Had it been me, I would have argued very directly that the defense wasn’t being truthful in its contentions about the net worth sweep, and I would have backed my argument up with the mountain of evidence I cited in the amicus, and as many of the Treasury (“hearsay”) emails that Lamberth allowed to be presented to the jury. It certainly seems to me that the reason there was a mistrial in this case is that half the jurors believed the government’s portrayal of itself as the “good guys,” and could not be talked out of that. If there is a retrial, I think this time plaintiffs counsel must go after the government’s story early and much harder and more directly, to try to undermine its credibility before any of the jurors commit themselves to it. And, yes, I certainly will make that case to my contacts at Cooper & Kirk, for whom I did the Perry Capital amicus (and two other ones).

        Liked by 6 people

        Reply

        1. Tim

          I wholeheartedly agree with your reaction, understanding that neither of us was in the courtroom, so our reactions are provisional. moreover, let’s not forget that this is a case alleging breach of the implied covenant of fair dealing, and Ps counsel should not be cautious in characterizing the extent to which FHFA/Treasury acted in bad faith both at the time of the NWS, and in subsequent actions defending it…including in the original Perry case before Judge Lamberth himself!

          rolg

          Like

          Reply

          1. @ROLG – What do next steps look like for this case? Is a new judge assigned? Is it realistic to expect new damage models to be considered during retrial? Are we looking at a few months until the next trial?

            Like

          2. @Steve

            this will be a do-over, so no new judge pending some motions from Ps that I don’t anticipate. I suspect (“without evidence”) that Lamberth would like to see this case settled, and I wonder if he doesnt try to send this case to mediation (non-binding) before he has to deal with it again…just my read of “mature” federal judges. but I dont expect a settlement even if he does this. so keep an eye on the docket and at some point this case will likely begin trial procedure anew.

            rolg

            Like

          3. I similarly saw the Twitter feeds of a couple of people in the courtroom and also posting about motions. @FnFGateFan and @bykatiebuehler were the main accounts I watched. What struck me, even leading up to trial, was the leash Lamberth kept on Plaintiffs. He didn’t let hardly any of the particularly harsh evidence against government be presented. Plaintiffs were arguing with one hand tied behind their backs. Lamberth, in my opinion, was asking for a hung jury with his rulings on motions. Hamish Hume I suspect would have tried harder to paint the picture of the government you describe, but I don’t think he had a choice. All of the evidence he wanted to present was denied.

            @ROLG, in a new trial, will there be any changes in motions in limine? Would Lamberth allow evidence he didn’t allow the first time around?

            Liked by 1 person

          4. @juice

            Ps counsel must figure out what the 4 in favor found persuasive and the other 4 opposed found unpersuasive (or persuasive from Ds perspective), and then work within the known parameters of what evidence Lamberth will let in to achieve a verdict in P’s favor. Ps are not going to get a different judge, and I dont see how Ps counsel are going to get Lamberth to change his decisions on various pretrial motions and his courtroom procedure.

            a very good trial lawyer once told me that trials are not won or lost on the evidence and testimony, but on whether counsel can present through the evidence and testimony a narrative that makes it as easy as possible for jurors to decide in your favor. trial as story telling, not an evidence weighing machine. there has to be a compelling hook, so that the jurors adopt one of the competing narratives that P and D have presented. this is even more the case in a financial trial involving transactions and situations outside the experience of jurors. what is that hook? all trials are different, of course, but the narrative hook is best when it is tangible and intimately understood by jurors…as in “if the gloves don’t fit, you must acquit”.

            if, as @unfortunateSCOTUS above intimates, 7 of 8 jurors are willing to give exit interviews, as it were, then Ps counsel must find the missing hook in their narrative.

            rolg

            Liked by 1 person

        2. “Moreover, the fact that Treasury required these book losses to be covered by draws of Treasury senior preferred stock that could not be repaid–”
          Why do we accept as undisputed fact that the Treasury senior preferred could not be repaid? Before the nws it was thought that it could be repaid under logical circumstances. Fannie and freddie just needed to ask (the Treasury) for permission first.

          Doesn’t this affect our legal cases?

          Like

          Reply

          1. My statement that the draws of senior preferred stock “could not be repaid” is shorthand for “…could not be repaid without Treasury’s permission.” But from the outset, Treasury’s intent was to not grant that permission.

            As I explain in all three of my amicus briefs, the provision for non-repayment (at the companies’ initiative) was a key element of Treasury’s plan for putting and keeping Fannie and Freddie in conservatorship until Congress could replace them with a secondary mortgage market mechanism more to the liking of what I call the Financial Establishment. This plan was foreshadowed as early as March of 2008, in a memo by a man named Jason Thomas circulated internally within Treasury (and also used as the basis for an article in Barron’s magazine that month). The idea was to claim that Fannie and Freddie were grossly undercapitalized even though they exceeded both of their applicable capital standards (minimum and risk-based) at the time, force them into conservatorship on that basis, and then have a regulator Treasury controlled, FHFA, run up their non-cash expenses (by $300 billion) to trigger draws of senior preferred stock that would pay a 10 percent after-tax dividend in perpetuity based on the highest balance of outstanding Treasury senior preferred FHFA could achieve with these accelerated and estimated non-cash accounting entries. Through the use of the non-repayment feature–imposed by no other regulator on any other financial institution at any time for any purpose–Treasury was able, as I’ve said elsewhere, to “transform massive, temporary and artificial book expenses created for [Fannie and Freddie] into massive, perpetual and real cash revenues for [itself].” The impending reversal of many of the non-cash book entries is what led Treasury to concoct the net worth sweep in 2012, which FHFA agreed to with no independent assessment or analysis of its own.

