Shortly after my book The Mortgage Wars came out in November of 2013, an executive of the Fairholme Funds connected me with the legal team at Cooper & Kirk in Washington D.C. (about 15 miles from my home), whom Fairholme had retained to pursue its suits against the government for imposing the Fannie and Freddie net worth sweep in August of 2012, and subsequently I flew to Miami for two days of meetings at the Fairholme offices. Thus began my involvement with all of the net worth sweep cases, the first filed on July 7, 2013.
I had written about the sweep in my book. I had noted that “In the first year and a half after its conservatorship, Fannie Mae reported a staggering $127 billion in losses, exhausting its capital and causing it to draw $75 billion under its senior preferred stock agreement with Treasury in order to maintain a positive net worth.” I pointed out, however, that of this $127 billion only $16 billion were actual credit losses, and that, “Virtually all of the rest of its losses were accounting entries made by the company’s conservator, FHFA, that pulled into Fannie Mae’s 2008 and 2009 financial statements over $100 billion in expenses that otherwise would have been incurred in the future, if they were incurred at all.” Fannie’s draws of senior preferred rose to $116 billion at the end of 2011, but then, after home prices bottomed out, it began to make money again. Fannie announced on August 2, 2012 that it had earned $5.1 billion in the second quarter, enough to add $2.5 billion to its net worth after the required senior preferred stock dividend to Treasury. Less than ten days later, Treasury and FHFA agreed to the net worth sweep, changing the dividend on Fannie’s senior preferred stock from 10 percent per annum to “everything you ever earn.”
I understood exactly what had happened. Treasury knew that a large number of temporary or estimated non-cash expenses put on Fannie’s books by FHFA were about to reverse and come back into income, not only greatly increasing the company’s capital but also making clear that its 2008-2011 losses had not been real, and that Fannie had been forced to take senior preferred stock it didn’t need but couldn’t repay, whose purpose was to “transform massive, temporary and artificial book expenses created for Fannie into massive, perpetual and real cash revenues for Treasury.” I laid out my thesis in a January 2015 paper titled Treasury, the Conservatorships and Mortgage Reform (accessible on this site, under the column labeled “Reference Documents”), and six months later, at the request of Cooper & Kirk, expanded on this paper in an amicus curiae brief written for the Perry Capital case, being heard by Judge Royce Lamberth. I did a second amicus brief in February of 2016 for the Jacobs-Hindes case in Delaware, and discussed it in this blog’s inaugural post, titled “Thoughts on Delaware Amicus Curiae Brief.” Back then I believed it was inevitable that the net worth sweep would be invalidated in the courts, as I said in that post’s final paragraph: “Sorry, Treasury. Because of the lawsuits, you’re now in a different game. Your actions, and your defense of those actions, no longer are being adjudicated only on the editorial pages of the Wall Street Journal; they also are being adjudicated in courts of law. There facts matter, and there you almost certainly will lose.”
Seven years later, those words ring hollow. Through some two dozen lawsuits contesting the net worth sweep, counsel for Treasury and FHFA have continued to advance a blatantly and provably false version of the reasons for and the actions behind it, with no significant adverse legal consequences. On the one case that reached the Supreme Court, Collins v. Yellen, the author of its unanimous opinion, Justice Alito, repeated the government’s false version of the rationale for the sweep—ignoring the contrary factual allegations put forth by the complainant (which in a motion to dismiss must be accepted as true), as well as the amicus brief I filed with the Court—then insisted that a clause appearing in a section of the Housing and Economic Recovery Act (HERA) titled “Incidental Powers,” allowing FHFA to act “in the best interests of…the Agency,” could be read to apply to the statute as a whole, thus overriding the specific “Powers of Conservator” listed in an earlier section. And even here, Alito had to construe that giving all of Fannie and Freddie’s future earnings to Treasury somehow was “in the best interests of the Agency [FHFA]” in order to rule that the net worth sweep was a legal act by the conservator.
For me, the Alito ruling was a defining event. I of course knew that he and the other five conservative justices on the Roberts Court were members of the Federalist Society, which was founded in 1982 and has been a fierce opponent of Fannie and Freddie since that time. But still, I did not believe the Court would make such a nakedly political ruling in the net worth sweep case until it actually did. Yet now that it has, it is foolish to ignore the ruling’s implications. One is that none of the remaining constitutional challenges to the net worth sweep percolating in the lower or appellate courts—whether on the succession clause, the appointments clause or the separation of powers—has any realistic chance of resulting in a voiding of the net worth sweep that is upheld by the Roberts Court. While it is possible that plaintiffs in suits alleging regulatory takings or breach of contract may win some minor amount in monetary damages—and even that will not be easy—the net worth sweep, as flagrantly illegal as it was, will not be overturned judicially.
With the net worth sweep legitimized, and a capital standard that imposes bank-like requirements on Fannie and Freddie’s low-risk credit guaranty business by adding huge amounts of conservatism, minimums and buffers to the risk-based framework mandated by HERA—and pretending that the companies’ $35 billion per year in guaranty fees absorb no credit losses—the companies are in an impossible position. The $192 billion in senior preferred stock that they were forced to take, could not repay, and doesn’t count as core capital must remain on their balance sheets, and they must replace the $242 billion in earnings swept by Treasury between the end of 2012 and the middle of 2019 with earnings they’ve been allowed to retain since then, at the cost of an equal increase in Treasury’s liquidation preference, now $289 billion and rising every quarter. And before they can be considered adequately capitalized under the standard made final by former FHFA Director Calabria in December of 2020, they must attain a level of “adjusted total capital” that as of September 30, 2022 was $301 billion, or 4.0 percent of total assets, a percentage that likely will increase in the future because it is procyclical.
This untenable construct for the net worth sweep and the “Calabria capital standard” was hard-wired into the January 14, 2021 letter agreement between former Treasury Secretary Mnuchin and Calabria. That letter stipulates that neither Fannie nor Freddie will be eligible to be released from conservatorship until “all material litigation [is] resolved or settled,” and each company “for two or more consecutive calendar quarters has and maintains ‘common equity tier 1 [CET1] capital’…in an amount not less than 3 percent of Seller’s [Fannie’s or Freddie’s] ‘adjusted total assets’.” Subsequently, the companies may continue to retain capital until “the last day of the second consecutive fiscal quarter during which Seller has had and maintained capital equal to or in excess of all of the capital requirements and buffers under the Enterprise Regulatory Capital Framework [ERCF]”. At that point, the net worth sweep will be resumed, at an amount “equal to the lesser of 10.0 percent per annum on the then-current Liquidation Preference and a quarterly amount equal to the increase in the Net Worth Amount, if any, during the immediately prior fiscal quarter.”
The letter agreement does permit each company to issue up to $70 billion in common stock (the same amount for both, notwithstanding that Fannie’s required capital is half again the size of Freddie’s) provided all material litigation has been resolved or settled, and Treasury has exercised its full warrant to acquire 79.9 percent of that company’s common stock. But few if any investors will put new capital into the companies, much less $70 billion, while the net worth sweep remains in place and Treasury’s liquidation preference rises in line with their earnings. Consequently, as long as the January 14, 2021 letter is in effect, Fannie and Freddie seem destined to remain in conservatorship until they can accumulate CET1 capital equal to 3.0 percent of their adjusted total assets, and they will have constraints on their executive compensation and dividend-paying abilities until they fully meet “all of the capital requirements and buffers” of Calabria’s ERCF.
How long might that take? We can make an estimate, using data as of September 30, 2022 from the companies’ most recent 10Qs. To be eligible to be released from conservatorship, Fannie would need $136 billion in CET1 capital, $230 billion more than the negative $94 billion it has now (because of the net worth sweep); Freddie would need $111 billion, or $168 billion more than the negative $57 billion it has. At what I estimate as their sustainable rate of after-tax retained earnings—about $13 billion per year for Fannie and about $9 billion per year for Freddie—Fannie would not be eligible for release until 2040, and Freddie not until 2041. Fully meeting their risk-based capital requirements would take even longer.
After over 14 years in conservatorship, what possibly could justify keeping the companies in conservatorship for another 18 years, or more? There is no economic reason. Fannie and Freddie are, and always have been, the highest-quality and lowest-risk sources of mortgage credit in America. Prior to the 2008 financial crisis, the serious delinquency rate on single-family loans owned or guaranteed by the companies was one-third that of the prime single-family mortgages held by banks, and less than one-tenth that of the mortgages originated by subprime lenders. Along with the rest of the industry, Fannie did experience a spike in credit losses on loans guaranteed between 2004—the year the issuance of private-label securities first exceeded the combined issuance of mortgage-backed securities (MBS) by Fannie and Freddie, and underwriting standards collapsed—and 2008, suffering average lifetime default rates on these books of about 10 percent (comparable data for Freddie are not publicly available). But from 2009 on, each of Fannie’s books of business has a lifetime default rate of less than 1 percent. And Fannie and Freddie’s total single-family credit guaranty books as of September 30, 2022 are pristine, with average current loan-to-value ratios of 50 and 53 percent, and credit scores at origination of 752 and 750, respectively. Any doubts about the companies’ credit quality should have been dispelled by the results of their last two Dodd-Frank stress tests, in which neither needed a dollar of initial capital to withstand a stylized repeat of the 30 percent nationwide decline in home prices during the time of the Great Financial Crisis.
Nor is there any structural reason to keep Fannie and Freddie under government control. The most severe and persistent criticism leveled against the companies prior to the crisis was that they should not be allowed to finance mortgages on their balance sheets; today they no longer are. And their entity-based credit guaranty business does not need “reform,” because it already is far superior to the senior-subordinated model used in private-label securitization. In the entity-based model, revenues on good loans from all years, regions and loan types are available to cover losses on any loans that go bad, and all loans benefit from a corporate guaranty. In contrast, each senior-subordinated pool must stand on its own, and the inability to reach beyond it for revenues—or add capital post-securitization—requires substantial initial subordination, which translates into considerably higher credit guaranty costs, while still leaving investors in the senior tranches exposed to losses that exceed the fixed loss-absorbing capacity of the subordinated tranches. Fannie and Freddie’s entity-based model makes them the credit guarantor “gold standard,” as they exist today.
Fannie and Freddie have neither an economic problem nor a structural problem. They have a political problem. And it will require a political solution.
It was a political judgment that put Fannie and Freddie into conservatorship in the first place. After the private-label securities market imploded in 2007, and banks began pulling back sharply on their mortgage lending, Treasury Secretary Hank Paulson knew this left Fannie and Freddie as “the only game in town” (his words) for mortgage lending. Because he did not want to rely on them as shareholder-owned entities to get the country through the financial crisis, however, he made the policy decision to nationalize them, while each exceeded their statutory capital requirements. Except he couldn’t admit that; it had to be a “rescue.” Thus was born the litany of fictions about Fannie and Freddie that persist to this day: that the $187 billion in senior preferred they had been forced to take (to cover non-cash losses) was a real economic cost, and a “bailout;” that they—and not the private-label securities market—had caused the financial crisis, and that their “flawed business model” required them to be “wound down and replaced” by Congress in legislation.
Congress, as we know, has been unable to come up with a workable alternative to Fannie and Freddie, because there isn’t one. What I call the Financial Establishment—large banks and Wall Street firms, and their advocates and alumni at Treasury and elsewhere—finally has accepted this, but continues to insist that Fannie and Freddie only can be released from conservatorship if they are capitalized like banks, and “reformed” (with the two preferred proposals being an explicit government guaranty on their securities, and allowing FHFA to charter multiple credit guarantors). Former FHFA Director Calabria obligingly saddled Fannie and Freddie with a meticulously engineered “risk-based” capital standard that produces 4-percent-plus capital requirements for the companies no matter how little risk they take, while current FHFA Director Thompson says she will defer to Congress on whether, how and when to move Fannie and Freddie off their 18-year-plus path of exiting conservatorship through retained earnings alone, with the net worth sweep and the Calabria capital standard staying as they are in the meantime.
It is hard to imagine, though, that Fannie and Freddie will remain in counter-factual limbo until 2040. Well before then, it seems inevitable that some administration will recognize and admit the absurdity of the status quo, and acknowledge the damage it is doing to the nation’s housing finance system. Whichever administration does so will get to restructure, recapitalize and release the companies in the manner and with the objectives it chooses.
The Biden administration is first in line. And Fannie has not been shy about expressing the extent of its problems with the policy and regulatory actions of FHFA and Treasury. In its 2021 10K, for example, Fannie said, ”We believe that, if we were fully capitalized under the [ERCF] framework, our returns on our current business would not be sufficient to attract private investors,” and that, “Increasing our returns may require substantial increases in our pricing or changes in other aspects of our business that could significantly affect…the level of support we provide to low- and moderate-income borrowers and renters.”
The average guaranty fee rate on Fannie’s single-family book of business nearly doubled between 2007 and 2021, rising from 23.7 basis points to 45.2 basis points (not including the 10 basis points it has had to charge and remit to Treasury since April of 2012). During this same period, Fannie’s percentage of credit guarantees on loans to borrowers with credit scores under 700 fell from 33 percent at December 31, 2007 to less than half that, 15 percent, at December 31, 2021. Fannie’s guaranty fees in 2021 already seemed to be at the threshold of affordability for most lower-credit-score borrowers, but the company’s need to get closer to a market rate of return on its required ERCF capital forced it to raise its average fee on new business in the third quarter of 2022 to 53.3 basis points (63.3 with the 10 basis points for Treasury), with that fee likely headed even higher, and the percentage of Fannie’s business done with lower-credit-score borrowers headed lower.
It would be a simple matter for a Democratic administration with a stated policy priority of supporting affordable housing to remedy this situation. It merely has to declare that the 2008 nationalization of Fannie and Freddie (by a previous administration) was unjustified and a mistake, and that it has had the severe and ongoing consequence of impeding access to homeownership for low- and moderate-income families. To reverse that action, it would declare the companies’ senior preferred stock to have been repaid (which it has been) and cancel it, along with Treasury’s liquidation preference. Next, it would require that Director Thompson (or her successor) replace the Calabria standard with one that is not designed to produce a pre-determined capital number, but instead reflects the actual risk of the loans the companies are guaranteeing, with a minimum required capital percentage consistent with those risks. In Capital Fact and Fiction, I explain why that minimum should be 2.5 percent, and note that with the credit quality of Fannie and Freddie’s current business, the 2.5 percent minimum would be their binding capital percentage for the foreseeable future. Eliminating Treasury’s senior preferred stock and liquidation preference, and a putting in place a true risk-based capital standard with a 2.5 percent minimum, will create a path for Fannie and Freddie to emerge from conservatorship relatively quickly, and to resume their traditional roles as the mainstays of large-scale, low-cost, finance for affordable housing.
Standing in the way of this remedy, however, are the Financial Establishment and its ally in the judiciary, the Federalist Society, who continue to falsely claim that the conservatorships of the companies are justified, the net worth sweep is proper compensation for Treasury’s “heroic rescue” of them, and that they only can be released if they are capitalized like banks and “reformed.” Some of the reason for this posture on Fannie and Freddie is ideological, but most is competitive. Banks have benefited greatly from having Fannie and Freddie run in conservatorship and grossly overcapitalized by FHFA. At December 31, 2007, banks held $2.29 trillion in single-family whole loans and MBS, or 23 percent of outstanding single-family mortgage debt, on their balance sheets. At June 30, 2022 (the latest date for which full data are available), banks held more than double that amount—$4.65 trillion, for a 36 percent market share. Moreover, because the rates on all new mortgages are set with reference to MBS yields, the same unnecessarily high guaranty fees that are blocking access to mortgage credit for affordable housing borrowers add, basis point for basis point, to the spreads on the long-term fixed-rate whole mortgages banks finance in their portfolios with government-guaranteed consumer deposits and purchased funds. It is, as they say, “about the money.”
Yet this cliché also highlights a compelling argument for the Biden administration to not keep giving the banks what they want, and instead “do the right thing” by Fannie and Freddie, and low- and moderate-income homebuyers. After Treasury told FHFA to put Fannie and Freddie into conservatorship, it gave itself warrants for 79.9 percent of each company’s common stock. Today, those warrants have very little value, just $3.2 billion, because—with the government’s current policy of laying claim to more than all of Fannie and Freddie’s net worth, and keeping them unreasonably mired in conservatorship for the next two decades—the companies have very little value, with their share prices averaging 44 cents yesterday. As noted earlier, I estimate their combined sustainable earnings to be about $22 billion per year. At a multiple of 10 times earnings—less than half the price-earnings ratio of the S&P 500—their market capitalization would be about $220 billion. Through exercising the warrants, bringing Fannie and Freddie out of conservatorship with a capital standard that allows them to price their business on an economic basis, and then selling the shares from its warrant conversion, the Biden administration could capture a very large portion of that $220 billion potential value for itself for whatever purposes it wishes, including an affordable housing fund.