            Because of the net worth sweep, Treasury’s liquidation preference in the companies has at this point grown to such a staggering amount that paying it off is not feasible, even if Treasury wished to allow them to begin doing it. If the current or a future administration wants Fannie and Freddie to function effectively and efficiently again as shareholder-owned secondary market entities, the only practical alternative will be for Treasury to deem their senior preferred to be fully repaid, and to cancel it and the liquidation preference. (In my view, converting Treasury’s senior preferred to common stock would be a de facto nationalization of the companies.)

            Liked by 4 people

          2. Thank You Tim.

            “From the outset, Treasury’s intent was to not grant that permission.”

            I understand that now. But, as an average investor I didn’t know that before the nws. At the time we thought that permission would be granted under reasonable circumstances. How could an average investor have known treasury’s real–secret–intent?

            My fear is that if we accept as something natural that the senior preferred wasn’t repayable (even when we didn’t know that), then a jury might think that we were already screwed before the nws (so the nws didn’t change that situation).

            Like

          3. It is a fact that the Treasury senior preferred was only repayable with Treasury’s permission. My (or anyone else’s) view of Treasury’s intent on permitting repayment is not relevant (and certainly not dispositive) in a legal case. And I would agree with you that a reasonable investor would have expected Treasury to permit repayment if the companies got to a point where that was feasible. And that’s what I would argue were I counsel for the plaintiffs in the Lamberth case. I would take the jury through the demonstrable facts of Treasury’s and FHFA’s actions during the first three and a half years of the conservatorship–emphasizing the roles of non-cash expenses and the “non-repayment” feature of the senior preferred stock in building up the companies’ annual dividend obligation to $18.7 billion–but then say that Treasury’s (and FHFA’s) plan to have Congress agree to “wind down and replace” Fannie and Freddie ran out of time in 2012, when after home prices had begun rising again it was clear that the companies’ mammoth loss reserves would be able to cover more than all of their remaining credit losses, leading to what Fannie Mae executive Dave Benson called “a golden age of profitability,” and that as a consequence both companies’ large deferred tax asset reserve would be released. Since FHFA and Treasury were the ones who had created the book losses for Fannie and Freddie in the first place, they had to know that most of them were about to reverse, and that’s why they agreed to the sweep–to keep the companies from recapitalizing. The “circular borrowing” (or “death spiral”) rationale was pure fiction for public consumption, and they knew it. (I doubt there are any memos at either agency fretting about circular draws during the three and a half years that they were actually happening; only when they had ceased do we start to hear of the “concerns” about them.)

            Moreover, we know what actually happened. As I noted in my Supreme Court amicus, “in just 18 months, from the fourth quarter of 2012 through the first quarter of 2014, the two companies earned—and paid to Treasury—$158 billion, more than half again what they had earned in their entire pre-crisis existence.” All of that would have become retained earnings had Treasury not swept it. And with that huge a reflux of earnings in such a short period of time, there would have been enormous pressure on Treasury to permit Fannie and Freddie to pay down their senior preferred–not the least because that large and quick a spike in earnings would have made clear that most of the draws of senior preferred were never warranted to begin with. Investors almost certainly would have expected Treasury to allow repayment of the senior preferred under those circumstances, and were I counsel for the plaintiffs I would argue that it would have had little choice but to have done so.

            Liked by 3 people

          5. I should clarify the final statement in my comment. Once Judge Lamberth ruled against expectancy damages in the remand, plaintiffs were not able to argue that Treasury would have allowed repayment of the senior preferred had the net worth sweep not been imposed. But I do wonder whether expectancy damages might have been remained in play had plaintiffs’ counsel made a stronger and more direct argument in earlier motions that the government’s version of the rationale for the net worth sweep was demonstrably and knowingly false.

            Liked by 1 person

          6. “plaintiffs were not able to argue that Treasury would have allowed repayment of the senior preferred had the net worth sweep not been imposed.”

            I understand that they can’t say that. But can they say that investors would have expected for the Treasury to allow the repayment?

            Because, although we don’t know what the Treasury would have done, we do know what investors expected.

            I know this isn’t enough for the expectancy damages, but at least is enough for a jury to see our point of view before the nws.

            Like

          7. @freddie

            since I haven’t been following the trial closely (to do that would require daily attendance at the court), I wonder whether Lamberth found that the Ps couldn’t argue for expectancy damages, or simply that they couldn’t put on the stand an expert who would testify as to his opinion regarding expectancy damages. big difference. if anyone thinks they know the answer to this, it would be helpful to this thread.

            rolg

            Liked by 1 person

          8. I don’t have Lamberth’s exact ruling on expectancy damages, but his October 3, 2022 Memorandum Opinion gave his reasoning for denying plaintiffs damages under the “lost-dividends theory”, and I imagine the same reasoning also would have applied to expectancy damages. Lamberth characterized plaintiffs’ argument that absent the net worth sweep Treasury would have allowed Fannie and Freddie to repay the senior preferred (thus giving rise to a resumption of dividends on the junior preferred) as follows:

            “Plaintiffs argue that a reasonable jury could infer that Treasury would have allowed a paydown [of the senior preferred] for four reasons cited in the report of their expert, Dr. Joseph R. Mason: 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 reacted to these arguments by stating, “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.” He went on say, “Delaware and Virginia law both require REASONABLE CERTAINTY as to the fact of damages; and a reasonable inference that it would be RATIONAL for one to take a course of action does not alone support a further inference that it is REASONABLY CERTAIN one would take that course of action,” before concluding that “defendants are entitled to summary judgment on plaintiffs’ lost-dividends theory of harm.”