From both a policy and a financial standpoint, therefore, Fannie and Freddie are worth far more to the Biden administration as vibrant companies run by private management to the benefit of homebuyers than as zombie companies run by FHFA to the benefit of banks. But to unlock that value, someone in the administration is going to have to step up and call the leaders of the Financial Establishment and the Federalist Society on their fictions about the two companies, and be willing to voluntarily cancel the net worth sweep without a judicial ruling saying it must do so, which will not be forthcoming. And the clock is ticking. In two years the opportunity to make defining policy and financial choices with respect to Fannie and Freddie may pass to the next administration, or the next, on towards 2040 or beyond.
HOWARD ON MORTGAGE FINANCE 
Tim,
Do you have any insight or comments on the following? I understand that Judge Lamberth was asked to make pre-trial rulings about what the jury will and won’t see and hear in the second trial. The public filings ask Judge Lamberth to:
— limit Susan McFarland’s testimony;
— prohibit witnesses from describing PSPA funding as a loan;
— restrict testimony about dividends payable to junior preferred shareholders;
— contract testimony about payments made to Treasury following the sweep;
— rule the Stegman Memo is inadmissible; and
— allow the jury to see additional materials reflecting FHFA and Treasury’s motives.
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No, and no. I didn’t follow the first Lamberth trial that closely–since it was about (relatively minor) damages, with few if any policy implications–and I won’t be the best source of insight or information on the second one either.
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“FHFA Requests Input on the Enterprises’ Single-Family Pricing Framework”
https://www.fhfa.gov/Media/PublicAffairs/Pages/FHFA-Requests-Input-on-the-Enterprises-Single-Family-Pricing-Framework.aspx
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This request for “Input on [Fannie and Freddie’s] Single-Family Pricing Framework” is in my view a highly significant development. It’s the first concrete indication we’ve seen from FHFA that it knows that former director Calabria’s Enterprise Regulatory Capital Framework (ERCF) has put it, and the companies, in an impossible position, and it is asking the mortgage finance community to tell it that it has to fix the blatant and obvious flaws in the ECRF, which would give the FHFA Director the political cover to do so.
The trigger event for this request for input seems to have been the high-profile industry backlash against the changes FHFA made to Fannie and Freddie’s loan-level pricing adjustment (LLPA) grids, which went into effect on May 1. The label that was (correctly and credibly) hung on these changes was that FHFA was requiring lower-risk borrowers to pay higher guaranty fees, unrelated to risk, so that higher-risk borrowers could be charged lower fees. This was such an easy and readily understandable “hit” that stories about it made news in the popular media. I view this request for input on Fannie and Freddie pricing to be FHFA’s plea for help to get out of the box it’s put itself in.
There isn’t a lot of subtlety here. The second paragraph in the press release announcing the request says, “FHFA also seeks input on the process for setting the Enterprises’ single-family upfront guarantee fees, including whether it is appropriate to continue to link upfront guarantee fees to the Enterprise Regulatory Capital Framework (ERCF), which was established in 2020, and has a significant impact on the risk-based pricing component of the Enterprises’ guarantee fees.” The description of the ECRF as having been “established in 2020” is not incidental. It’s the Thompson-led FHFA telling us that the ERCF was done by Calabria, so it’s something they’ve inherited, and isn’t their fault.
There is another plea for help in the body of the Request for Input. Towards the end, FHFA says, “Given the substantial amount of capital required to be held by the Enterprises on new mortgage acquisitions as a result of the ERCF, the Enterprises are not currently earning commercially reasonable aggregate returns on new single-family mortgage acquisitions. FHFA estimates that the Enterprises are generally earning mid-single digit returns on equity on aggregate new single-family mortgage acquisitions.” Unless you count zero, there are only nine single digits, so “mid-single digits” is somewhere in the range of 4 to 6, which is very far from being a “commercially reasonable” rate of return on capital. How are Fannie and Freddie supposed to ever be able to raise new equity under such circumstances? What has been evident to so many of us now is being acknowledged by FHFA. (One wonders–or at least I do–whether the capital plans required of the companies by the May 20 deadline asked the obvious question: “Given the net worth sweep, the liquidation preference, and the ERCF, what are you expecting us to do?”)
I definitely will file a comment in response to this request for input, which I will publish as a blog post when I do. I’ll want to get it in well before the August 14 deadline–so that others making comments can review and and consider what I say–but I also don’t want to get it in too early. My current thinking, therefore, is to submit my comment sometime in the first half of June (before I leave for a trip on the 16th).
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Tim
thanks for giving us the benefit of your reading between the lines of this FHFA cri de coeur. but I suppose there can be two polar comment responses relating to “align[ing] pricing and capital frameworks,” either raise guarantee fees or reduce capital requirements, and the banking industry likely will express its preference for the former, no? my reading is that this post-Calabria FHFA and the Biden administration should prefer the latter.
rolg
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I’ve always felt the Biden administration should prefer more reasonable (and lower) capital requirements–and lower guaranty fees–for Fannie and Freddie; what’s new here are the pretty clear statements from FHFA that it, too, now thinks that ERCF capital is too high. In its press release, FHFA cites its “series of steps to update the Enterprises’ single-family guarantee fee pricing framework” (i.e., the LLPA changes) in an attempt to “better align the pricing and capital frameworks” of Fannie and Freddie. We know how those “steps” turned out. Fannie and Freddie also have been raising their fees, but as Fannie said in its first quarter 2023 10Q, those increases have been “primarily driven by the overall weaker credit risk profile” of the purchase-money mortgages it’s acquired recently, rather than being a generalized attempt to increase its overall return on capital. With both companies’ average guaranty fees now at record levels–and far above what is justified by the risk of the underlying loans–their business growth has flattened out, unsurprisingly. Further hikes in guaranty fees won’t boost returns significantly; the only way to do that is by lowering the (grossly excessive) ERCF requirements. FHFA now seems to be acknowledging that.
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Tim,
If we take FHFA’s question on its face, are they not implying a desire to simply disconnect the capital requirement from the g-fee? Essentially, keep the high capital requirements, lower the g-fee and make non-economic returns of low single digits. That’s what I understand Sandra Thompson desires. Am I missing something?
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What you’re missing is that it isn’t possible to “disconnect” the guaranty fee from the capital requirement. Keeping the capital requirement high while lowering the guaranty fee doesn’t disconnect the two, it just produces a very low return on capital. And a non-economic return on capital is inconsistent with the chartered structures of the companies FHFA is supposed to be conserving, which are “private entities with a public purpose.”
I suggest you read this sentence in the FHFA press release again: “FHFA also seeks input on the process for setting the Enterprises’ single-family upfront guarantee fees, including whether it is appropriate to continue to link upfront guarantee fees to the Enterprise Regulatory Capital Framework (ERCF), which was established in 2020, and has a significant impact on the risk-based pricing component of the Enterprises’ guarantee fees.” And I wouldn’t put any importance on the distinction between upfront guaranty fees and the base guaranty fees that are paid over time. FHFA, Fannie and Freddie all combine the two into a total guaranty fee by assuming an average life of the upfront fees that allows them to be converted into basis points per year. Economically, you can neither value, nor treat, the upfront fee any differently from the ongoing fee.
I believe FHFA focused its Request for Input on the upfront fee component because that’s where the firestorm of criticism has been: it used the upfront fee (LLPA) to lower the total guaranty fee of higher-risk loans, and to raise the total fee of lower-risk loans. And it’s asking, “Should we keep linking this fee [and thus the total fee] to the ERCF, which was promulgated by my predecessor in 2020 and has a ‘significant impact’ on where we have to set the [entire] risk-based fee?” The only sensible answer to that question is: “No, link the guaranty fees to a more reasonable capital standard, and you will solve both of the problems you have now–your guaranty fees on higher-risk loans are way too high to be affordable to low-and moderate-income borrowers, while at the same time, even with these high fees, the return on your ERCF required capital is way too low to be attractive to the investors you say you want to tap to recapitalize the companies to get them out of conservatorship.” I think that’s the response Thompson is looking for the industry to give her, so she then can be “responsive” to it, and do what she should have done when she was named director.
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Tim/Juice
one must admit, it is a rather oblique way of asking the question, “should we retain the Calabria capital standard?”, by asking “should we continue to tie G fees pricing to the Calabria capital standard?”
rolg
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It is, but I think my interpretation of the motive behind the Request for Input–that Director Thompson wants the industry to tell her to fix or replace the ERCF– is correct. If the answer to “Should risk-based pricing be calibrated to the ERCF” is “Yes,” that doesn’t solve the problems of unaffordable guaranty fees and a noncompetitive return on Fannie and Freddie’s capital that FHFA has said it is very much aware of, and concerned about. And the answer, “Leave the ERCF as it is but calibrate the companies’ guaranty fees to something else” is nonsensical. By ruling out the alternatives, you’re left with the conclusion I’ve come to. And I think the reason for the “oblique way of asking the question” is that Thompson doesn’t want to be seen as being directly critical of her predecessor, and is more comfortable with an RFI that essentially says, “Let me tell you what I want you to tell me.”
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Tim,
Assuming you are correct and ST is looking for cover to scrap the “Calabria” ERCF through this g-fee request for input, this is where FHFA being a political appointee (post SCOTUS ruling) gets messy. Let’s say ST gets her way and has cover to revert the capital requirements lower, whats to stop the next admin’s FHFA pick from simply resetting the capital requirement right back to the ERCF world? Is there anything the Biden admin can do to essentially lock in any change on the capital requirements (and other housing policy changes) so a future admin’s FHFA pick cant scrap it all together (does releasing the GSEs from conservatorship help)? Or is the housing market just going to be subject to admins ping-ponging every 4-8 years?
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The SCOTUS ruling on the appointment of the FHFA director WILL make that agency somewhat more political than it had been before. As to the capital question, I have a couple of comments. First, while I would hope that Thompson would “scrap” the Calabria standard, it seems more likely that she will keep its structure but just reduce the size and or/number of minimums, add-ons, buffers and cushions Calabria added in 2020. This should be fairly non-controversial. Second, I wouldn’t be too concerned about the capital standard “ping-ponging every 4-8 years,” because the 2008 Housing and Economic Recovery Act (HERA) requires it to be risk-based. For ideological reasons, Calabria cynically added enough minimums, add-ons, buffers and cushions to produce the 4 percent-plus “bank-like” capital percentage he wanted, thus making the ERCF NOT risk-based (in violation of the HERA he professed to follow assiduously). Assuming Thompson corrects this deliberate overcapitalization of the companies (at least partially), I can’t see a future FHFA director doing again what Calabria did in 2020.
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Tim
Hope you had a chance to listen to the hearing today with the FHFA director. I couldn’t get a positive vibe out of her, for any of the questions that had to do with C’ship Exit or capital buffer reduction. I felt it was more of a lip service, checkbox kind of response for those questions (Safety and Soundness, Tax payer risk, Congress has to act, Treasury has to act) that we have been so used to, all these years, that even I can go and answer those questions with a 80,000 foot view response.
While I did not expect her to come out and reveal her plans post the comment period, wanted to hear your thoughts on whether you still think this RFI will brighten the prospects of an exit? Are you still feeling the same, based on anything that sounded like reading between the lines ?
Most of the times (particularly with Mark Calabria), the RFI was a checkbox activity. Despite so many commenters saying the capital is too high, Mark Calabria, at the end went with what was his definition of buffer. So not sure if the RFI would be utilized sincerely this time around and wanted to hear your thoughts on that as well.
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I was not near a computer yesterday morning to view the Thompson testimony live, but have read summaries of and comments on it (so now don’t feel I need to watch the replay). I had not expected her to say anything new or unexpected, and it appears she didn’t. In response to the criticism of FHFA’s recent changes in loan-level price adjustments (LLPAs), however, she did continue to claim “it simply is not true” that these changes cause borrowers with stronger credit to subsidize borrowers with weaker credit, when in fact it IS true. If she’s digging in on this, it doesn’t portend flexibility on other, more nuanced, policy issues.
Thompson’s written testimony was equally inflexible, and defensive, and reinforced my view of her as the “caretaker of the status quo” (as I have felt was the case since she was appointed). I viewed FHFA’s request for input on Fannie and Freddie’s single-family pricing framework in this light: it wasn’t an initiative to “brighten the prospects of an exit;” it was a response to criticism of the agency’s LLPA changes (“well, if you don’t like this, what SHOULD we do?”). But still, I think the RFI could end up being a constructive step forward, if enough commenters make clear in their responses to FHFA that the problems it’s having with trying to make higher-risk loans more affordable without either raising fees on lower-risk borrowers or keeping the companies’ returns on capital buried in the “mid-single digits” are uniquely the consequence of the ridiculous non-risk-based ERCF, which Thompson keeps defending in the name of safety and soundness. Even if she doesn’t do anything to fix the ERCF herself, changing the public dialogue around what I call the “Calabria standard” should make it easier for a successor FHFA director to do so.
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If you were CFO of Fannie Mae at this moment in time you would have significant input into the capital plan delivered to FHFA, although another senior official would likely be responsible for the “non-financial” aspects of that communication. You have stated clearly what needs to change (what you would plea on behalf of the enterprieses), but in this forum you are free to speak without repercussions. If you were in their place now, and possibly advising other senior officials, knowing the near-to-intermediate term hopelessness, and that you are dealing with your regulator and possible blowback I’m wondering what the approach would be.
They are captives, and under current circumstances, not concerned with shareholder returns – although arguing for a profitable rate of return would positively impact theoretical shareholders. As such, in the capital plan, I can’t see them arguing for return of the overpayments, reversal of the NWS (I know, a court domain), repeal of the liquidation preference, or cancellation of the SPSPA – maybe, possibly hinting at a lowering of the capital rule. Do you believe the capital plan request affords leadership the opportunity, or leadership would take the liberty, to include comments on their predicament, the feasibility of any escape, or will they just offer their best effort at some long-term Hail Mary capital plan? If this is too much a Crystal Ball request I understand, but you’ve walked a mile or two in these shoes.
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I have never understood what FHFA thinks it will be getting in the capital plans it has asked Fannie and Freddie to file by May 20. FHFA knows that as of the end of the first quarter of 2023, Fannie was $253.4 billion, and Freddie was $163.3 billion, short of fully meeting the risk-based capital requirements of the ERCF. Neither company has access to the capital markets because of the net worth sweep and Treasury’s liquidation preference, which are not within their control. Fannie and Freddie could shrink their balance sheets (which already have stopped growing because their guaranty fees are so high), but then they wouldn’t be accomplishing the mission of their charters. The only other tool they have for closing their mammoth capital gaps is continuing to retain their earnings, as they have been doing. And if that’s all they do, it will take them close to two decades to meet the requirements of the ERCF (as long as the net worth sweep remains in effect). There IS no financial wizardry they can employ (or a “Hail Mary capital plan”) to reach full capitalization any faster. This is totally a regulatory (and political) problem, which no capital plan filed by Fannie or Freddie can solve.
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I don’t know where a reader views comments submitted by others on FHFA.gov.
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I’ll try to make my question simple and brief, but please feel free to be as technical and encompassing as befits the topic. My understanding is that the Fed holds some $2.6 T in MBS, has (recently?) reported significant losses in this segment, and wishes to “exit” sooner rather than later. I remember seeing these “wish to exit” stories and related analysis well over a year ago. And now we have a lingering banking crisis which makes other financial institutions, investors, and potential MBS buyers “jittery,” interest rates continue to rise, and I imagine the Fed-held MBS have low rates. Can you give us a little history and elaborate on how this particular situation is a drag on or roadblock to “solving” or ending the GSE c’ships?
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I addressed each of these topics–the Fed’s holdings of agency MBS and the implications of the recent bank failures for efforts to remove Fannie and Freddie from conservatorship–in comments on this blog about a month and a half ago. Rather than repeat or summarize those answers here, I’ll just link to them:
For the Fed’s holdings of agency MBS (compared with Fannie’s portfolio holdings): https://howardonmortgagefinance.com/2023/01/04/a-political-problem/#comment-29568
For the implications of the recent bank failures: https://howardonmortgagefinance.com/2023/01/04/a-political-problem/#comment-29576
The Fed has been modestly reducing its holdings of agency MBS for the last year–from a high of $2.74 trillion in April of 2022 to $2.575 trillion currently, about a 6 percent annual decline–but I don’t recall it ever saying it intended to exit entirely from those holdings. I think it more likely will continue to allow most (then perhaps all) of its liquidating MBS to run off unreplaced.