            My criticism of Dr. Mason’s approach to the paydown issue (and Boies-Schiller’s reliance on it) is that it was too general, and thus unconvincing. I think the “lost-dividends theory,” and possibly expectancy damages, would have had a much better chance of being accepted had Hume framed FHFA’s actions the way I’ve done in the set of comments above: Treasury put Fannie and Freddie in conservatorship not because they were in danger of failing but for policy reasons; FHFA engineered their losses–and the required draws from Treasury–by booking over $300 billion in non-cash expenses between the third quarter of 2008 and the end of 2011; when the housing market began coming back in 2012 it was clear to Treasury AND FHFA that most of these losses would come back onto the companies’ books as income–as indeed they did–and that’s why they did the sweep. Had they NOT done the sweep, the booking of $158 billion in net income in 18 months would have made clear to everyone that the earlier losses had not been real, and under those circumstances Treasury would have had no realistic alternative but to allow Fannie and Freddie to pay back borrowings that were forced on them by FHFA, and that they never really needed. THAT would be a far better argument to make to a jury.

            Liked by 3 people

          9. Tim

            I agree that a theory of a case involving breach of implied duty of fair dealing should focus precisely on unfair dealing, which would include, among other things, fictitious and pretextual accounting entries prior to the NWS that paved the way for the (false) claim that the NWS was reasonable and prudent.

            Testimony in a courtroom generally speaking is limited to what (i) the relevant actors did/saw/heard/thought etc regarding events, that they participated in or witnessed, that are the subject of the case, and (ii) expert testimony that can serve to frame this testimony in a relevant context. You could not testify under (i) but I suspect you would be well-qualified to testify under (ii) as to the bad faith accounting adjustments that you have discussed both on this blog and in amicus briefing.

            Perhaps this focus would require P counsel to revise their theory of the case, but I wonder if counsel did, who would be a better expert than you to explicate GSE accounting, both faithfully and unfaithfully done.

            rolg

            Like

          10. In my first comment in this (now fairly long) string, I said, “If there is a retrial, I think this time plaintiffs’ counsel must go after the government’s story early and much harder and more directly, to try to undermine its credibility before any of the jurors commit themselves to it. And, yes, I certainly will make that case to my contacts at Cooper & Kirk, for whom I did the Perry Capital amicus (and two other ones).”

            I have a longstanding policy on this blog of not commenting on my private interactions with principals involved with Fannie and Freddie issues. So while I can say that I have followed through on my pledge to “make [my] case to my contacts at Cooper & Kirk,” I don’t wish to go beyond that.

            Liked by 5 people

    1. Whether or not this development is a “big deal” depends on how you’re viewing it. FHFA’s press release says that “FHFA is eliminating upfront fees for certain first-time homebuyers, low-income borrowers, and underserved communities to promote sustainable and equitable access to affordable housing,” and that “The new fee reductions will go into effect as soon as possible.” Upfront fees (or Loan Level Price Adjustments, LLPAs) are a major component of Fannie’s guaranty fees. In the second quarter, over one-third of Fannie’s guaranty fees came from the amortization of LLPAs or other buy-downs or purchase discounts. If these fee changes affect one in five borrowers, the result over time would be at least a seven percent drop in average effective fee rates for the company, or about 3 basis points. It’s unlikely that Fannie could make this up through “the upfront fee increases for second home loans and high balance loans announced earlier this year,” or cash-out refinances.

      And that gets to the larger “what does this mean” question.

      In its 2021 10K, Fannie made a few comments about its current binding capital requirement (the Calabria standard, or ERCF), its pricing, and its returns. It said, “When it is fully applicable to Fannie Mae, this [ERCF] framework will require us to hold significantly more capital than the statutory minimum capital requirement…” and that “if we were fully capitalized under the framework, our returns on our current business would not be sufficient to attract private investors.” Those two statements together would make one think that Fannie would be taking steps to raise its average guaranty fees. But Fannie also said, “FHFA, in its capacity as conservator, can direct us to make changes to our guaranty fee pricing for new single-family acquisitions.” That appears to be what is happening here.

      And THIS is what I would say is the “big deal.” Fannie has been given an unreasonable and indefensible capital requirement, and its only option for responding to it is to raise its average guaranty fee to try to earn a market return on this (unnecessary) capital. But now FHFA is coming in and saying, “No, we want you to LOWER your fees.” And the conclusion I draw is that the current leadership of FHFA either has no conception of what is required to release Fannie from conservatorship (which includes a market return on the capital it will need to raise), or it has no real intention to release it at any time in the foreseeable future, and instead wants to run Fannie as if it were a federal agency, while letting its return on capital fall even further below a level investors would find attractive. I suspect the latter.

      I have never felt that the current leadership of FHFA had the desire, knowledge or courage to lift the shackles that past administrations had put on Fannie and Freddie and take the initiative to restore them to their traditional positions of conduits of funds from international capital markets investors to homebuyers, and this most recent announcement from FHFA certainly doesn’t change that.

      Like

      Reply

      1. “has no real intention to release it at any time in the foreseeable future”

        Does this blog allow an examination of that? If I recall correctly you are of the opinion that the present admin will begin the process of reform, but what if it doesn’t have the stones to?

        If all court cases fail, as I suspect they will based on rulings to date, are we left hoping DeSantis – a Federalist Society contributor – starts the process? Better question: If warrants expire 9/7/2028 does govt care? and if it does, how much sooner does the recapitalization have to begin from that date? Serious question, that.

        Like

        Reply

        1. @Robert

          I suppose if the govt could justify the NWS, it could justify some future deal in which the warrants’ maturity was extended…I dont see the warrants maturity date as having any bite in the rabbit hole world of GSE conservatorship.

          rolg

          Liked by 1 person

          Reply

          1. Robert–Since the SCOTUS opinion on the APA claim last June, my view has been that the most promising avenue for getting Fannie and Freddie out of conservatorship any time soon, and through that conveying significant value to the holders of Fannie and Freddie common and junior preferred, is for the senior economic officials in the Biden administration to realize that it is in their best political and policy interest to recognize and admit that the Treasury senior preferred has been completely paid off (with interest), to deem it repaid and cancel it, and then to require FHFA to replace the Calabria capital standard with one that more closely reflects the risks of the one business the companies are allowed to do (guarantee the credit risk of residential mortgages), so that they then can obtain that capital, be released from conservatorship, and get back to their traditional business of providing large amounts of affordable secondary mortgage market funds to low- and moderate-income homebuyers.

            Under Sandra Thompson, FHFA will not be the entity that takes the lead in removing Fannie and Freddie from conservatorship; the initiative for that will have to come from either the National Economic Council or Treasury. To date, neither Brian Deese (NEC) nor Janet Yellen (Treasury) have given any public indication that Fannie and Freddie are an element of their policy agendas. I’m hoping this is only because of the impending mid-terms.

            Liked by 2 people

          2. Leaving Fannie and Freddie to a future administration to determine their fate would be a huge policy blunder, IMO. I believe there are people in Treasury that understand this. Whether they will take the initiative following the midterms is another question. I hope they will, but we won’t know for sure until they do.

            And yet, if Treasury is going to start the process of releasing Fannie and Freddie following the midterms, I wouldn’t expect to hear anything at all until it happens. More or less in exactly the state we currently find ourselves.

            But the thought of leaving these entities in the hands of a future Calabria is truly mind-boggling and depressing. I just don’t know why they would take that chance.

            Like

  10. Tim and ROLG,

    Today 5th circuit ruled against CFPB funding mechanism as being against appropriations clause.

    https://www.politico.com/amp/news/2022/10/19/appeals-court-cfpb-unconstitutional-00062626

    FHFA was somehow differentiated in the opinion, but seems funding is more directly in conflict with the constitution since, while in conservatorship and under the NWS, 100% of GSEs net worth is owed to Treasury, so any deductions to fund FHFA seems like a direct appropriation by Treasury outside of the appropriations process. Is it too late to amend or file a complaint against the NWS on these grounds? FHFA ran afoul of appropriations and continues to do so with every sweep payment.

    Liked by 3 people

    Reply

    2. Prior to HERA (in 2008), Fannie and Freddie’s regulator, OFHEO, had to get its proposed budgets, paid for by the companies, authorized by Congress. When I was Fannie’s CFO (2000-2004) we liked that arrangement, because it put a check on what OFHEO could charge us, and how large of a bureaucracy it could have. Not surprisingly, our critics and opponents wanted the opposite– a larger OFHEO, unchecked by Congress, with more powers. They got their way in HERA, including having Congress removed from the appropriations process of the new regulator, FHFA (OFHEO with the nameplate on the building changed).

      Let’s assume this wasn’t constitutional, based on the CFPB case. What would be the remedy? Inserting Congress into the FHFA budgeting process again. A case attempting to do that almost certainly would have to be filed derivatively, and it’s not clear to me who would have either the standing or the incentive to file such a suit, since the benefit from winning it would be somewhat reduced administrative expenses for Fannie and Freddie going forward. There is not a way, by my understanding, to link a voiding of the net worth sweep to an alleged unconstitutional appropriations process in HERA, passed back in 2008.

      And after skimming the Fifth Circuit opinion, what drove the ruling against the CFPB (other than a clear disdain for that agency, described as having a “capricious portfolio of authority” that includes the ability to levy “knee-buckling penalties against private citizens”) was the “non-delegation doctrine,” which states that the legislative branch–with “power of the purse”–cannot delegate that power to the executive branch (in this case, the Federal Reserve, which is part of the executive branch). That’s not what’s happening with FHFA–Fannie and Freddie pay the assessments whether Congress appropriates them or not. As to the decision in the CFBP case itself, it struck me as a sweeping precedent–Congress can NEVER delegate its spending authority to an agency of the executive branch. To my recollection, that happens frequently. Will all of these instances be litigated and overturned, or will this (to my mind) very aggressive decision by the most conservative court of appeals in the land be reviewed by SCOTUS and either affirmed with the full knowledge of the consequences of doing so, or overturned?