And I suspect banks also are reassessing the huge increases in fixed-rate mortgage holdings they’ve amassed since Fannie and Freddie were forced into conservatorship (quantified in the second comment I’ve linked). I have felt for quite a while that some, and perhaps many, regional banks might have talked themselves into believing that because they’d been able to keep the rates they paid on demand and time deposits at close to zero since the 2008 financial crisis–even when the Fed funds rate rose from zero to 2.5 percent between the end of 2015 and 2019–that this had become the new financial reality for them, greatly reducing the risk of funding long-term fixed-rate mortgage with these deposits. If so, the recent jumps in the rates they’ve had to pay to keep those deposits from fleeing would have come as a rude shock to them (as it did to Silicon Valley Bank, Signature Bank and now Republic Bank). And if the rates on short-term consumer deposits are NOT going to stay close to zero, how should a bank holding long-term fixed-rate mortgages respond? There’s not a reliable hedging relationship between the Fed funds rate and consumer deposit rates (the former is a market rate, whereas the latter are “sticky”). Do you try to hedge anyway? Do you go unhedged (probably not if regulators start watching what you’re doing)? Or do you elect to reduce your relative exposure to mortgages? I would think this last is the most likely.
Together, commercial banks and the Fed hold more than half of all the single-family mortgages outstanding today. If both are paring back their holdings, that will put significant upward pressure on the spreads between fixed-rate mortgages and other intermediate- to long-term securities. By far the largest group of investors who could alleviate some of that pressure are contractual investors like mutual funds, pension funds and life insurance companies. But they tend to buy only mortgages guaranteed by Fannie, Freddie or Ginnie Mae. Under these circumstances, you would think that any policymaker paying attention would understand that it’s now time to reassess the wisdom of keeping Fannie and Fannie–the conduits through which contractual investors channel the large majority of their residential mortgage funding– grossly overcapitalized and over-regulated to the benefit of the banks. We know where these policies have led us, and if we don’t like it (and we shouldn’t) it’s easy to fix–give Fannie and Freddie reasonable capital standards that allow them to price their credit guarantees on an economic (and a more affordable) basis, cancel the net worth sweep and Treasury’s liquidation preference, and then remove the companies from conservatorship.
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Tim,
Guaranty fees seem to be increasing according to Fannie Mae’s Q1 2023 earnings release.
“Average charged guaranty fee on newly acquired single-family conventional loans, net of TCCA fees, increased 2.3 basis points to 51.6 basis points for the first quarter of 2023, compared with 49.3 basis points for the fourth quarter of 2022.”
The G-fees charged in Q1 2023 are ~5bps higher than their current book of business, and inclusive of the TCCA fees, the Q1 G-fees charged are up to 61.6 bps.
“Q1 2023 – Average charged guaranty fee on new conventional acquisitions, net of TCCA fees: 51.6 bps”
“Average charged guaranty fee on conventional guaranty book of business, net of TCCA fees*: 46.6 bps”
Freddie Mac G-fees for single family business are similarly +4bps higher Q/Q (55 bps vs 51 bps) and are current being priced +7bps higher than their average for the current book of business (55 bps vs 48 bps).
Is FHFA beginning to price the G-fees higher to reflect the return requirements of the capital requirements?
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According to Fannie, its recent increases in guaranty fees are more a reflexion of a changing mix of business than a specific effort to increase the expected returns on their credit guaranty business. In its first quarter 10Q, Fannie said the increase in its average charged guaranty fee (of 3.7 basis points) between the first quarters of 2022 and 2033 was “primarily driven by the overall weaker credit risk profile of our first quarter 2023 acquisitions,” with a much higher percentage of that new business being purchase money mortgages, with higher average LTVs. In a table in its 10Q, it showed an average LTV on its new business in the first quarter of this year of 79 percent, compared with 71 percent in the first quarter of 2022 (when 57 percent of the loans it acquired were for refinances, compared with just 16 percent last quarter).
Freddie’s statement about fees in its 10Q was more vague, and a little puzzling: “The average estimated guarantee fee rate on new acquisitions increased primarily due to higher contractual guarantee fees and faster expected credit fee recognition driven by higher estimated prepayments on new acquisitions.” Freddie didn’t say WHY its contractual guaranty fees were higher, and it doesn’t give quarterly information on the credit characteristics of its new acquisitions, as Fannie does. But I would imagine it saw a similar jump it the average LTV of it first quarter 2023 acquisitions as well. (And it’s odd to me that Freddie would be expecting FASTER amortization of the loan-level-price-adjustment component of its new business guaranty fees–both it and Fannie are experiencing the opposite on their existing business, which is why both companies’ guaranty fee revenues have been falling for the last few quarters–and mortgage rates were higher six months ago than they are today).
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I’m not sure if it is, or is not, a sign that the winds of change have shifted when David Stevens is now supporting recap and release.
https://www.linkedin.com/pulse/final-comments-llpa-changes-david-h-stevens-cmb/?utm_source=share&utm_medium=guest_mobile_web&utm_campaign=copy
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Dave has advocated for “recap and release” for some time; he just wanted it to be accompanied by Congressional “reform,” with that most recently meaning an explicit government guaranty of Fannie and Freddie’s MBS (but not debt), and the ability for FHFA to charter multiple credit guarantors. Now, because he says he “hate(s) it when housing issues get politicized,” as has happened with FHFA’s changes to Fannie and Freddie’s loan-level price adjustments (LLPAs), he says he’s willing to drop the conditions, and just advocate for their recap and release in a way that “maintain(s) the integrity of these two very important institutions” (without specifying what that way is….).
So, Dave is shocked that there is gambling going on at Rick’s Cafe. My first boss at Fannie, David Maxwell, used to say that “Fannie Mae is political to its bone marrow.” For the past two decades, those politics have worked decidedly against Fannie and Freddie, and in favor of the large banks (who make up the majority of the dues-payers of the Mortgage Bankers Association, which Dave used to lead). So I think the significance of Dave’s epiphany is that he does realize, and now is willing to say, that what the big banks have been able to get Treasury and FHFA to do with Fannie and Freddie since the financial crisis IS beginning to have negative repercussions on primary market lenders (here, via the LLPA issue), and he doesn’t like it.
That’s been my point since the Calabria capital standard was made final. And I don’t like being cynical, but nobody seemed to be outraged when the primary victims of the non-economic guaranty fee pricing caused by that standard were the low- and moderate income homebuyers who take out the majority of high-risk loans. But when FHFA then says Fannie and Freddie must raise the LLPAs on loans to higher-income, better credit-score borrowers to (slightly) lower the fees on affordable housing loans, well, THAT’s a problem. No. The problem is making Fannie and Freddie’s sole business non-economic in the first place. And if the LLPA looniness gets more people to focus on that– including in the Biden administration–that will be a good thing.
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Tim–It’s absolutely unfair of you to employ observable history, facts, and logic in your answers about mortgage market developments.
I’ll give you 20 years or so to stop doing that.
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Tim,
As of March 31, 2023 have you calculated or do we know these two figures: (1) based on each enterprises assets, the amount of regulatory capital required by FHFAs final rule; (2) the amount of capital the enterprises may claim as being retained.
Although your insight on these other amounts (most known), if changed, is always appreciated, I’d like to keep separate in the discussion any funds needed for or considerations of JPS, SPS, liquidation preference, NWS (amounts overpaid through the sweep), etc. Or if you know a source that has the amounts calcuated you may just point us all there. Thank you again for your efforts!
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All of the data you’re interested in come from Fannie and Freddie’s 10Ks or 10Qs. Neither company has put out a 10Q for the first quarter of 2023 (which will contain the balance sheet numbers as of March 31); based on the timing of the last few years I’d expect both to put out their first quarter 10Qs either on Monday May 1 or Tuesday May 2.
We do have all these data as of December 31, 2022. In its 10K for that period, Fannie said that even though it had positive net worth under GAAP of $60.1 billion, “we had a $258 billion shortfall of our available capital [a negative $74 billion] to the adjusted total capital requirement (including buffers) of $184 billion.” The same numbers for Freddie were a GAAP net worth of $37.0 billion, available capital of a negative $41 billion, an adjusted total capital requirement of $122 billion, and shortfall of available capital of $163 billion.
Both companies’ junior preferred and senior preferred stock outstanding have not changed for over a decade: Fannie has $19.1 billion in junior preferred and $120.8 billion in senior preferred outstanding, while Freddie has $14.1 billion in juniors and $72.6 in seniors.
Their liquidation preference rises every quarter. As of December 31, 2022 Fannie’s was $180.3 billion (and will increase to $181.8 billion as of March 31, 2023 due to the $1.4 billion increase in its net worth during the fourth quarter), while Freddie’s December 31, 2022 liquidation preference was $107.9 billion, on the way to $109.7 billion at the end of the first quarter of 2023, for the same reason Fannie’s is increasing. Finally, for the current post I calculated the amount of earnings swept by Treasury between the end of 2011 and the middle of 2019 as $161.6 billion for Fannie and $103.2 billion for Freddie, a combined total of $264.8 billion (rounded to $265 billion in the post).
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Thank you, again! What does “available capital” actually mean in the above context?
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That’s the term Fannie Mae uses to describe the capital that counts against Calabria’s ERCF standard. I would just call it “regulatory capital.” And you may not be surprised to learn that, since this is something ex-director Calabria came up with, it’s not straightforward. As Fannie says in a footnote to Note 12 in its 2022 10K (yes, a footnote to a note), “Available capital (deficit) for all line items except total capital and core capital also deducts a portion of deferred tax assets. Deferred tax assets arising from temporary differences between GAAP and tax requirements are deducted from capital to the extent they exceed 10% of common equity. As of December 31, 2022, this resulted in the full deduction of deferred tax assets ($12.9 billion) from our available capital (deficit).” If you’re uncertain about how Fannie comes up with what it calls its current capital shortfall, you’re not alone.
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For all practial purposes these EOY ’22 numbers are just as good as the 1st Q ’23 numbers I originally requested; without some significant policy or economic developments the Titanic’s prospects aren’t changing – as you’ve often stated. I’d like to believe the financial statement obfuscations you allude to above are unintentional and flow naturally from financial and accounting complexities; however, everything from HERA, to the SPSPA, to the NWS and letter agreements reeks of nefarious intention (my words, not Tim’s) – maybe socialist ideological intentions is a better description.
Given our previous discussion about waiving title insurance, and the new revelation that the GSEs may seek to charge more fees for higher credit score borrowers to cover lower credit borrowers, it seems we are on an ideological path which appears to disregard economic and financial realities, as well as any realistic idea of a significant shareholder directed profitable enterprise. As always the devil is in the details, but I would be interested to read your thoughts on this new revelation. At least one financial reporter says these new proposed higher fees for better credit score borrowers are on the FNMA Website.
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I’ve seen several recent comments about Fannie and Freddie raising guaranty fees on lower-risk borrowers and intending to use the proceeds to reduce fees for higher-risk borrowers, generally accompanied by expressions of shock or outrage that the companies would do something so foolish. I checked Fannie’s website, and found (a) the site has been totally redesigned since the last time I looked at it, and (b) there was no obvious mention of these pricing changes, even in the single-family section. I did notice, though, that the “Pricing and Execution” tab in single-family highlights the company’s “LLPA [Loan Level Price Adjustment] Matrix” on its first page, and reminds lenders that this matrix is effective “for all whole loans purchased on or after May 1, 2023, and for loans delivered into MBS with issue dates on or after May 1, 2023.” These impending pricing changes are very likely what people are now focusing on. They are, however, not Fannie’s (or Freddie’s) ideas; they come directly from FHFA.
FHFA has been issuing pricing edicts for the companies for the past sixteen months. After having locked in former Director Calabria’s indefensible risk-based capital standard requiring the companies to grossly over-capitalize against all categories of loans, and particularly higher-risk ones, FHFA has gone on to insist that Fannie and Freddie LOWER their LLPAs on higher-risk loans–to “advance their mission of facilitating equitable and sustainable access to homeownership”–and also try to hit an (as-yet not publicly announced) average target return on the (ridiculous) amount of capital they’re being required to hold, by raising their fees on lower-risk loans, starting on the first of May.
It’s surprising to me that followers of Fannie and Freddie just now seem to be catching on to what’s happening with them. I’ve been saying for a very long time that the massive overcapitalization of the companies forces them to price their business on a non-economic basis. The May 1 LLPA grids reflect that–compounded by FHFA’s heavy-handed attempt at cross-subsidization to modestly reduce the impact FHFA’s own capital policies are having on affordable housing borrowers. It’s not Fannie and Freddie that are doing this; it’s FHFA. And it’s totally unnecessary. If FHFA really wanted to “advance [Fannie and Freddie’s] mission of facilitating equitable and sustainable access to homeownership,” it wouldn’t be imposing the equivalent of price controls on their business, it would scrap the Calabria capital standard, and replace it with a true-risk based standard that lets the companies price their business themselves, on an economic basis.
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Hi Tim –
I hope all is well. Thank you for all you do. Any insight into the following….
https://www.fanniemae.com/newsroom/fannie-mae-news/tender-offer-for-any-all-certain-cas-notes
Just seems like a roundabout way to keep bleeding money from Fannie and Freddie. Sell these products at a huge economic loss – then buy them back. This is just maddening….
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Virtually all of Fannie and Freddie’s CRTs are uneconomic at the time they are issued, in the sense that the present values of their expected interest payments (significantly) exceed the present values of the expected credit losses transferred. But FHFA gives them capital credit for issuing CRTs–and as their regulator it directs them to–so they do so (although because of adverse pricing Fannie hasn’t issued a CRT in almost three months). As the CRTs age and also start to pay down, however, many of them get to where the present value of their expected interest payments exceeds the present value of the (negligible) expected credit losses transferred and the value of the capital credit, PLUS the cost of buying them back, and that’s why the companies tender for them. The death of CRTs is economic, even if their birth is not.
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Tim,
Any thoughts on Director Thompson defending this structure?
https://www.fhfa.gov/mobile/Pages/public-affairs-detail.aspx?PageName=Statement-from-FHFA-Director-Sandra-Thompson-on-Mortgage-Pricing.aspx
Cheers,
Justin
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The letter to Thompson from the House Financial Services Committee criticizing FHFA’s pricing changes gave her an easy strawman to go after, by claiming that they would “incentivize homebuyers to reduce their down payments and carry additional debt.” They won’t do that, and she said so. But the rest of her defense was wrong, and continued to demonstrate either an inability to understand or an unwillingness to change the real problem, which is the deliberate and unnecessary overcapitalization of all of Fannie and Freddie’s credit guarantees because of the Calabria capital standard, which she has refused to replace with one based on risk and economics.
The first bullet point in Thompson’s statement is: “Higher-credit-score borrowers are not being charged more so that lower-credit-score borrowers can pay less. The updated fees, as was true of the prior fees, generally increase as credit scores decrease for any given level of down payment.” The second sentence is true, but the first is not. I don’t want to accuse Thompson of being dishonest, so it’s possible that when she says “more” in the first sentence she means “more than lower-credit score borrowers.” And of course that’s not true–given the Calabria capital requirement, the guaranty fees for lower-credit score borrowers are tens of basis points higher than they are for higher-credit score borrowers. But Thompson’s pricing changes HAVE added to the guaranty fees for higher credit-score borrowers in order to reduce the guaranty fees for lower credit-score borrowers (while still leaving the former much lower than the latter, just higher than they otherwise would have been).
And the reason she’s doing that is what I noted briefly in a comment above, and have explained in more detail elsewhere (and in considerably more detail in the post, “Mind the Gap”): after former director Calabria put unjustifiably high capital requirements on higher-risk loans, and Thompson followed up by setting a minimum return on capital target for Fannie and Freddie to aim for, she is making a futile attempt to mitigate the inevitable consequence of those two actions–much, much higher guaranty fees on higher-risk loans–by asking higher credit-score borrowers to pay a little more for their loans so that lower credit-score borrowers can pay a little less. And that palliative leaves everyone unsatisfied: higher-risk borrowers still have guaranty fees that are unaffordable, and far higher than they should be on an economic basis, while lower-risk borrowers are (justifiably) unhappy that their guaranty fees–already much too high because of the Calabria standard–are going up even further “to subsidize riskier borrowers.” The obvious solution to both of these problems–which FHFA hasn’t yet been willing to embrace–is to scrap the Calabria standard and replace it with one based on risk, not politics (or Calabria’s objective of “taxing” Fannie and Freddie’s credit guaranty business to move more mortgages onto bank balance sheets). Perhaps the current criticism of the recent pricing actions will make “doing the right thing” more palatable to FHFA, from a self-preservation standpoint.
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Tim,
I know earlier in the year you had some glimmer of hope that Biden admin MAY potentially take up the GSE issue and move to “fix” the never ending conservatorships. Now that that we are approaching the summer, and with the action (and inaction) we have seen from FHFA/admin on this issue to date, is it safe to call it on the Biden admin tackling this issue or is it still too early to call?
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In a response on March 1 to essentially the same question, I said, “I suspect that whomever was behind the nomination of Calhoun in the first year of the Biden administration will see if they can’t knit together a coalition of policy officials confident enough in the benefits of recapitalizing (under a true risk-based standard) and releasing Fannie and Freddie as healthy, management-run companies to be able to take on the fight with [the Financial Establishment] leaders they know is coming once they make their proposed policy public. But we’ll only hear from them if and when they think they’ve reached a ‘tipping point,’ and believe they have a decent shot at prevailing.” I’d still say that today. And back then I also said, “If I’m being honest with myself, I’d have to say–to use a legal phrase–that I still think it’s ‘more likely than not’ the status quo will persist during the remaining term of this administration. But I also think the chances of a favorable resolution to the conservatorships in the next 20 months are well above zero, and may be closer to 50-50.” I’d stand by that statement as well (although I’d phrase it differently today, since while I meant “may be closer to 50-50 than to zero”–i.e. above 25 percent–some thought I meant “may be close to 50-50.” I don’t think the chances are that high, unfortunately). But we’ll see. The more people who notice, and complain about, how inexplicable Fannie and Freddie’s pricing is–or if, as I expect, the companies’ already sky-high capital requirements go up even further because investors won’t buy the amount of credit-risk transfer securities FHFA is counting on them to be able to sell–then maybe the profile of the “Fannie and Freddie problem” will increase within the administration, and the chances of a favorable solution to it will increase as well.
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Tim
I suspect that FHFA is going to get new and substantial congressional interest in its supervision of the FHLBs. normally, this is a sleepy area of federal finance, but WSJ reports (https://www.wsj.com/articles/banks-leaned-on-a-little-known-lender-in-march-as-customers-fled-c09ef6ab?mod=hp_lead_pos7 paywall) that given the recent stress over bank deposit flight arising in connection with the Fed’s substantial increase in short term rates, FHLB advances exceeded $800B as of year end, 2022, and it is likely to be substantially more now. FHFA has itself announced it will conduct a review of the FHLBs.
who knows the outcome of this enhanced FHLB bank advance activity and, I suspect, much greater congressional attention to FHLBs and FHFA’s regulation of them, but I wonder if you think this portends a welcome congressional review of the GSEs status as the FHLB lending exposure has greatly increased. taxpayer risk has greatly increased seemingly silently by virtue of the FHLBs’ massive new bank lending. seems to me that anyone in congress that is concerned by this development might also think it is high time for some private money to be raised by the GSEs.
rolg
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I’ve become a cynic on the Federal Home Loan Banks. They were created to serve as a supplemental source of liquidity to the thrift industry–savings and loans and mutual savings banks–which all but disappeared in the late 1980s. The banks, who vociferously opposed Fannie and Freddie issuing agency debt and using it to fund mortgages predominately for low- and moderate income homebuyers, had no problem saying, “Hey, let’s keep these guys around; they can use their agency debt to be a source of low-cost supplemental liquidity for us!” Congress has dutifully acquiesced to their playing that role ever since.
What we’re seeing now with FHLB advances to banks is very similar to what we saw during the financial crisis, when outstanding advances briefly topped $1 trillion. Nothing was done in response to that then, and I would be surprised if anything substantive is done about it now, particularly since FHFA is doing the review. Remember, this is the agency who did a study on Fannie and Freddie’s CRT programs, and when it found these programs cost the companies $30 in interest payments for every $1 of credit risk transferred in good times, and $3 in interest payments for every $1 of risk transferred even during a period of extreme credit stress, its response was, “We need to study this more.”
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Tim
I will only note that the FHLBs provide a massive back door expansion of the federal government’s program of deposit insurance provided by the FDIC. all of these FHLB advances to banks (which are in essence bank deposits) are in amounts in excess of what the FDIC insures as deposits. you can simply add the FHLBs’ advances to banks (likely well in excess of $1T currently) on top of the FDIC’s deposit insurance exposure in accessing taxpayer risk.
when you take into account the 15 year conservatorship of the GSEs and this massive unacknowledged backdoor federal government deposit exposure, you have a federal financial regulatory program that doesn’t know its tuchus from its elbow (imho).
rolg
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Tim–
I won’t shock you or other “GSE cognoscenti” by predicting that the FHFA and the Hill contemplating policy making or policy changes to the Federal Home Loan Bank System will be the next “DC Clown Show.”
Just as neither side knows what Fannie and Freddie do or how they do it, these “posers” know even less about the Bank System–which applies to both political parties–since the regional banks should have been mercy-killed years ago when the savings and loan industry disappeared.
Instead, the congressional and regulatory clowns–plus the town’s industry hustlers–enhanced the system’s bank largesse and allowed the FHFA to be in charge.
The next move the FHFA takes regarding the Bank System will be its first.
The Bank System’s services are duplicative and wasteful. Let’s see if any Republican or Democrat can/will defend them.
I’ll be looking forward to hearing those dated arguments.
Bill Maloni
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Tim,
Please feel free to delete, edit, or address this Q in any way you feel is helpful to those of us seeking any clarity we can get. Readers, do not hold Tim to these numbers – just illustrative discussion. In some basic Internet searches I find the largest single company IPO ever executed netted ~ $33B, and the most successful year on record for the entire IPO market was $216B (2021, I believe). If there are no changes to some combination of the current letter agreement, regulatory capital rate, NWS, liquidation preference, the warrants or UST’s views on getting their full ask for the senior preferred shares I can’t see equity offerings would ever get us there – wherever there is. It’s difficult to fathom IPO investors believing a heavily regulated entity with considerable government overshight that limits the companies ability to innovate and grow profits is the best opportunity for their capital.
The UST wants something like $190B for the seniors and, theoretically, can force receivership if equity raises fall short. If they truly intend to keep the GSEs, and if junior preferred are to receive anything, the UST will most certainly have to take a huge haircut on the seniors. Given all that has transpired it doesn’t seem plausible they would do anything to leave value for commons. The logistics and timing around trying to raise new capital while dealing with the NWS, senior preferred shares, liquidation preferences, ridding themselves of the old shares, and assuring IPO investors, etc. is beyond my comprehension.
In light of all the above, when I see something like the following in all its naivete my head just wants to explode …. “if SPS were converted to commons. In the worst case for commons (SPS swap + warrant exercise), the government would hold up to 5 trillion shares at 2 cents each, worth $100 billion (after recap/release). After a R(everse) S(plit) (1000 to 1) – which would probably be done concurrently with recap/release – the government would hold 5 billion shares at $20 each. Commons therefore could rise to 20 $, but someone who has 10,000 (shares) now would afterwards only own 10.”
Can you give us the benefit of your experience as a former CFO with the realities of equity raises and some of the other problematic features mentioned above?
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I’m not going to comment on the specifics of the statement you quote that made your head want to explode, except to say that I sympathize with your frustration over what one reads on the few remaining websites that discuss the prospects for Fannie and Freddie preferred and common stock. I’ve almost stopped checking them, because so much of what appears there is uninformed nonsense (often from people wishing to turn their hopes into reality).
The vast majority of the “predictions” for the prices of Fannie or Freddie stock –whether preferred or common–lack (or don’t offer) an analytic context. I’ll give you mine, starting with the common stock.
The price of any company’s common stock has three basic variables: its current earnings, its number of common shares outstanding–which together determine the earnings per share (EPS)– and the multiple the market attaches to that EPS. Today, two of those three variables are unknown for Fannie and Freddie: the number of shares of common that ultimately will be outstanding when the companies are finally deemed by their regulator to be adequately capitalized, and the multiple the market will assign to their EPS. Without a theory about where those two variables will end up, and why, it’s not possible to make a credible guess about a target common stock price.
So, let’s go back to where we are today. As I said in the current post, Fannie and Freddie are on a track created by former Treasury Secretary Mnuchin and former FHFA Director Calabria–remaining in conservatorship until they can accumulate, through retained earnings, enough common equity tier 1 (CET1) capital to equal the 3 percent of adjusted total assets target set by Calabria. Given their current negative CET1 capital, that could take them two decades, because as long as the Treasury’s liquidation preference rises in line with their earnings—as is the case now—they can’t raise outside equity. The stock market doesn’t like that, which is why today the price of Fannie and Fannie common shares is 48 cents.
To get to common or preferred stock prices materially higher than what we’ve seen for the last fifteen years, some administration will need to deal with the net worth sweep (which has only been suspended, not canceled) and the liquidation preference. Who will do that, when, and why? Unless someone has a theory about that—and uses this theory to explain how that will affect the two unknowns in our common stock price equation (the final number of shares outstanding and the P/E multiple)—their common stock price prediction is meaningless. And until the net worth sweep and liquidation preference are dealt with, the junior preferred stock will remain “zero-coupon perpetual” securities, trading on speculative value.
I’ve offered what I think should happen with the sweep, liquidation preference, and capital requirement in the current post. To date, there is no sign that any of it is happening, or will happen. But nor does there seem to be any indication that the administration is considering any other solution to Fannie and Freddie’s long-running conservatorships. We seem to be still on the path of “two decades to release from conservatorship through retained earnings” that we’ve been on for the last two-plus years.
I’ll close with a quick comment on the notion that ending the net worth sweep and liquidation preference will likely involve the conversion of Treasury’s liquidation preference into common stock. Again, one has to ask, who benefits from this? It does not seem to make financial sense for Treasury, in that it negatively affects both of the unknown stock price variables—it hugely raises the number of common shares outstanding pre-capital raise, and also holds down the companies’ P/E multiple by reinforcing the perception of investors that the government views, and treats, Fannie and Freddie fundamentally more adversely than all other U.S. financial institutions. Those confidently predicting a conversion of Treasury’s liquidation preference (and it’s hard to justify converting only the senior preferred and not the entire liquidation preference) to common appear to be downplaying this point.
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“Taxpayers spent nearly $200 billion to bail out the government sponsored entities (GSEs) —Fannie Mae and Freddie Mac — for shortcuts they took that led to the financial crisis.”
–Diane Tomb is chief executive officer of the American Land Title Association.
https://www.housingwire.com/articles/opinion-the-risk-from-fannie-maes-mission-creep/
–March 27, 2023, 1:20 pm By Diane Tomb
This article was written in response to reports of a new Fannie Mae pilot program regarding waiving title insurance. I’m sure she means well, but the quote above shows how thoroughly the myth that FnF led us into the 2008 financial crisis has penetrated and how firmly it is established.
Do you have any insight regarding this program, Tim? It is probably a lost cause to rebut her FnF beliefs.
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Why do you assume “she means well?”
More than likely she is opposed to anything which threatens the sweet deal
her industry has created for itself and engaged in anti-GSE hyperbole.
We’ve seen it before.
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It’s hard to blame Ms. Tomb for saying “Taxpayers spent nearly $200 billion to bail out the government sponsored entities” when Treasury and FHFA–who know better–keep saying the same thing. But going on to say that the bailout was the consequence of “shortcuts they took that led to the financial crisis” is her own interpretation, and a weak (and not credible) attempt to depict a pilot program waiving title insurance requirements for certain transactions as a potential threat to the stability of the U.S. financial system.
I suspect this program is FHFA’s idea, and an effort to save some mortgage borrowers from having to pay title insurance in instances where there seldom is any risk to the security of the title. When I was at Fannie, this is the sort of fight we would never pick with other partners in the mortgage financing chain, because it makes everybody else in that chain nervous that you might do the same thing to them, thus causing you political support. Perhaps FHFA doesn’t care about that, and perhaps Fannie and Freddie are going along because (a) they don’t want to say no to FHFA on this, (b) their “friends” in the industry, assuming they still have any, aren’t doing them much good , and (c) with FHFA’s and Treasury’s current policies toward them designed to keep them mired in a conservatorship run by FHFA for the next two decades, how much worse could things get?
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Tim
Given that the GSEs are financial insurers with no risk of deposit flight, it occurs to me that there is an example of a financial guarantor in the banking sector that might offer an example for the amount of capital that should be required of a financial guarantor. That is the FDIC’s Deposit Insurance Fund (DIF).
The DIF at 12/31/2022 held $128.2 billion of capital to insure a total of $11 trillion of bank deposits (out of a total of $18 trillion, with the difference representing the uninsured deposits of individual depositors in excess of $250,000), or a capital ratio of 1.27%.
Even given that bank risks are more diverse than the risks the GSEs insure against, I wonder why this 1.27% capital ratio might not serve as a good comparable for a sensible GSE capital ratio.
rolg
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The FDIC is a different type of financial guarantor compared with Fannie and Freddie. The FDIC’s Deposit Insurance Fund (DIF) is more analogous to the reserves of a property and casualty insurer, in that both types of insurance are required of the customers who make up their client base (banks for the DIF, and home and auto owners for property and casualty insurance companies). Because of that, each of these insurer types can make up for unexpectedly high current losses by raising their premiums on future business to whatever level is necessary, and their customers have no choice but to pay up (that’s why virtually all property and casualty insurers are rated AAA). Fannie and Freddie can’t do that, at least not nearly to the same degree; their current capital and guaranty fees have to be able to handle a specified amount of stress losses on their own, without the help of future income (or premiums).
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Don Layton had an in-depth article about G-fees this week. He believes G-fees have to go up by 20bps to match the new capital requirements requirements. Alternatively, he recommends lowering the capital requirement materially so G-fees don’t need to be raised.
https://furmancenter.org/thestoop/entry/current-gse-guarantee-fees-are-too-low-to-be-consistent-with-regulatory-capital-does-this-mean-a-large-increase-is-coming
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I’d say that’s a pretty darn good analysis. I like to see the turnaround and common sense approach from Mr. Layton. Starting to feel less and less like we’re all taking crazy pills. I believe the SVB, Signature, FNB, etc. issues will increase the likelihood of discussion regarding Fannie and Freddie. This topic will suck up a lot of oxygen over the next short while – it’s unrealistic to think that Fannie and Freddie won’t continue to come up in those discussions. The court of public opinion may bring the spotlight to so many unaware of what’s been going on. We’re so in the details we more than likely often forget that not many people could explain who Fannie and Freddie even are – let alone what they do, what’s happened to them, where they are not etc.
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“But the most robust hard evidence that the ERCF is just too high – with $319 billion required across both companies, per the FHFA – is that this result is so wildly inconsistent with that of the government-mandated and -designed ‘severe adverse’ stress test results, which recently showed at most just a $4.5 billion loss. Simply put, a large financial intermediary does not need to be capitalized at nearly 70 times its worst-case government-defined stress test loss.”
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I did not have a positive reaction to the Layton piece.
I almost stopped reading it when he wrote, “Before conservatorship, [the average guaranty fee] was set by the GSEs themselves at a low level as much for political reasons (in particular to help maintain their lobbying power in Congress…) as economic ones.” That’s utter rubbish. Layton wasn’t at Freddie during the period he was referring to, while I was responsible for setting Fannie’s target guaranty fees through 2004. They were determined by highly sophisticated pricing models that were purely economic. (I discuss a bit of this in my August 2022 post, “Mind the Gap.”) And it gets worse, when he gets into a screed about their portfolio businesses and the “implied guarantee” on their debt, claiming that they “exploit[ed] this free implied guarantee to create a giant, profit-making subsidy for themselves… [that] disproportionately benefitted their management and shareholders rather than homeowners.”
What’s the point of saying this? First, it’s counterproductive to a quick and clean exit from conservatorship, because it reinforces the “flawed business model” notion pushed by the banks. Second, what Layton is claiming about the “retained subsidy” of the portfolio business is taken straight from the talking points of FM Watch in the early 2000s, and is completely made up. Yes, Fannie and Freddie’s debt benefited from an “implied government guaranty” that lowered their cost of borrowing. But that was a deliberate feature of their charters. And a second feature of those charters was they could only use their debt to buy mortgages and MBS whose yields (or prices) ALSO benefited from that same guaranty. There is no way to “retain” a subsidy that’s attached both to the debt you’re issuing and the only asset you’re allowed to buy. No, the role Fannie and Freddie’s portfolios played was to keep the spreads between the rates on mortgages and MBS from getting too high relative to fixed-term debt. Whenever that happened, Fannie and Freddie would issue (relatively cheap) debt, and use the proceeds to buy (relatively expensive) mortgages and MBS, thus keeping spreads in line. That’s economics, not politics, and it was beneficial to homebuyers. The banks didn’t like it because it held down THEIR portfolio spreads, and that’s why they invented the story Layton is parroting here.
To have to read this nonsense from Layton at a time the public is learning that the Federal Reserve has been short-funding its now $2.6 trillion portfolio of agency MBS since its inception in 2009–and is on track to lose over $100 billion this year from doing so–and also learning about unregulated and unsupervised banks “playing the yield curve” because their Basel III capital standards allow them to do so without penalty, is galling. But, yes, do take uninformed and mis-aimed shots at Fannie and Freddie to distract from what the banks and the Fed are doing.