      Like

      Reply

      1. I like your thought experiment. Perhaps things were ok up until the PSPAs, which then vested all authority of the secondary housing market to FHFA and Treasury, and now to an even greater extent since the director is removable at will, 100% of the secondary mortgage market is controlled by the executive branch today. Congress can’t check it unless it passes laws to stop the executive branch. The President could really do just about anything, use the money for whatever they want (for instance the Affordable Care Act). Is that not really the crux of our problem? The agency HAS done whatever they wanted with no checks by either Congress or the Judiciary.

        Like

        Reply

      2. Tim,

        Collins plaintiffs already added the appropriations argument to their case back in June of this year, after the 5th circuit en banc issued a 5 judge concurring opinion (now 7 total judges on the circuit agree) that the “CFPB structure violates the Constitution’s separation of powers by empowering it to act without oversight from Congress through the appropriations process.” In her opinion, Judge Jones wrote that the proper remedy in these cases would be to vacate the challenged action, reasoning, “Just as a government actor cannot exercise power that the actor does not lawfully possess, so, too, a government actor cannot exercise even its lawful authority using money the actor cannot lawfully spend … a constitutionally proper appropriation is as much a precondition to every exercise of executive authority by an administrative agency as a constitutionally proper appointment or delegation of authority … The proper remedy here is to disregard the government action.”

        On a separate note, the 5th circuit 3-0 opinion last night shed some light about the Collins SCOTUS remand question that’s currently being litigated (in Collins, Rop, and Bhatti). They derived that in order for plaintiffs to prevail on remedy, they must meet 3 conditions, “(1) a substantiated desire by the President to remove the unconstitutionally insulated actor, (2) a perceived inability to remove the actor due to the infirm provision, and (3) a nexus between the desire to remove and the challenged actions taken by the insulated actor.” In this specific case, they ruled the plaintiffs didn’t meet these conditions because they couldn’t provide direct evidence that Trump wanted to do this, instead citing secondary sources “these second hand accounts of President Trump’s supposed intentions are insufficient to establish harm”

        The question now is does the Trump letter satisfy all 3 conditions? One can make the argument it does as its first hand source, direct from the President himself. 1) Trump claims he wanted to fire Mel Watt from day one of his administration, 2) Trump claims he would have done it if not for the for-cause removal protection, 3) Trump claims he was denied the time to carry out his goals due to this restriction (of privatizing the GSEs and monetizing the government stake for a huge profit), which would have resulted in GSE shareholders benefitting. So on paper it seems to satisfy all 3 conditions.

        Like

        Reply

        1. I have a different perspective on the likelihood of the appropriations issue leading to a judicial reversal of the net worth sweep, and it’s based on the experience to date. I thought it was a “slam dunk” that plaintiffs would win on the claim that the NWS was a violation of the APA–on both the facts and the law. We lost that at SCOTUS, on the ludicrous argument that a clause in the “Incidental Powers” provision of HERA, lifted from the FDIC Act, that allowed the regulator to act in its own interest could be read as applying to the statute as a whole (thus overriding the specific language spelling out the powers of the conservator). I wasn’t confident we’d get a favorable remedy if the director of FHFA was found unconstitutional because he could not be replaced by the President, but we didn’t even get that far–SCOTUS claimed, without evidence, that an acting director (which DeMarco was) WAS removable, so it didn’t need to address the issue of remedy at all. This leads me not to give any chance to the potential for the net worth sweep to be voided because the budget of FHFA is not subject to the Congressional appropriations process. I understand that an argument can be made to the contrary; I just don’t think it will succeed.

          Like

          Reply

          1. Thanks Tim, I just figured I would share Judge Jones similar ruling / interpretation on appropriations remedy for you and your readers. But you raise valid concerns…

            Curious as to your thoughts on the 2nd half of my comment re: remedy potential on the Collins remedy remand? The 3-0 panel joined by Willet seem to create a straight forward 3-part condition test that needs to be satisfied in order to be entitled to remedy.

            Like

          2. I don’t have any basis for speculating on how the Collins remedy remand might be handled by the lower court. But if it rules that the appropriate remedy is a voiding of the net worth sweep, that ruling would have to survive appeals up through SCOTUS to become effective, and I can’t see that happening.

            Like

          3. There’s two possible outcomes I see with regards to what the Collins SCOTUS remand remedy could look like, neither of which “directly” vacate the NWS.

            1) The up-shoot is plaintiffs prevail and can prove Trump was on his way to privatizing the GSEs but fell short 1 step, which he ran out of time to do, addressing the senior pfds. Remedy would be to force the treasury to choose between the two options they laid out in their reform plan of converting the snr pfds to common shares or writing them down.

            2) The more realistic remedy, and this is much less speculative (and one closer to what SCOTUS probably had in mind), is to order the treasury to return the 2017-2019 CASH NWS payments (which totaled ~$45b) that were made under Watt back to the GSEs balance sheet (in exchange for the LP going up $ for $). No counter-factual analysis would be required here as it is not hypothetical / debatable that one of Calabria’s first actions as Director, in tandem with Mnuchin, was to suspend the cash dividend payments of the NWS. This is simply stating what would have happened if Trump had Calabria start day 1 in 2017 (which he was prevented from doing). While on the surface it might not appear as powerful as writing down the senior pfds in one shot, it could have a powerful effect as it may ultimately lead to settlement / reform as I believe in no scenario is the government going to write a $45b cash check outflow as this remedy would require (even if their LP increased an equal amount).

            So at a minimum I believe we should get a remedy that entitles us to reverse Watt’s implementation of the NWS, which was contra to Calabria’s / Trumps desired position, for 2 years that saw ~$45b of cash move over from the GSEs to the government.

            Liked by 1 person

    1. Layton doesn’t say anything in this piece that he hasn’t said before—and that’s the problem with it. He repeats his contention (and the refrain of his fellow “bankistas”) that the problem with Fannie and Freddie pre-crisis was their “flawed business model”—ignoring the facts that the companies’ pre-crisis delinquencies and post-crisis defaults on single-family mortgages were one-third those of banks and less than one-sixth those of loans put into private-label securities—and also claims that Fannie and Freddie were “fixed” while he was caretaker CEO of Freddie by getting them out of the portfolio business and getting them to issue credit-risk transfer securities (whatever you think about their portfolio businesses, they were duration-matched at the time of the mortgage meltdown and making huge amounts of money that offset some of their credit losses, and Layton doesn’t seem to have noticed that with home prices flat to falling the spreads on existing CRTs have soared and the issuance of new CRTs has ceased, making clear what should have been obvious without these developments—investors buy CRTs when they have little chance of transferring credit losses and back away from them when they’re most needed by the issuers, so that they cost Fannie and Freddie far more in interest payments than the companies can ever hope to see in loss reimbursements).

      Layton also unhelpfully repeats the fiction that “It took nearly $200 billion of taxpayer money to bail them out.” No. That “nearly $200 billion” was paper losses put on the companies’ books by FHFA between June of 2008 and December of 2011, virtually all of which was subsequently reversed, at which point FHFA and Treasury agreed to a net worth sweep that returned all of that money, and $150 billion more, to the “taxpayer,” making this not a bailout by the government but a huge moneymaker for it.

      As for Layton’s observation that “the question of what to do with the GSEs has…been answered…[with] reform, recapitalize and release,” that’s been obvious to everyone since the 2018 mid-term elections (and ten years of futile efforts to replace Fannie and Freddie through legislation). And, yes, the Calabria capital requirement has to be scrapped and replaced by one that much more closely reflects the risk of the credit guaranty business the companies actually do—and the results of the last three years of Dodd-Frank stress tests–but not by the “this looks about right” capital standard proposed by Layton in an earlier piece. Finally, it should NOT take “a minimum of 5 years,” or anywhere close to that amount of time, to complete the return of Fannie and Freddie to the fully capitalized, shareholder-owned entities they once were.

      Liked by 5 people

      Reply

  12. Click to access 20220722162334690_Petition%20for%20Writ%20Of%20Certiorari.pdf

    Tim and Christian, Have you read this PETITION FOR A WRIT OF CERTIORARI in the case of JOSEPH CACCIAPALLE, et al., that was filed by Hamish Hume? For me, a layman and not a lawyer, it is a fascinating and logical, common sense rebuttal of the lower Courts decision to prevent the Takings argument. It is brought by Preferred holders of Fannie Mae and Freddie Mac, if I have understood it correctly. Would you please comment on this?

    Like

    Reply

    1. This petition for cert was filed a few months ago, and I read it then. I thought it was very well argued, and that on the merits the Court should grant it. But, will it?

      Close readers of the blog and my comments won’t be surprised by my opinion: I don’t think so. This opinion is very much colored by my view of the SCOTUS decision on the APA claim in Collins, for which I think Justice Alito, and the rest of the Court, did intellectual and analytical gymnastics to arrive at a ruling that had been determined before any of the briefs had been filed, intended to give the members of the Federalist Society a victory over two companies they have loathed since the society’s inception.

      I was interested to see Hume’s final argument: “For example: government regulators have the power to put Bank of America, Wells Fargo, and Citibank into conservatorship or receivership. According to the Federal Circuit, that means that, no matter what the facts and circumstances are, those regulators have the power to take 100% of all dividends those regulated banks may pay in the future – no matter what. This cannot be squared with the Takings Clause. This Court must therefore grant certiorari to ensure that the Takings Clause still exists for shareholders in regulated financial institutions.”

      I can imagine the six conservative Supreme Court justices reading this and thinking, “First of all, Treasury would never take 100 percent of all of the earnings of a big bank. But if it ever did, counsel for that bank should file a petition for cert with us. We’ll grant it, and make things right for them.”

      That sounds cynical, but it’s not without justification. And I have personal experience with a different set of standards being applied to Fannie Mae than to any other financial institution, when the Chief Accountant of the SEC, Don Nicoliasen, handed FHFA’s predecessor agency–the Office of Federal Housing Enterprise Oversight–the victory it sought in its accusation of accounting irregularities against the company in 2004, by opining that Fannie had not applied the accounting standard for derivatives, FAS 133, correctly, while never saying what specific aspect of that standard it had gotten wrong, even when asked to do so by Fannie’s outside auditor, KPMG, which continued to support that accounting. This sort of regulatory “rifle shot” aimed at one company was unprecedented, and ultimately was supported neither by the accounting profession (which took two and a half years) nor the DC District Court judge hearing a civil case in the matter (which took eight years), but it had the effect its proponents desired–removing Fannie’s top management, which put the company on a destabilizing path that led to just enough financial weakness to allow Treasury to force its board to accept conservatorship in the fall of 2008.