As for the rest of the paper, it’s great that Layton doesn’t think Fannie and Freddie need to hold 4 percent capital to safely do a credit guaranty business that has a credit loss rate of 4 basis points a year on a normalized basis, and can withstand a stylized repeat of the Great Financial Crisis through absorbing all of the resultant credit losses with only its current guaranty fee income, and not have to touch its capital all. Virtually every other knowledgeable person who has objectively reviewed Fannie and Freddie’s business and the Calabria capital requirement has come to the same conclusion–and their opinions don’t come with all of the baggage Layton attaches to his.
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[Edited] This is a follow-up to my question a few days to a week back, asking your opinion on whether the window for this admin is closing /closed and thanks for your opinions on the same.
Given the recent developments with Silicon Valley Bank, I am of even stronger conviction that the optics of doing anything to release the GSEs in this environment would be politically twisted by both parties and in addition the wrongful fear of what may happen if the GSEs again cause havoc in a deteriorating financial market. I am feeling that the current admin will not want touch this with a 100 foot pole for fear of the GSEs and housing becoming a hot potato in the election year… My 2 cents is that they will leave it to be the problem of the next admin.
Do the recent developments change anything in your opinion that there could still be an opportunity for (rather an increase the chances of) some action, opposite to what i am hallucinating–a dormant 18 month project…
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EP–If you focus just on the optics and surface politics of the Silicon Valley Bank situation, it’s understandable to see it as a step back (or at least a long pause) in the process of getting Fannie and Freddie out of conservatorship. But I actually view the meltdowns of SVB and Signature Bank as exactly the sort of shock that could cause policymakers to realize that continuing to make policies for Fannie and Freddie based on the self-serving fictions of the Financial Establishment and the banks, while ignoring the observable realities of the financial markets, is a path to eventual disaster.
There was an article in the Washington Post this morning recounting how key members of the Biden economic policy team–Janet Yellen, Lael Brainard and Cecilia Rouse (a member of the Council of Economic Advisers; the Post didn’t mention nominated but not yet confirmed CEA chairman, Jared Bernstein)– met with the president’s chief of staff, Jeff Zeints, to decide how to respond to the failures of SVB and Signature Bank. They seem to have quickly understood what had happened, and the threats to the financial system that should have been apparent before (there was ample data for anyone who looked), but now were “front and center.”
It’s astounding how we keep making the same mistakes over and over. There are two fundamental ways financial institutions get into trouble–taking too much credit risk, and taking too much interest rate risk. Left unregulated or unsupervised, it’s been shown time and again that too many institutions talk themselves into doing both. That’s what happened with mortgage credit risk leading up to the 2008 financial meltdown, when Treasury and the Federal Reserve, in the name of “free market discipline,” declined to regulate either subprime loan originators or the private-label securities issuance process. And as we’re all learning, this time the regulatory lapse was Congress passing (at the strong urging of the banking lobby) S2155 in 2018, raising the threshold at which banks were subject to Dodd-Frank stress testing and enhanced supervision from $50 billion to $250 billion. SVB and Signature both fell beneath that new threshold.
When the Covid pandemic hit, both SVB and Signature had large inflows of consumer deposits. With loan demand down, they each invested much of that money in longer-term (and higher-yielding) assets, including mortgages and MBS. “Playing the yield curve” is like playing Russian roulette: usually there’s no bullet in the chamber, but sometimes there is. And bank managers are left on their own to make the decision of whether to play that game, because the Basel III bank capital standards–which former FHFA director Calabria insisted on imposing on Fannie and Freddie–have NO capital consequence at all for taking interest rate risk. The only way to keep banks from doing it is through stress testing, and enhanced supervision. But SVB and Signature were exempted from both.
As Yellen, Brainard, Rouse (and I’m sure Bernstein) know, interest rate risk at banks is now a BIG systemic problem. There is a chart from the FDIC showing up in the financial press that gives unrealized losses on investment securities at FDIC-insured institutions. Those losses rose from nothing at the end of 2021 to $700 billion on September 30, 2022, as short-term interest rates rose throughout the year. And that’s just the securities; it doesn’t include long-term fixed rate whole (i.e., unsecuritized) mortgages.
We don’t know how many banks did what SVB and Signature did–but the bank regulators (and the senior members of the Biden economic team) do. And very few banks hedge their interest risk. Nor does the Federal Reserve. As I noted in a comment yesterday; it was short-funding all of the $2.6 trillion in agency MBS it acquired since 2009, and while it made over $100 billion (turned over to Treasury) in 2021 when short-term interest rates were essentially zero, it started losing money on its securities portfolio last year after it began to hike the federal funds rate, and it’s on track to LOSE $100 billion this year. That gives you some idea of the problems the banking system might be facing.
How does all this relate to Fannie and Freddie? They’re in conservatorship–and grossly overcapitalized and over-regulated–because that’s what the banks wanted. Banks and their supporters used fictions about the companies’ operations and risks to convince policymakers (and, through a compliant media, the general public) that Fannie and Freddie needed at least 4 per cent capital to do their (very low-risk) credit guaranty business safely, and that they should remain in conservatorship until they accumulate that amount of capital through retained earnings, which likely will take another 20 years.
Banks have profited handsomely from the constraints imposed by Treasury and FHFA on Fannie and Freddie’s business since 2008. As I noted in my current post, “At December 31, 2007, banks held $2.29 trillion in single-family whole loans and MBS, or 23 percent of outstanding single-family mortgage debt, on their balance sheets. At June 30, 2022 (the latest date for which full data are available), banks held more than double that amount—$4.65 trillion, for a 36 percent market share.”
I’ve raised the issue numerous times of the systemic risk involved in shifting that large an amount of mortgages from contractual investors–mutual funds, pension funds and insurance companies, which can manage the interest rate and options risk of MBS–to commercial banks who can (or do) not. But that’s only been a theoretical concern, until last Friday.
I have little doubt that the Biden economic team now realizes that the credit risk-taking frenzy that nearly collapsed the world financial system in 2008 may have been replicated over the past several years of zero short-term interest rates by an interest rate risk-taking frenzy, led by commercial banks. And after they contain the damages from this risk (assuming that they do), does it not make perfect sense for them to then move to fix one of the main contributors to the interest rate risk-taking frenzy–having allowed the banks to cripple Fannie and Freddie by making false claims about their operations and risks, and tying them up in conservatorship for another 20 years, so that mortgages that otherwise would have been safely funded by contractual buyers of MBS instead go into short-funded bank portfolios?
Quite contrary to your reaction, then, I think the SVB and Signature bank failures, and the associated awareness of the risks that have been building up in the banking system over the past several years, make action on getting Fannie and Freddie out of conservatorship more likely during the remaining months of the president’s term, by raising the profile of the companies (and the roles they could be playing in mortgage finance), undermining the credibility of the Financial Establishment and the banks (who’ve been telling fictitious, and we now know dangerous, stories about Fannie and Freddie since the 2008 crisis), and giving the Biden economic team more incentive, and courage, to stand up to the leaders of the Financial Establishment and take them, and this issue, on.
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Tim
Thanks for your last comment. but I wonder who in the Biden administration understands that GSE are precisely in the opposite situation than banks with respect to interest rate risk.
banks bear interest rate risk by being buyers and holders of GSE mbs and treasuries, whereas the GSEs (having reduced their retained mortgage portfolios) avoid most interest rate risk by being sellers of mbs.
now, GSEs bear credit risk as a guarantor of mbs, but this credit risk has been significantly reduced by the elimination of various forms of toxic mortgages. and the fear of a run on the bank, because of the withdrawal of deposits, simply doesn’t exist for the GSEs.
as an aside, I know people employed at VC portfolio companies who parked large amounts of uninsured deposits at SVB. they were sweating bullets that they wouldn’t make payroll the following week after shutdown, and would eventually lose their jobs.
Why hold uninsured deposits at SVB? when you peel the onion, you will find an unholy daisy chain of favoritism in the VC community, with VC sponsors (and executives at portfolio companies) getting special treatment from SVB…if they hold portfolio company deposits at SVB. First Republic does essentially the same thing outside the VC community, though I know this only by reputable hearsay.
these are games that banks play, and they play havoc with peoples’ lives.
rolg
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Tim, I wish you would write an opinion piece in either the NYT, WP or WSJ explaining this. The timing may be right for the nation to hear this important message.
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Tim,
Apologies ahead if this question doesn’t fall within the realm of your blog. I recently noticed CHLA requesting that FHFA expand the GSEs’ retained portfolio limits for the next 12 months. My guess is it is not coincidence that they’ve raised this issue in light of concerns of some banks’ MBS holdings in a mark-to-market environment as rates have risen. Do you have any thoughts regarding the request, and or perspective as to whether it would be considered by FHFA? Thanks
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Let’s start with some facts. At December 31, 2022, Fannie held $79.5 billion of mortgages and mortgage-related securities in its portfolio, well below the $225 billion cap imposed by Treasury (although Fannie said in its 2022 1oK that it was “currently managing our business to a $202.5 billion mortgage asset cap pursuant to instructions from FHFA”). Freddie Mac held $92.7 billion of mortgages and mortgage-related securities in portfolio as of the same date, and subject to the same caps.
So my first question would be, what is the CHLA actually requesting? Does it want FHFA to tell Fannie and Freddie to get closer to their current caps? If so I would not be in favor of that. Banks, large and small, have a long history of wanting Fannie and Freddie to do what they want them to do, when they want them to do it. That shouldn’t be up to the banks. Ideally it would be up to the companies, although while they are in conservatorship it’s up to FHFA. And I have no idea how FHFA might respond to the CHLA’s request, although I suspect it would defer to Treasury, since Treasury was the institution that first required Fannie and Freddie to shrink their portfolios, immediately after it forced them into conservatorship in 2008.
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“Fannie held $79.5 billion of mortgages and mortgage-related securities in its portfolio”. Thanks, I was fixing to ask you that.
Looks like CHLA isn’t happy with the Fed no longer purchasing MBS and want FnF to take up the slack. The market for those securities seems to have vanished with healthy yield curve.
Tim, what would you do in this environment?
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This is a classic case of “be careful of what you wish for.”
I was responsible for Fannie Mae’s mortgage investment portfolio for over 17 years (between September 1987 and December 2004). When I left, it had over $900 billion in mortgages and mortgage-related securities, compared with about $80 billion today.
During the entire time I was running it, commercial banks tried to get either Congress or Fannie’s regulator (the precursor to FHFA, called OFHEO) to limit its size or hamper its operations in some way (most frequently, by imposing “user fees” on our debt to raise its cost). There was a simple motivation for this opposition–Fannie’s portfolio activities lowered mortgage rates, which reduced the profits on the loans banks held in THEIR portfolios.
In 1999, three large banks, two mortgage insurers and one subprime lender formed a lobbying group called FM Watch. At that point, the criticism of our portfolio went public, and involved two contentions–the interest rate risk on our (and Freddie’s ) portfolio was a source of great and dangerous systemic financial risk, and our holdings of mortgages had no effect on the overall level of mortgage rates. Neither was remotely close to being true, but both criticisms were made constantly, including by the then-Chairman of the Federal Reserve, Alan Greenspan (who should have known, and I believe did know, better).
Flash forward to the financial crisis. One of the first things Treasury did after requesting FHFA to put Fannie and Freddie in conservatorship was to make a 10 percent (later increased to 15 percent) per year reduction in the size of each company’s mortgage portfolio a key component of the Senior Preferred Stock Purchase Agreement, even though both portfolios were highly profitable at the time, and provided badly needed net interest income that was helping to absorb their credit losses.
And of course, Fannie and Freddie’s portfolios DID help keep mortgage rates down, and with them getting out of the portfolio business that left a void that needed to be filled somehow. Not coincidentally, the Fed began purchasing agency (Fannie, Freddie and Ginnie) MBS in January 2009, and continued to expand that program through what it called “quantitative easing,” with its agency MBS holdings hitting a peak of $2.74 trillion last April.
And here is the irony alert. How did the Fed–which had relentlessly criticized the duration-matched portfolio I ran at Fannie for being too systemically risky–fund its huge portfolio of agency MBS? It credited the reserve accounts of the banks used by the sellers of those MBS. Those reserve balances receive an interest rate tied to the federal funds rate, so the Fed was literally short-funding almost three trillion dollars worth of MBS. That worked great as long as the rate on bank reserves was near zero. In 2021, the Fed made enough on its combined agency MBS and Treasury securities portfolios to be able to turn over $107.9 billion in profits to Treasury (helping to reduce the federal deficit).
But what’s happened since? At December 31, 2022, Fannie reported that the average pass-through rate on its $4.0 trillion of MBS was 2.18 percent. The rate on the Fed’s now $2.61 trillion agency MBS portfolio probably isn’t much different from that. So it wasn’t surprising that after the interest on bank reserves rose to 2.40 percent in late July of last year, the Fed said in September that it would no longer be remitting any of its profits to Treasury (because there weren’t any), but instead begin to accumulate “a deferred asset,” which totaled (a negative) $18.8 billion by the end of the year. Currently, the Fed is paying 4.65 percent on its reserve balances, so its agency MBS and Treasury portfolios are likely to LOSE in 2023 about what the Fed remitted to Treasury ($1o7.9 billion) in 2021, if not more. That’s over a $200 billion adverse swing to the Federal budget in two years.
So, in retrospect, would it have been better to have left Fannie and Freddie’s mortgage portfolios alone, and not made the companies run them off by more than 90 percent, with the Fed picking up the difference? Of course, just as it would have made sense not to have forced the companies into conservatorship in 2008, then begun giving all of their income in perpetuity to Treasury when they returned to profitability in 2012. But just as it’s proving very difficult to unwind the damage regulators have done to Fannie and Freddie (and low- to moderate-income homebuyers) since the crisis, it would be equally difficult to get regulators to reverse themselves and decide it’s systemically valuable to have Fannie and Freddie back in the business of buying mortgages funded with agency debt, and actually managing the resulting interest rate and options risks associated with that activity (as neither the Fed nor most banks do). It would be great if we could magically do a pre-September 2008 reset with Fannie and Freddie in both of these areas and–in answer to your question–if I were king I would do it.
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As a response to the Senators’ March 3 letter to the Biden Administration asking for action to lower the cost of home ownership, I plan to send this letter to each of the signatories. Is there anything you would change?
Dear Senator:
I read today the letter dated March 3, 2023, that you and 18 other Senators, all committee chairman, wrote to President Joseph Biden asking his administration to utilize a “whole government approach” to address our nation’s housing needs. In the last paragraph, you state “The depth of our country’s affordable housing crisis is undeniable.”
But your letter ignores the one step that the administration could do tomorrow to dramatically reduce the cost of single-family mortgages.
In 2007, the guarantee fees charged by Fannie Mae and Freddie Mac, those applied to the ongoing costs of the mortgage, were 17 basis points (0.0017%) (FHFA Report: Fannie Mae and Freddie Mac single-family guarantee fees in 2007 and 2008, released July 2009.)
In 2023, the guarantee fees are now 43 basis points. (FHFA Single Family Guarantee Fees Report, January 25, 2023 Contact: Adam Russell.) These extra points are added on to every monthly payment a homeowner makes on the mortgage.
According to the Federal Reserve Bank of St. Louis, the median home price in the United States was $467,700 as of the fourth quarter of 2022. On a 6% mortgage, those additional basis points increase a homeowner’s monthly payment by $79.14, or $949.68 over a year. Over the mortgage lifetime, those extra guarantee points cost a homeowner $28,490.40. That’s a lot of money.
Fannie and Freddie charge those fees because they have been saddled with massive capital rebuilding requirements by the Federal Housing Finance Agency. But in reality, the capital requirements in effect during the summer of 2008 were totally adequate for the GSEs to survive the financial crisis. If the government had done nothing in 2008, Fannie and Freddie would have suffered only moderate losses, and would never have completely depleted the capital they had at the start of the crisis. For a fuller explanation, see the Brief for Timothy Howard as Amicus Curiae filed in the United States Supreme Court case Collins vs Yellen.
The only reason the GSEs are still in conservatorship is because the financial establishment, the big banks and Wall Street firms, want it to continue. When the GSEs have to charge high guarantee fees, the big banks can increase their fees as well.
Those fees are raping homeowners nationwide. The Biden administration could eliminate most of those fees by releasing Fannie and Freddie from conservatorship. No act of Congress is required, only the political will to do so.
Will you help fight for lower mortgage rates? Home buyers across America would thank you.
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[Edited] ”17 basis points (0.0017%)”
Hi Jeff,
I think you made a typo in your draft. 17 basis points is 0.17%, not .0017%
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I agree. Thank you. Great catch!
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Jeff–Overall, I think your proposed letter is fine.
You asked a specific question, though: “Is there anything you would change?” And the honest answer is, “If it were me writing to one of the senators, yes.” But it’s not me, and with rare exceptions, I do not make detailed comments on or suggest edits to the written work of others, because that sets a precedent that easily and quickly could spiral out of control.