      Liked by 1 person

      Reply

  13. Thoughts on the latest out of lamberth’s court?

    Seemed to me like he was super excited to limit the damages to the terrible expert testimony that only talked about $1.6b in liability…

    The courts continue to appear farcical..

    Like

    Reply

    1. I wasn’t at the pre-trial conference, nor have I kept up with all of the most recent filings. It didn’t surprise me, though, that Lamberth is not going to permit plaintiffs’ counsel to argue for reliance damages.

      Like

      Reply

    2. The lawyers are free to argue higher damages, but without expert testimony. Not sure how successful that will be, but the big picture – that the jury might be able to see – is this: Gov got 140bn more in cash because of the illegal NWS. would be shameful to punish this with a 1.6bn punishment. like robbing a bank and having to pay only the parking ticket.

      Like

      Reply

  14. Tim, plaintiffs in Lamberth have filed a new document with two strategies: 1) offer reliance damages as an alternative and 2) saying the drop in share price the day after NWS underestimates the damage, but at a minimum a drop to zero should be used as a proxy of lost value, thus roughly 2$ a share for FNMAS. They also ask for new expert testimony to explain why the drop in share price underestimated the real damage.

    On Reliance Theory, it is interesting because it assumes par value as base case and then shifts the burden of proof to defendants to lower that amount.

    Interestingly, the $2 per share of FNMAS, plus 6% interest since 2012, is $3.38, or roughly the current market price for FNMAS.

    Like

    Reply

    1. All of the recent legal filings–including this document identifying new strategies for determining damages (which I have not seen)–make me wonder if one or both parties might request a continuance (i.e., a postponement of the trial date) at tomorrow’s pre-trial conference. We will soon find out.

      Like

      Reply

  15. @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?”

    Like

    Reply

    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.

      rolg

      Like

      Reply

      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.

        Liked by 1 person

        Reply

        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.

          rolg

          Like

          Reply

          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?

        Like

        Reply

        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.

          Like

          Reply

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

            Like

          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.

            rolg

            Like

          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!

            Like

          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.

            Like

          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.

            Like

          7. This is outside my area of expertise, but I would question how one would value the (eventual) liquidation preference of Fannie and Freddie junior preferred if the government has no incentive to–and has given no indication that it ever would–liquidate the companies.

            Current government policy for Fannie and Freddie was set by former Treasury Secretary Mnuchin and ex-FHFA Director Calabria in January of 2021: both companies would be allowed to retain earnings (with a corresponding increase in Treasury’s liquidation preference) until the “Capital Reserve End Date,” defined as “the last day of the second consecutive fiscal quarter during which Seller [Fannie or Freddie] has had and maintained capital equal to or in excess of all of the capital requirements and buffers under the Enterprise Regulatory Capital Framework,” at which point the net worth sweep would be turned back on. Dividends on junior preferred and common stock also could be resumed at that point.

            As of June 30, Fannie and Freddie were $423 billion away from meeting all of their capital requirements. Even with no business growth and $27.5 billion per year in retained earnings (a high estimate, in my view), it would take them fifteen years to get any dividends turned back on. In the “but for” world in which the net worth sweep never happened, the companies would have more capital (I’ll take Hume’s word for it that it’s $149.4 billion), but their annual pace of retained earnings would be reduced to $8.6 billion ($27.5 billion in after-tax earnings, less $18.9 billion in senior preferred dividends), so it would take them at least thirty years to meet the Mnuchin-Calabria requirements for getting their dividends turned back on, although at that point there would be no net worth sweep (to the benefit of the common stock).

            Were I counsel for the government, I would argue that its current policy toward Fannie and Freddie is for them to use their retained earnings to eventually become adequately capitalized, and that it has NO intent to ever liquidate them, given the pivotal role they play in U.S. housing finance. And without an assumed liquidation date, it’s not clear how one discounts back to get a liquidation value on the junior preferred.

            We will, of course, shortly learn what approach plaintiffs’ counsel actually does take to argue for damages for breach of implied covenant, given the restriction put on by Lamberth that these damages must be limited to “lost value.”

            Like

          8. @Tim and @unfortunate

            let’s recall the context of this inquiry.

            the jury has already decided on the merits that the government breached the implied covenant of good faith in adopting the NWS. so now the jury has to consider what the P junior preferred shareholders’ expectancy damages are…that is, in the counterfactual world where the NWS was not adopted, what were Ps’ reasonable expectations as to future value.

            Ps should be able to present evidence that those reasonable expectations would be for the senior preferred to have been paid off in accordance with their terms…reasonable because that is in fact what the actual historical distributions would have accomplished, the “10% moment”, absent the NWS. Ps should be able to present evidence that given the capital structure of the GSEs without any senior preferred stock, the junior preferred would have substantial value…even without dividend payments, as the junior preferred ascended to the top of the equity capital structure. this, notwithstanding regulatory capital requirements that might require additional equity capital raises (which, to the extent these additional capital raises are common stock, would serve to increase the fair value of the junior preferred).

            will Ps present this evidence, will Lamberth permit this evidence to be presented to the jury, will the jury buy it?

            rolg

            Like

          9. ROLG–Judge Lamberth explicitly addressed the argument that “it would have been RATIONAL for Treasury and FHFA to agree to a paydown of the Liquidation Preference, eventually, in some way, shape, or form” in his Memorandum Opinion, and he rejected it, saying “Delaware and Virginia law both require REASONABLE CERTAINTY as to the fact of damages, and a reasonable inference that it would be RATIONAL for one to take a course of action does not alone support a further inference that it is REASONABLY CERTAIN one would take that course of action.” I think that door to the barn has been closed, unfortunately.

            Liked by 1 person

    2. I believe the Rop verdict was just released.

      https://www.opn.ca6.uscourts.gov/opinions/opinions.php?todo=today

      “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.”

      Like

      Reply

      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

        Reply

        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.

          rolg

          Like

          Reply

          2. 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.

            Like

  16. 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.

    rolg

    Like

    Reply

    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).

      Like

      Reply

  17. 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

    Reply

      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.

        rolg

        Liked by 1 person

        Reply

    2. @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.

      rolg

      Liked by 1 person

      Reply

      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

        Like

        Reply

        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

          rolg

          Like

          Reply

          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……

            VM

            Like

          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”

            https://law.justia.com/cases/federal/district-courts/district-of-columbia/dcdce/1:2013cv01053/160910/82/
            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

            Like

          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.

            @soto

            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.

            rolg

            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

      Reply

      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

        Reply

        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.

          Like

          Reply

  19. 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.

    rolg

    Like

    Reply

    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!

      Like

      Reply

      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

        Reply

    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.

      Like

      Reply

    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

      Reply

      1. Tim,

        Your (simple, clearheaded) proposal to “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” and conclusion that “2.5 percent [would likely] be acceptable to a broad enough group of opinion leaders to…[allow the GSEs to] break out of the “Calabria capital standard straightjacket” the companies currently are in, and get them out of conservatorship and recapitalized.” makes me wonder what you think about FHFA’s recent announcement retracting the stress test it recently ran. And whether you might have a guess at what the model’s errors might be. Also, any guesses as to what you might anticipate the new model to contain (or a wish list of what it *should* contain beyond what’s mentioned in this post)?

        I don’t mean to disparage the aforementioned erstwhile FHFA director, but FHFA’s failure to release the stress tests as legally mandated during his tenure was…curious. One would be forgiven for thinking, upon reading this Nov 7 statement by FHFA that they were peering through a looking-glass that renders things ever curiouser and curiouser.

        Stress Test Results
        November 7, 2022

        Fannie Mae is reevaluating its 2022 stress test results and the associated report due to our recent identification of errors in an underlying model. Once this evaluation is complete, we will post an updated 2022 report on this website. Until we publish that updated report, you should not rely on the information in this report for any purpose. (from: https://www.fanniemae.com/newsroom/fannie-mae-news/2022-stress-test-results)

        Like

        Reply

        1. First off, the stress test I am advocating for the revised capital rule is different from the Dodd-Frank stress tests FHFA has Fannie and Freddie run each year. The latter are stylized tests, modeled after the stress tests the Federal Reserve requires banks with $100 billion or more in assets to run. The “severely adverse scenario” of the Fed’s Dodd-Frank stress test posits a sudden adverse shock to a number of economic and financial variables, and runs for only nine quarters. The stress test I advocate as the basis for Fannie and Freddie’s risk-based capital rule should be a cash-flow model of how the prepayments, defaults, administrative expenses and revenues of each company’s current book of business behave in an environment that mirrors what occurred during the Great Financial Crisis beginning in the second half of 2007, running until the projected quarterly revenues of these current books exceed total losses plus expenses. In my view, the Dodd-Frank test is “easier” than the one I recommend using to determine Fannie and Freddie’s risk-based capital.

          But I did see that FHFA had said that Fannie was reevaluating the results of its 2022 Dodd-Frank stress test because of potential errors in that model. My expectation of the results of that reevaluation, however, is that it won’t show too significant a difference from what was published in the fall, for the simple reasons that those initial results seemed in line both with what Freddie Mac reported in ITS 2022 stress test, and were consistent with what Fannie had reported for its stress tests in 2020 and 2021, given what we know happened with home prices and interest rates since then. Tempting as it may be to do so, I don’t suspect that FHFA is going to try to “fiddle” the results of Fannie’s 2022 test to try to bring them closer to the percentage required by the Calabria capital standard.

          Like

          Reply

  21. 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

    Like

    Reply

    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

      Reply

        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

          Reply

    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

      Reply

      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

        Reply

      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

        Reply

        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.

          rolg

          Like

          Reply

          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

  23. 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

    Reply

    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.

      rolg

      Like

      Reply

      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

        Reply

  24. 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

    Reply

    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.

      Like

      Reply

      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

        Reply

  26. 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

    Reply

    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

      Reply

    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

      Reply

      2. 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.

        rolg

        Like

        Reply

        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

          Reply

          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.

            rolg

            Like

Leave a comment