So with that caveat, I do have one observation: I would soften your statement that “the capital requirements in effect during the summer of 2008 were totally adequate for the GSEs to survive the financial crisis.” I don’t think you want to suggest that the then-current minimum capital requirement of 45 basis points on credit guarantees should be restored. One way to soften that would be to say something like, “the capital requirements in effect during the summer of 2008, as low as they were, still would have been adequate for the GSEs to survive the financial crisis.”
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Thank you very much and I will make that change. Letters should go out tomorrow to all 19 senators and Pres Biden and Treasury. I obviously do not expect to see any changes, but perhaps this will help chip away at the massive block of resistance.
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Tim
this is all speculation of course, but suppose SCOTUS does rule, as I expect, that the appropriation clause of US Constitution is violated by CFPB’s funding mechanism, but also, as I expect, relief is granted prospectively. this would require CFPB’s funding to originate from congress post-SCOTUS ruling. One might also speculate that there are many Republicans in the House in 2024 that are not fond of the CFPB, and there may be a stalemate in congress regarding the funding of the following year’s CFPB. if this strategy is followed, CFPB would be “amended” as an institution by financial starvation.
now read through to FHFA. while CFPB is likely more despised in some circles of congress than FHFA, a financial starvation strategy for CFPB could lay the groundwork for conditional funding of FHFA…conditional on the formulation of a workable conservatorship release policy.
In essence, a legal issue could pave the way for a political solution.
So as to your excellent essay, “A Political Problem”, perhaps it might play out to be a combined Political/Legal Problem.
rolg
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ROLG– As you say, this is all speculation, but I really wonder how a transition would be handled from the CFPB getting its funding from the Federal Reserve to being funded pursuant to a congressional appropriation. I can’t imagine, for example, that if Speaker McCarthy refuses to bring a bill funding the CFPB to the floor–because a majority of his members don’t like that agency–it would just “starve to death”. I would think there would have to be some version of a continuing resolution that keeps it going until some annual funding amount could be agreed upon by both houses of Congress, and that the President signs.
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Tim
I can imagine. “defund the…..” seems to be in vogue in these partisan and spirited times. just a thought.
rolg
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Tim,
Will you give us your take on what tangible benefit(s) the financial establishment (FE) is gaining with the GSEs held indefinitely in limbo? If we restrict the “FE” to those with direct business interests in mortgage related businesses, property ownership and investments, financing, and securitizations, etc. it seems reasonable we would see some metrics that would bear out these benefits thus far gained: e.g., has there been any significant changes in the private label MBS segment benefiting those players; are banks increasing profitability with higher fees in mortgage related businesses; anything market share related with larger banks vis-à-vis smaller institutions; are private entities buying up more significantly more properties for rental income; etc.
Forgive my awkward groping, this is the business you know best. What are we missing? I do realize the FE may be playing more for the long-term prospects as well. Without something tangible and significant one is left with more nefarious financial and social engineering interpretations that aren’t easily dismissible.
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GSE Investor–I’ve covered the “why does the Financial Establishment want to do this to Fannie and Freddie” question on a number of occasions, including in the post “Some Simple Facts,” and, more recently, the current post (which you may want to re-read), in which I pointed out:
“Banks have benefited greatly from having Fannie and Freddie run in conservatorship and grossly overcapitalized by FHFA. At December 31, 2007, banks held $2.29 trillion in single-family whole loans and MBS, or 23 percent of outstanding single-family mortgage debt, on their balance sheets. At June 30, 2022 (the latest date for which full data are available), banks held more than double that amount—$4.65 trillion, for a 36 percent market share. Moreover, because the rates on all new mortgages are set with reference to MBS yields, the same unnecessarily high guaranty fees that are blocking access to mortgage credit for affordable housing borrowers add, basis point for basis point, to the spreads on the long-term fixed-rate whole mortgages banks finance in their portfolios with government-guaranteed consumer deposits and purchased funds.”
I didn’t say it in either post, but banks also benefit from the 10 basis point fee Fannie and Freddie have had to charge and remit to Treasury since 2012. All originators add this fee on to the rates they quote to borrowers, but Treasury only gets the 10 basis points if the loan goes into a Fannie or Freddie MBS; if a bank originates a mortgage and holds it in portfolio, or buys it from another originator, it keeps the 10 basis points (which the homebuyer is paying). Add all these things up–a market share increase of over 50 percent, and getting to keep both the higher guaranty fees Fannie and Freddie have to charge because of overcapitalization and the 10 basis points only paid to Treasury if it’s a Fannie- or Freddie-guaranteed loan–and that’s a LOT of money the banks are getting from the government’s misguided policies towards the companies.
I’ve also discussed in various places how Wall Street benefits from the current regulatory structure for Fannie and Freddie. In this case, it’s FHFA’s insistence that the companies issue wildly non-economic credit-risk-transfer (CRT) securities, both to meet the requirements of FHFA’s annual scorecard and to “buy down” their greatly inflated capital requirements. These CRTs are very profitable for Wall Street firms to underwrite and trade, and extremely profitable for their customers to invest in–and it’s all paid for, indirectly, by the homebuyers whose loans Fannie and Freddie are guaranteeing. To learn more about this “tangible benefit to the Financial Establishment,” and why it’s so outrageous, read my post, “Comment on ERCF Rule Amendments,” available under the heading “Top Posts” on the right-hand side of all of my blog posts.
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Tim,
RE: “Add all these things up … and that’s a LOT of money the banks are getting from the government’s misguided policies towards the companies.”
I’m curious if you had any plans to do an updated accounting of this and also if you had considered teaming up with other industry experts, think tanks, or community lending advocates to help you with the task and help get the message out. A good journalist would be helpful as well. Americans needs to be better informed about this. Thank you.
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Tim,
Despite the notion that something will happen eventually, status quo cannot exist for ever, courts’ opinions in other cases will apply here as well and the 1000s of non-visible hints that shareholders are hallucinating, I do not see anything that concretely points to the fact that this saga will end any time soon. Is my assessment half-correct?
Practically, we have not seen the 3 letters GSE uttered by Janet Yellen in the last 2 years….At least Steve Mnuchin gave us a continuous feed of something may happen through his 4 years. Whether it happened or not is a different story. And coming to FHFA heads, Mark Calabria again was more visible, but Sandra Thompson is completely hidden other than the standard FHFA Annual Performance scorecard report calling out stability, taxpayer first and the standard verbiage that gets rolled over from prior-year reports. And last but not the least the White House is missing in action also.
Can we assume with certainty that the window has closed for this regime with the midterms? And, given the fact that elections are right around the corner in 18 odd months?
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EP– I agree with the statement you make in your first paragraph (there is nothing that “concretely points to the fact that this saga will end any time soon”), but believe the statement in your concluding paragraph (“the window has closed for this regime with the mid-terms”) is premature, and too strong.
The list in your middle paragraph of things that didn’t happen in the Biden administration with respect to Fannie and Freddie leaves out one important event that did: on Friday, September 10, 2021, somebody at the White House told Mike Calhoun, then the president at the Center for Responsible Lending, that his appointment as the next Director of FHFA (replacing Mark Calabria, who had been dismissed immediately after the SCOTUS ruling in Collins) would be announced the following Monday, September 13. It was not, nor was it announced on any other day, and not long afterwards, we learned that the next Director of FHFA would be the current acting Director, Sandra Thompson.
There can be little doubt as to why Calhoun’s nomination was put on hold, and then withdrawn in favor of Ms. Thompson. Calhoun is very knowledgeable about Fannie and Freddie, and he had been highly critical of the Calabria capital standard–how unjustified (and non-risk-based) all its conservatism was, and how the impact of this conservatism fell disproportionately on low- and moderate income homebuyers. As Director of FHFA, he almost certainly would have replaced that standard with one based more on the true economics of the companies’ credit guaranty business. This, of course, is not something the Financial Establishment wants. Over that September weekend, therefore, leaders of the FE mobilized and worked their contacts at the White House to get the Calhoun nomination delayed, then got it sidetracked. The acting FHFA director, Ms. Thompson, had spent her entire time at FHFA enveloped in the fictions about Fannie and Freddie (promulgated by the FE), and thus was the perfect candidate to represent them as permanent Director. And that indeed is what happened.
But…the fact that Calhoun was nominated at all is compelling evidence that some person, or group of people, in the administration 18 months ago was (or were) aware that having him lead Fannie and Freddie out of conservatorship, and restore them as “real companies” providing low-cost affordable housing financing was good public policy for the President’s party. They just got rolled by the FE, and didn’t have enough support, or firepower, to fight back and win.
I am almost certain that the contact at the White House who put the Calhoun nomination on hold, and supported the Thompson nomination, was Brian Deese, then the head of the National Economic Council. (As I’ve mentioned previously, Deese was at Treasury during the time of the net worth sweep, and his name appears frequently in the “bad fact” memos among the senior staff at Treasury produced in discovery for the Court of Federal Claims cases.) Deese has now left the NEC, and has been replaced by Lael Brainard, who does not have the same degree of exposure to, or involvement in, the long history of fictions about Fannie and Freddie as high-risk triggers of the Financial Crisis, who need to be capitalized like banks to prevent disaster from striking again.
I don’t read as much into the silence about Fannie and Freddie from key members of the Biden economic team as others do. Janet Yellen hasn’t made many public comments on any topic (in my view she’s been the least visible Secretary of the Treasury since G. William Miller, who served in the Carter administration when I first started following the financial markets). And Sandra Thompson of course has fully bought into to FE story. I suspect that whomever was behind the nomination of Calhoun in the first year of the Biden administration will see if they can’t knit together a coalition of policy officials confident enough in the benefits of recapitalizing (under a true risk-based standard) and releasing Fannie and Freddie as healthy, management-run companies to be able to take on the fight with FE leaders they know is coming once they make their proposed policy public. But we’ll only hear from them if and when they think they’ve reached a “tipping point,” and believe they have a decent shot at prevailing.
Am I predicting this will happen? If I’m being honest with myself, I’d have to say –to use a legal phrase–that I still think it’s “more likely than not” the status quo will persist during the remaining term of this administration. But I also think the chances of a favorable resolution to the conservatorships in the next 2o months are well above zero, and may be closer to 50-50.
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Great response Tim.
I too would think that, given the powerful influence of the FE and the Federalist Society, it may be best to fly under the radar for as long as possible, and perhaps just suddenly come out with another amendment that clears the way for the companies out of conservatorship. I would also add that it would be incredibly foolish for this administration to forego this opportunity and leave the 100bn on the table, ready for the other party to grab in 2 years. Gary Hindes has hinted, in a letter that was briefly public on twitter, that indeed there may be something coming by November. Sandra Thompson has been detail-tweaking the capital rules, which makes no sense at all if there is not a path out of conservatorship.
On that note, I know you feel the capital standard is currently too high and would not provide an attractive return for investors. The other argument I read was that, in fact, even at 6-8% ROE (instead of the usual 10%) may be fine for investors that are bound long-term, like pension funds and insurance companies. Would love to hear your thought on this.
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It’s not just that I feel the capital standard for Fannie and Freddie is too high, by any objective standard it IS too high (as I’ve tried to explain in many posts, including “Capital Fact and Fiction”). Eliminating the net worth sweep and Treasury’s liquidation preference, but keeping the Calabria standard in place, might prove workable for investors (particularly compared with status quo), but it most definitely would not be workable for low- and moderate-income homebuyers, who would continue to either be blocked from owning a home or have to greatly overpay on their mortgages, for absolutely no reason. My consistent approach to removing Fannie and Freddie from conservatorship has been to do so in a way that provides maximum benefits to all of the companies’ stakeholders–investors, the government and homebuyers–and that will continue to be what I seek, and advocate.
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Would it be possible to create 2 pie charts, both depicting a typical mortgage of a set dollar amount with the “slices” that each entity involved in the mortgage receives and a total dollar amount a consumer pays. One pie chart would depict an optimal capital rule without all of the buffers etc., the other depicting the current state under the Calabria standard? I think that would perhaps go a long way in presenting WHY a new capital rule is good for the American people.
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If you’re asking if I could create pie charts like this, it’s not an ability I have (I had staff who did that when I was working, and subsequently never felt the need to learn to do it myself). Beyond that, though, I believe the people within the Biden administration who have the power to require a redo of the Calabria capital standard understand what the issues are, and don’t need a pie chart to illustrate them. They just need the will–and the confidence that they can overcome the opposition of the Financial Establishment–to get it done.
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Tim,
In your scenario where there is a “favorable resolution the conservatorships in the next 20 months,” do you believe/envision the only way this can happen is if they replace ST with a new FHFA director (such as Calhoun), or do you think it can be accomplished with her in charge of FHFA?
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The sort of recapitalization and release from conservatorship I’ve advocated for Fannie and Freddie will not be feasible unless Treasury has gotten on board with it (since Treasury will have to approve the cancelation of the net worth sweep and its liquidation preference in the companies). My strong view is that if Janet Yellen asks Sandra Thompson to have FHFA re-do the Calabria capital standard so that it does not use add-ons, cushions, buffers and minimums to produce a pre-determined “risk-based” capital number, but instead is based on the true risks of the loans the companies guarantee, and has a minimum capital requirement that reflects those risks, then Thompson would do so. And if she declines, I would expect her to be replaced.
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[Edited] I’m not sure I’m grasping the nuance. You’re saying it’s more likely than not that nothing happens with this administration (things remain status quo), yet within the administration’s remaining time-frame a favorable resolution might nearly be 50-50. So, please correct if I’m wrong but if you were to handicap this, I’m interpreting you as intimating between 40-60 and 49-51 (good resolution : nothing happening).
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Let me try to clarify this for readers.
I said: “…I’d have to say –to use a legal phrase–that I still think it’s ‘more likely than not’ the status quo will persist during the remaining term of this administration. But I also think the chances of a favorable resolution to the conservatorships in the next 2o months are well above zero, and may be closer to 50-50.”
“‘More likely than not’ that the status quo will persist” means that I think there is less than a fifty percent chance that the conservatorships of Fannie and Freddie will be resolved during the Biden administration’s current term. Saying that the chances of a favorable resolution are “well above zero, and may be closer to 50-50” means that those chances MAY be above 25 percent.
That’s not very high. To push the chances higher, I’d need to see some signs–whether made public or gleaned from private sources– that there is a core group of senior officials in the administration focusing seriously on what to do about Fannie and Freddie’s plight, and that they are considering taking action.
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Excellent. Tracking. The above 25% should’ve been my baseline assumption. Your original comment was wrongly inferred by me.
I infer you haven’t gleaned much that’s positive from the administration. My hope is that’s because everyone’s on a gag order!
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Thanks Tim for that explaination
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Do you think this recent letter from Dem Senate leaders might spark more of a focus on this issue from within the Administration?
https://t.co/lfLDVRPw1F
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No, unfortunately. The letter says, “The depth of our country’s affordable housing crisis is undeniable”–which I agree with–then thanks the President for “considering the measures suggested in this letter as your Administration continues its work to address housing needs in communities across the nation.” But getting Fannie and Freddie–who finance half the nation’s single-family mortgage loans, and a much higher percentage of its affordable housing loans–out of the $420 billion capital hole regulators under the control of this administration have put them in isn’t even one of the “measures suggested in this letter.” It’s a stunning sign of how thoroughly our nation’s legislators have been swayed by the fictions they’re constantly being told about the companies by leaders of the Financial Establishment (who also are among their largest campaign contributors). The signatories of this letter have no idea there ARE severe problems with Fannie and Freddie, so of course they won’t have “fixing Fannie and Freddie” on their affordable housing “to-do” list. That’s why it really is going to be up to the senior economic policy officials in the administration–who do know what the problems are–to take the lead on getting Fannie and Freddie out of conservatorship, and back to where they can play their traditional roles of being the primary source of ample, low-cost mortgages for low- and moderate-income homebuyers.
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The letter to the president is too vague, in my opinion. However, the Independent Community Bankers of America make a good point in regards to fixing the housing problem.
https://www.icba.org/newsroom/news-and-articles/2023/03/03/icba-statement-on-fannie-mae-and-freddie-mac-2022-earnings-release
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If there is a “good point” in the ICBA letter it eluded me.
The opening sentence in the ICBA’s statement on Fannie and Freddie is fine: “ICBA and the nation’s community banks strongly urge the Federal Housing Finance Agency and the U.S. Treasury to expand efforts to resolve the government’s ownership of Fannie Mae and Freddie Mac and set them on a path to raise capital and eventually exit conservatorship.” But the ICBA then simplistically, and misleadingly, says that their problem is that they “remain undercapitalized,” and wrongly interprets their recent financial reports as showing signs of difficulty: “The 2022 earnings reports from both government-sponsored enterprises reflect substantially decreased levels of annual net income following a turbulent year in the housing market.” The drop in both companies’ earnings in 2022 relative to 2021 was driven by two factors, neither of which was problematic: less income from amortized guaranty fees because refinances in 2002 were much lower than in 2021, and a much higher provision for future loan losses in 2022 because home prices flattened out that year, and the companies’ accounting regulations require them to immediately boost their loss reserves to account for all “current expected credit losses” in the future. Fannie’s single-family delinquency rate in the fourth quarter of 2022 was actually below where it was prior to the pandemic. It, and Freddie, are in excellent financial shape, but the ICBA mistakenly implies otherwise–probably because of lack of knowledge rather than bias (unconscious or otherwise).
The reason I point this out is to make readers aware that letters like the ICBA’s that seem constructive almost do more harm than good, because they reinforce, and build on, the fictions about Fannie and Freddie created by the Financial Establishment and repeated endlessly in the media. What the ICBA describes as a single problem for Fannie and Freddie–undercapitalization–is really two problems: they have too little core capital, because of the net worth sweep, and they are being required by the “Calabria capital standard” to hold far more capital than necessary to survive a repeat of the Great Financial Crisis. This is a very important distinction, because the solution to the ICBA’s definition of the problem is releasing Fannie and Freddie from conservatorship so they can go out and raise the $420 billion needed to close their current capital gap; the solution to my definition of the problem is for Treasury to cancel the net worth sweep and its liquidation preference, and for FHFA to replace the Calabria standard with a true risk-based standard and an appropriately-sized minimum capital requirement, so that the companies can close the capital gap that remains with an amount of new equity that is feasible to raise in the capital markets, and that will allow them to price their credit guarantees much more reasonably and affordably, to the benefit of homebuyers. It would have been great had the ICBA urged the latter.
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SCOTUS agrees to hear a challenge to the CFFB v Community Financial Services Assn. Any relevance to FHFA?
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Yes. The Supreme Court granted a writ of certiorari on a petition from the government to review a recent ruling by the Fifth U.S. Circuit Court of Appeals that a provision in the enabling statute of the Consumer Financial Protection Board (CFPB)–the fact that it does not have to get an annual appropriation from Congress to fund its operations–violates the Appropriations Clause of the Constitution, and thus is illegal. The enabling statute for the FHFA, HERA, also exempts FHFA from the annual appropriations process; FHFA can spend as much as it wants and Fannie and Freddie must pay it (the CFPB gets its funding from the Federal Reserve, with an annual limit of 15 percent of the Fed’s annual earnings remitted to Treasury). In granting cert on this case, the Court did not agree to hear it during its 2022-2023 term, which means it likely will be argued this fall, with a decision in the first half of 2024 (probably late in the first half). A ruling on the Appropriations Clause with respect to the CFPB–and, if it is found to be in violation of the clause, the proposed remedy for that violation– will have obvious ramifications for FHFA.
I find this case fascinating at the 36,000 foot level, because of cross-cutting political agendas. The conservative legal establishment probably hates the CFPB more than it hates Fannie and Freddie. Conservatives took their first shot at the CFPB in the Seila Law case, contending that its single director removable from office only “for cause” was a violation of the Appointments Clause of the Constitution. The Supreme Court agreed with plaintiffs in a June 2020 decision, but granted only a limited remedy–i.e., they didn’t “kill the beast.” The precedent in Seila Law then carried over to Fannie and Freddie in Collins, in which SCOTUS also ruled that the FHFA director was unconstitutionally appointed, but then conveniently simplified the remedy issue by asserting that Ed Demarco, who authorized net worth sweep, WAS removable at will because he only was acting director, even though HERA is silent on this, and SCOTUS cited no precedent in which an acting senior official at any federal agency was deemed removable other than for cause.
So now the CFPB’s opponents are back at SCOTUS with another Constitutional issue, the Appropriations Clause. But this one is a shotgun, rather than a rifle. There are many federal agencies, including the Federal Reserve and the FDIC, whose operations are not subject to annual appropriations. Will SCOTUS really say these entities are illegally funded (the Fed gets its funding from Treasury, and the FDIC from banks), and if so what will the remedy be? SCOTUS will need to be very careful in how it deals with this Pandora’s Box.
I therefore find it hard, at this point, to speculate about the implications for Fannie and Freddie, and the net worth sweep, of SCOTUS granting cert in the CFPB case. It has too many complications, and conflicts of political agendas.
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Tim
Seila was a case involving an appointment of a admin law judge adjudicating a single accounting firm’s sanction. Funding for an entire agency, even an “independent” one, is of course of broader scope…not that J. Roberts as the influential Chief Justice likes broad scope rulings as an institutional matter. so the remedy would address the injury, and one can see SCOTUS declining to find any palpable injury on the part of private plaintiffs (how would the private plaintiffs be better off if the CFPB was congressionally funded?), and decide that only prospective relief (agency funding by congressional appropriation) should be in order. and in the case of the GSEs, if one might posit that the GSEs were injured by the FHFA funding arrangement (after all it was their money that went to pay for the fine work done by FHFA), one would need the GSEs to bring an action should the CFPB case result in a plaintiff win, and they wont do that…in which case private GSE shareholders would have to go the derivative shareholder route, which is torturous and uncertain.
rolg
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I was trying to avoid making a prediction about this case, but I agree with you that the legal issue presented by Consumer Financial Services Association of America is too narrow to result in the sort of sweeping SCOTUS ruling against the CFPB as an institution that its opponents want, and thus is highly unlikely to open up a path for Fannie and Freddie to have the net worth sweep cancelled because of the Appropriations Clause. But I’m content to wait to see how this all plays out (which should take at least a year for the SCOTUS decision in the CFPB case).
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Tim/ROLG,
While I agree that SCOTUS is unlikely to let the 5th circuit remedy stand as is for an appropriations clause violation, IF (big if) it does stand, the ruling applied to the FHFA/Collins case (where the Appropriations clause is being argued today for GSE shareholders) would require the NWS to be vacated. A total of 7 5th circuit judges to date have already ruled/agreed with the opinion that the proper remedy for an appropriations clause violation, is to vacate the challenged action. As Judge Jones explained in her 5 judge concurring opinion ruling that later inspired and was affirmed by the 3-0 Judge Wilson CFPB ruling in front of SCOTUS today,
“To remedy the separation of powers violation arising from the CFPB’s budgetary independence, I see no other option than dismissing the enforcement action against these appellants. The reason is simple. 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. Indeed, 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. Accordingly, as in cases involving Appointments Clause defects or other separation of powers problems with a government actor’s authority to act, the proper remedy here is to disregard the government action. Because the CFPB has prosecuted this enforcement action using funds derived without a constitutionally footed appropriation or oversight, the court should dismiss the enforcement action against the appellants. A dismissal also comports with the Supreme Court’s admonition that courts should “create incentives to raise” separation of powers challenges by providing adequate remedies. (Lucia)”
Something to watch closely, is now that the CFPB SCOTUS case has been postponed until next term, with a ruling to come some time in Q1-Q2 of 2024, the 5th circuit actually has the opportunity to rule on the Collins appropriations ruling (as well as the removal provision remedy remand) ahead of SCOTUS (should be by the end of the year as briefing is currently going on). And if they apply the same logic and remedy they used in the CFPB appropriations case with equal force to the FHFA appropriations case, they may very well order the NWS to be vacated at some point this year, prior to SCOTUS having a chance at reversing their ruling and/or remedy. The only way the 5th circuit wouldn’t come to the same conclusion that they did in the CFPB case is if they find a way to differentiate CFPB from FHFA (which they and SCOTUS have failed to do in the past with regards to the original Collins constitutional case).
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@UnfortunateScotus,
I agree. Although Tim and ROLG are right in the ultimate outcome in front of SCOTUS, the intermediate decision by the 5th circuit in advance of that ruling likely being on the side of plaintiffs could well be something to prod the administration to actually take action that they seem unwilling to take. I still think Tim is right that this is a political problem, rather than legal at this point, but such a win in a court of appeals could move the administration to take action that currently seems unlikely.
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@unfortunate
the 5th C will rule in Collins on whether the fed district court below was correct in not considering the Collins amended complaint adding the appropriations claim in its consideration of the removal remedy mandate from SCOTUS…the 5th C likely will not reach the merits of the appropriations claim (though its view of the merits may incline it to reverse the court below and instruct it to consider the appropriations claim). district court decided that the case on mandate from SCOTUS precluded it from considering the appropriations argument as it was a “new claim”, while Collins argues that the appropriations claim was subsumed in the separation of powers removal remedy analysis…so, at this stage of the proceeding this will be more about appellate procedure than the merits. govt briefs due in April, oral argument may be heard.
rolg
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ROLG,
Plaintiffs are asking for two rulings re: appropriations claim. The first ruling is as you accurately described above, to reverse the district courts opinion to allow the appropriations claim to proceed in the first place (this is covered under section II(A) of plaintiffs opening brief.
And the second requested ruling is under section II(B) of plaintiffs opening brief, tilted “Plaintiffs’ Appropriations Clause Allegations Satisfy the Motion to Dismiss Standard,” in which plaintiffs specifically ask the 5th circuit to rule on whether FHFA is distinguishable from CFPB in regards to the appropriations claim (plaintiffs argue it isn’t), and if it isn’t, to grant their requested remedy, “Plaintiffs have stated a claim that the FHFA’s self-funding structure violates the Appropriations Clause and that the appropriate remedy for this constitutional violation is to vacate and set aside the Third Amendment. Here again, this Court should put Plaintiffs in the position they would have been in but for the violation of the Constitution.” Notice how it says “THIS COURT” should put Plaintiffs in the position.
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@unfortunate
fair enough. I just dont think the 5thC will decide the merits of a claim that wasn’t even adjudicated below…I hope I am wrong.
rolg
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The way I see it, there are two paths going forward, either 1) the companies are kept in perpetual conservatorship (effectively making them federal agencies but without the federal financial reporting requirements), or 2) the companies are recapitalized and released back to their original public-private partnership status. But in order for the second scenario to occur, government officials will have to act in good faith (e.g., unwinding the NWS, establishing a true risk-based capital standard, etc.) because no individual or institution is going to put one penny of new capital into these companies given the way they and their shareholders have been treated.
So, if this administration is really and truly interested in getting Fannie Mae and Freddie Mac out from under their stifling conservatorships and back to their full capabilities, Treasury and FHFA will need to take a realistic approach to recapitalization. And to that end, I have updated my April 2022 essay (and supporting documents) to reflect just such a process. I have also provided more emphasis on their affordable housing mission. As before, words and phrases that are highlighted in blue are hyperlinks to reference materials.
https://drive.google.com/file/d/1LNWzb9QhI1GiOk8W_2MYgERyE4yNRU04/view?usp=sharing
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Thanks Bryndon. Sharing it on Facebook, iHub, Tweeter, Stock twits and Google Board.
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“ What we have collectively witnessed over the last decade with the conservatorships of Fannie Mae and Freddie Mac is nothing short of a national tragedy, and a global stain on American exceptionalism.” – agreed 100 percent.
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Bryndon–I’ve read your updated paper, and think it’s excellent. Your plan and the one I’ve proposed are very similar, with the one major exception being the treatment of the warrants. (I haven’t tried to estimate the stock prices of new equity issues, so can’t comment on the plausibility of yours.)
I agree that the warrants should never have been granted (Treasury gave them to itself after Hank Paulson told Fannie’s board that he would not tell them the terms of the conservatorship that he was using “the awesome power of the government” to force them to accept), and would love for them to be canceled. But the realist in me finds it hard to imagine what core group of senior officials in the Biden administration would risk the ire of the Financial Establishment–which wants to keep Fannie and Freddie in conservatorship and handicapped with overcapitalization and over-regulation for as long as possible–without ANY financial benefit to itself. Even with the lure of the warrants, there as yet has been no perceptible sign from anyone in the administration that they’ve put getting Fannie and Freddie out of conservatorship and back doing credit guarantees on an economic and an affordable basis on their “to do” list.
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Messieurs Howard and Fisher,
My sincere gratitude to the both of you – men of honor and integrity, indeed.
“… this is a political problem …” – J. Timothy Howard
“… there is a straightforward and uncomplicated way to recapitalize the two companies … that is ethical and just … [by a] Government, acting through its officials … [which] must demonstrate by word and by deed their sincere intent to recapitalize the two companies and return them to their shareholders.… and it can happen this year.”
– Bryndon D. Fisher
The qualitative essence of M. Fisher’s proposal is that this can be solved relatively quickly, but only by a government that deals in good faith. This problem has never been about mathematics, nor finance, but politics, as so concisely put by M. Howard. The NWS-senior preferred-liquidation preference-FHFA Capital Rule boondoggle is nothing more than Beltway-Wall Street doublespeak – an overly-sophisticated three-card monte designed to conceal the misdirected blame for the 2008 crisis on the GSEs and the truly straightforward and simple solutions to ending the conservatorship. The GSEs are effectively a UST piggybank. This conservatorship was constructed by force and subterfuge, created out of thin air by the strokes of pens and, as such, aside from the politics, should be reversed by the strokes of pens. The more we share the words of Messrs. Howard and Fisher on every forum, especially with our representatives, the more we may hope for a speedier, more rational solution.
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I second that. Already shared it with my representatives and most members of Congress. Currently sharing it with members of the media.
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at some point, the value of Treasury’s warrants in a restructuring and release of the GSEs has to become a feature and incentive. imo, a divided congress that makes social spending legislation difficult to pass is a condition that would cause someone in the Treasury to pause and consider the presence and usefulness of free money represented by the warrants…so I dont see how the warrants cannot be part of the solution.
rolg
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Agreed. The value of the government’s position can be allocated to housing initiatives. The only reason I can think of why an administration that is retaining earnings would not restructure and sell its stake locking in its reforms is because the markets would not bear it given valuations and capital requirements. I think this is why Calabria and Mnuchin could not restructure the equity and access third party capital and why Mnuchin kicked the can.
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For the second time this month, I am leaving a comment by Fanniegate Hero on the blog in order to make a point about why I delete (or choose not to accept) certain comments from readers.
On Thursday afternoon, Bryndon Fisher posted a detailed and specific proposal for getting Fannie and Freddie out of conservatorship, which included “extinguishing” the warrants for 79.9 percent of Fannie and Freddie’s common stock. I responded by saying that I thought his proposal was excellent, but that I viewed conversion of the warrants and the ultimate sale of the resulting shares of stock as one of two key incentives (the other is getting credit for unlocking Fannie and Freddie’s potential to provide meaningful support to affordable housing borrowers) for senior economic officials in the Biden administration to risk taking on the Financial Establishment, which benefits from the status quo with the companies. And I also pointed out that so far there has been no detectable sign from anyone in the administration that they are even thinking about Fannie and Freddie (which isn’t to say that there may not be discussions behind the scenes we’re unaware of).
GSE Investor’s comment commending Bryndon’s and my work to readers was fine, but subsequent ones—which I deleted or didn’t accept—added nothing new or useful, and if accepted would have ended a strong string of comments on a weak note. ROLG’s comment got by (despite using the vague word “restructuring”) because he took a position on converting versus extinguishing the warrants, and explained it. But the next comment, from Fanniegate Hero, was an easy deletion call; by moving the string completely away from the specific and informative to a vague “word jumble,” it obfuscates, rather than clarifies or challenges, the original points that were made. That’s not what I want on this blog.
A word about the term “restructuring.” The drawback to using it with respect to Fannie and Freddie is that it’s too general, to the detriment of clarity. A typical financial restructuring involves the reorganization of debt, which obviously isn’t the companies’ problem. And even saying they need an “equity restructuring” is still unnecessarily general. Fannie and Freddie’s equity problems are literally unique: they have $193.5 billion in Treasury senior preferred stock that does not count as regulatory capital, that they were forced into taking because of non-cash expenses put on their books between the middle of 2008 and the end of 2011 by FHFA, and that they cannot repay (as Fannie reiterated in its 2022 10K), and Treasury also has a liquidation preference in them of $288.2 billion as of December 31, 2022, which will grow in every future quarter until it is eliminated. Since THAT’s their “equity problem,” why not just call it that? And it’s a problem only Treasury can fix.
One also might argue that Fannie and Freddie junior preferred stock are candidates for “restructuring,” but that’s in a very different category from the senior preferred and the liquidation preference. Those have to be eliminated first, before it makes sense to think about redeeming (or converting) the junior preferred and replacing it with some other form of equity. Moreover, I would argue that changing the amount, type or mix of junior preferred stock is a decision properly made by company management, in conjunction with their financial advisers, and not FHFA.
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Thank you for the feedback; it’s very much appreciated.
I view the warrants like I do everything else that doesn’t further the companies’ release from their conservatorships – through the lens of practicality rather than fairness.
In order for the companies to raise new capital, government officials will need to say and do things that will encourage sophisticated investors (individual and institutional) to buy new common shares in Fannie Mae and Freddie Mac. Attempting to sell stock from the warrant exercise (which doesn’t contribute one dime to the recapitalization process) will not do that and, in fact, will likely be viewed by many potential investors as more unreasonable and harmful government actions towards these entities.
The steps I’ve suggested the government take would allow the companies to operate at their most effective and efficient level. And, as a result, would produce one very important benefit for the Federal Government – healthy and substantial tax revenues. That should be their focus, if they truly want the companies out of conservatorship.
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I agree that having the government sell shares of Fannie and Freddie common stock obtained from conversion of the warrants will complicate the process of raising new equity, but that’s a problem investment bankers know how to deal with. And I don’t agree that the warrant conversion “will likely be viewed by many potential investors as more unreasonable and harmful government actions towards these entities.” Fannie and Freddie each include shares from conversion of the warrants in their published figures for basic and fully diluted weighted-average common shares outstanding, and I think most investors now deem such conversion to be a foregone conclusion.
Moreover, the benefits you’re attributing to “the steps [you’ve] suggested”– allowing “the companies to operate at their most effective and efficient level,” and producing “healthy and substantial tax revenues” for the government–will be the result of giving them a more reasonable capital standard and freeing them from the constraints of being operated by their conservator; their effectiveness, efficiency and amount of tax paid will not be materially affected by an increased number of common shares outstanding because of conversion of the warrants (although their stock price will be).
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From a common sense perspective, I believe that exercising the warrants, although it wouldn’t contribute one dime to recapitalization and could be seen by investment bankers as harmful and more unreasonable treatment of the GSEs), actually can further the progress toward release. After all, why shouldn’t it be believed that the current administration wouldn’t be motivated by such a revenue windfall, even to the tune of 100 billion dollars for affordable housing, especially in the context of a Republican congress that would otherwise oppose printing such money?
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FHFA Issues Notice of Proposed Rulemaking Modifying Certain Provisions of the Enterprise Regulatory Capital Framework:
https://www.fhfa.gov/SupervisionRegulation/Rules/Pages/Enterprise-Regulatory-Capital-Framework-Amendments.aspx
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It may take a while for me to be able to review this NPR, but I’ll note any reactions I have to it once I do.
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A quote from the Fact Sheet on the Proposed Rule Changes
FHFA estimates that under the proposed rule, the total common equity tier 1 capital (CET1) required to meet the riskbased capital requirements and buffers for the Enterprises’ guarantees on commingled securities as of June 30, 2022 would decline by approximately $5.1 billion.
Overall, FHFA estimates that under the proposed rule, the total CET1 required to meet the Enterprises’ risk-based capital requirements and buffers as of June 30, 2022 would decline modestly from approximately $226.4 billion to approximately $220.8 billion. Similarly, total required adjusted total capital would decline from approximately $302.4 billion to $294.2 billion.
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I did see the fact sheet, which saved me from having to read the entire hundred-page NPR. It’s not worth wading through all that just for a net required adjusted total capital reduction of $8.2 billion, on a base FHFA says is $302.4 billion.
Let’s start with that figure though. Where did it come from? Fannie and Freddie publish their required adjusted total capital each quarter, using rounded numbers. In the third quarter of 2022, for the two companies combined it was $301 billion; in the fourth quarter it went up by $5 billion, to $306 billion (more on that later).
The first thing that has to be said about this $306 billon fourth quarter combined required adjusted total capital figure is that it’s almost entirely fake. To get it that high, FHFA has had to (a) pretend that the companies’ $30 billion in annual guaranty fees absorb no credit losses; (b) ignore the fact that the risk-based stress test is run on a liquidating book (which means it’s already conservative without the “stress capital buffer,” since the companies as going concerns will be doing billions of dollars of profitable new business); (c) add a “stability buffer” that isn’t risk-based at all, but instead a penalty for doing more than a small amount of credit guarantees, and (d) include high minimum capital requirements on very low-risk loans. Given this, for FHFA then to issue this NPR doing micro tinkering with minor elements as if it were fine-tuning a high-performance racing engine—in the name of “safety and soundness”—is beyond ludicrous.
But what is going to stop FHFA from continuing to regulate Fannie and Freddie in a world of make-believe? It will have to be some “shock” of reality, and one that may play that role is what’s currently going on in the credit-risk transfer (CRT) market. Part of FHFA’s elaborate construction of its capital standard for Fannie and Freddie is reducing their artificially high required capital somewhat if they issue CRTs that cost them billions more in interest payments than they ever can hope to recoup in reimbursed credit losses. Both companies have done this, but Freddie especially. Freddie reduced its required adjusted total capital from 4.80 percent of total assets on June 30, 2020 (when the Calabria standard first was calculated for the companies) to 3.70 percent on September 30, 2022, mainly by issuing large amounts of CRTs. Fannie’s lesser CRT use resulted in its required adjusted total capital falling from 4.55 percent of assets on June 30, 2020 to 4.27 percent of assets on September 30, 2022.
In the 2022 10K Fannie put out last week, it said that, “The rise in interest rates throughout 2022, increased macroeconomic and housing market uncertainty, and the increased issuance of credit risk transfer transactions from Fannie Mae, Freddie Mac and mortgage insurers throughout much of 2022 has negatively impacted investor demand and reinsurer capacity for our credit risk transfer transactions,” adding, “Taking into account the increasing cost of these transactions, the resulting capital relief, and the credit risk transfer market capacity, we have chosen to increase the first loss position retained by Fannie Mae compared with prior transactions.” Freddie simply noted “higher spreads on recent [CRT] transactions” in its 2022 10K. Yet a quick review of the pricing of recent Fannie CRT deals (I follow those, not Freddie’s) reveals the magnitude of the problem that’s reared its head.
Fannie’s CRT program is called “CAS.” Fannie paused its CAS program in March of 2020, coincident with the pandemic. When it resumed CAS issuance in October of 2021 (after FHFA proposed to increase the capital credit for CRTs that September), it paid a weighted average spread (WAS) of 300 basis points over 1-month SOFR (the secured overnight financing rate, the successor to LIBOR)—which at the time was 10 basis points—for $1.2 billion of CAS on which Fannie took the first 25 basis points of loss, and was given protection up to 200 basis points of loss. As a percent of the total insured pool of loans ($71.1 billion), the initial 310 basis-point cost of these CRTs (which may fall over time, as CRTs prepay faster than the underlying loan pool) was about 4 basis points.
Fannie issued one CRT deal a month through September of 2022, after which it paused issuance again, because of concerns about investor receptivity. On that last deal, it had to take the first 125 basis points of credit loss itself (versus 25 basis points on its October 2021 deal), and paid a WAS of 380 basis points over SOFR for protection of up to 385 basis points of loss. And by that time 1-month SOFR had risen to 2.25 percent, which raised the total initial interest cost of this $592 million CAS issue to 6.05 percent, or 12 basis points of the $28.7 billion loan pool.
As I noted, Fannie issued no CRTs in the fourth quarter of 2022, but then did issue one this January. That was a $731 million deal, on a pool of $21.9 billion of loans. For that Fannie took the first 100 basis points of loss, bought protection of up to 490 basis points (the last 200 essentially a give-away, since losses will never get that high) and still had to pay a WAS of 306 basis points. And because SOFR in January had risen to 4.30 percent, the total initial cost of this CAS deal, at 7.36 percent, was 25 basis points of the underlying loan pool. The CAS Fannie did this February had an even higher WAS (357 basis points) over a higher SOFR (4.55 percent), raising its total initial cost to 8.12 percent, or 29 basis points—well over half Fannie’s total guaranty fee on these loans, and more than seven times the 4 basis-point cost of the CAS issued as recently as October of 2021.
This can’t go on. With home prices likely to drift downwards for the next couple of years (according to Fannie’s economists), investors aren’t going to take the volume of CRTs FHFA wants Fannie and Freddie to issue, even at these recent ridiculously expensive prices. And when the companies slow or stop issuing the CRTs investors don’t want, their risk-based capital requirements are going to go up, and by a lot—just as Freddie’s came down a lot between June 30, 2020 and September 30, 2022 (and by the way, Freddie’s required adjusted total capital percentage went up by 10 basis point on December 30, 2022, to 3.80 basis points, so this already has begun).
A reckoning for FHFA’s jury-rigged capital system—a fake 4.0 percent-plus “risk-based” capital requirement that can be bought down by issuing non-economic CRTs that make money for Wall Street and investors—thus does not appear to be too far off in the future. It will be very interesting to see how this develops, and how policymakers react to it.
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Tim, ROLG … any comments on litigants potentially pursuing the Major Questions Doctrine in the courts? … Given Congress created HERA, HERA created FHFA, and with all the litigation to-date basically siding with HERA, FHFA, UST, etc. … is there any viability?
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there is no litigious path forward with the GSEs. this has become a workout with the executive branch as the decision maker…14 years and counting. gift your grandkids your GSE stock and wish them well.
rolg
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I’m not familiar with the Major Questions Doctrine, but as I said in my current post, I don’t believe there is any theory of law that will result in a successful challenge to the Fannie and Freddie net worth sweep that will be upheld by the Roberts Supreme Court, given its ruling on the APA issue in Collins.
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I agree. Would you please comment here on Olson’s sight to victory? https://seekingalpha.com/article/4578038-fannie-and-freddie-the-scotus-remand-and-the-5th-circuit
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My policy is to not comment on opinion pieces unless the author is someone with recognized expertise in the subject they’re addressing (which is not the case here).
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Thank you Tim and ROLG for your reply. Not to beat a dead horse, but if either of you choose to explore it any further the following link is a primer on the Major Questions Doctrine from an international law firm with a number one ranking from Vault Law in the Banking and Financial services sector. In a nutshell, the basic idea is a separation of powers doctrine – looking at administrative agencies vs Congressional authority to act. Thank you both, again.
https://www.davispolk.com/insights/client-update/basic-primer-major-questions-doctrine
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GSE investor–Taking a look at this piece, I’ll amend my statement: I AM familiar with the legal argument underpinning the SCOTUS decision in West Virginia vs EPA, I just didn’t know it was called the Major Questions Doctrine. Now that I do, though, it doesn’t change my opinion about the chances of this doctrine being used to overturn the net worth sweep; to the contrary, it reinforces that opinion.
As the article states, prior to West Virginia vs EPA, the “Supreme Court had never before invoked the major questions doctrine by name” until this case, in which the six conservative justices (with all three liberals dissenting) “cited a line of recent precedents in support of the Court’s holding that ‘in certain extraordinary cases’ where there is reason to doubt that Congress authorized a particular agency action, ‘both separation of powers principles and a practical understanding of legislative intent’ require the agency to point to ‘clear congressional authorization’ for its action.
I have two reactions to the application of the Major Questions Doctrine (MQD) to FHFA, and Fannie and Freddie. The first is, what “particular agency action” by FHFA required “clear congressional action” by Congress? Was it the net worth sweep? If so, what are the chances that the Roberts court–which just contorted itself a year and a half ago to justify finding the net worth sweep to be a legal action by FHFA under the APA–would cite the MQD as a reason for reversing itself? Somewhere, I think, in the range of zero, zilch and nada.
Which brings me to my second point. The conservative lawyers in the Federalist Society have been looking for legal arguments that can be used to justify rulings that limit “the administrative state” (i.e., regulatory agencies) for some time. The MQD was the weapon chosen to try to limit the power of the EPA, which the Federalist Society abhors. But just as Federalist Society lawyers would never use the SCOTUS ruling in Collins to allow the FDIC as conservator of a bank to give all of its future earnings to Treasury under the Incidental Powers section of the FDIC Act, they’re not going to use the MQD in an attempt to block FHFA’s ability to use the net worth sweep to keep Fannie and Freddie (also abhorred by the Federalist Society) in indefinite conservatorship.
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just saw Tim reply, so I will be brief. MQD is a gussying up of J. Scalia’s quote, to the effect that Congress doesnt hide elephants in molehills when it writes a statute. that is, a major exercise of administrative power must be tied to clear congressional authority. eg if FTC promulgates a rule banning non-compete provisions nationwide, it will be attacked by plaintiffs under the MQD, as the FTC’s authority to label non-competes as a restraint of trade is not apparent from its organic statute.
MQD’s possible applicability to the GSEs? well, the statute of limitations on the NWS has lapsed, so not applicable there. Maintaining the GSEs in conservatorship for over 14 years where there is no rational basis for continuing conservatorship, given reform over the past 14 years leading to current capital levels, elimination of loan warehousing and elimination of toxic mortgages? based upon the judiciary’s (other than 5th circuit) treatment of the GSEs to date, that argument wont fly…HERA authorizes conservatorship, and leaves it open as to how long and on what basis it should be ended. so the judiciary will find that not only is there no molehill in HERA, but it will find an elephant-sized hole for FHFA/Treasury to dither.
rolg
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To clarify (for any purists), the exact Scalia quote, in his 2001 decision in Whitman v. American Trucking, was “Congress…does not…hide elephants in mouseholes.”
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Tim, Brainard is confirmed according to multiple reports. You mentioned her positively in one comment, would much appreciate more background/ insights about her from you. Exciting times!
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My two reasons for feeling positive about the appointment of Lael Brainard as Director of the National Economic Council are that she’s coming from an eight-year stint at the Federal Reserve (most recently as Vice Chair), and she’s not Brian Deese.
I view the Fed as significantly more economically and financially oriented, and not as political or ideological, as Treasury, and therefore I expect Brainard’s background there to lead her to be more fact-based and objective on issues relating to Fannie and Freddie and their conservatorships. That would be welcome. And while Deese was highly capable and well respected in his role at the NEC, I always was troubled by the fact that his name appeared frequently in the memos produced during discovery in the Court of Federal Claims cases, showing that senior Treasury officials (including Deese) were well aware that they were telling the public a false story about why they had proposed the net worth sweep for Fannie and Freddie. For him to have taken the lead in a switch from fiction- to fact-based policies regarding Fannie and Freddie would have required him effectively to “call in an airstrike on himself,” which I found it hard to envision him doing. With Brainard now at the helm of the NEC, that’s no longer a constraint.
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Tim
Thanks for that opinion. Could you also shed some light on where and how the National Economic Council comes into the picture in this long, tiring conservatorship saga? What role do you see them playing, if any, in a positive direction for resolution and exit? Thanks in advance.
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The NEC website states,”By Executive Order, the NEC has four key functions: to coordinate policy-making for domestic and international economic issues; to give economic policy advice to the President; to ensure that policy decisions and programs are consistent with the President’s economic goals; and to monitor implementation of the President’s economic policy agenda.”
I have argued that shifting from keeping Fannie and Freddie overcapitalized and over-regulated to the benefit of banks to capitalizing and regulating them on an economic basis to the benefit of low-and moderate-income homebuyers is in the best economic interests of the Biden administration. Since the NEC’s portfolio is economic policy, having a new Director of the NEC take a fresh look at the Fannie and Freddie conservatorships–at the same time as the new Chair of the Council of Economic Advisers, Jared Bernstein, is doing the same thing–holds out a realistic possibility that a sensible, fact-based approach to these two companies may indeed be forthcoming. I’m not predicting this–there are very powerful interests working against it–but I do think the odds of it happening are higher today than they were a few weeks ago, and not insignificant.
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National Economic Council Director Brian Deese is leaving. Cecilia Rouse, the chairwoman of the Council of Economic Advisers, has long planned to return to Princeton next month. Her likely replacement will be Jared Bernstein.
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and Vance replaces Toomey on banking committee. That could be interesting.
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Please help an advertising guy understand something … when you say guaranty fees, are you talking about a percentage added on to the cost of a mortgage, like points at closing, or are you talking about an increase of the interest rate charged over the life of the loan? I couldn’t get a clear answer in my online search. The former wouldn’t seem to me to have much impact, but the latter would increase a borrower’s cost substantially. Thank you.
Jeff Wood
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The easiest way to think about guaranty fees is as basis points added to the mortgage rate. Fannie’s average guaranty fee on new business done in the third quarter of 2022 (we’ll get the fourth quarter data in a couple of weeks) was 63.3 basis points, 10 basis points of which went to Treasury because of a “temporary” tax levied on Fannie and Freddie in 2012, which was extended last year, with the other 53.3 basis points going to Fannie. Most of that 53.3 basis points goes to cover the cost of capital under the Calabria standard.
In actuality, though, it’s a bit more complicated than that. Both Fannie and Freddie price most of their credit guarantees through a combination of basis points paid over the life of the loan and a lump-sum payment up front called a “Loan Level Price Adjustment,” or LLPA. In their financial reports, the companies convert up-front LLPAs into basis points by assuming an average life for the loans they’re attached to, which means that the 63.3 basis point average guaranty fee rate cited in the first paragraph is really just an estimate. If the loans associated with the LLPAs in question prepay more rapidly than expected, the realized guaranty fee on those loans will be higher, since the LLPA received will be “earned” over a shorter period of time. The opposite will be true if loans prepay more slowly than expected–the effective guaranty fee realized will be lower, because the LLPAs will be spread out longer.
All lenders price new mortgages assuming they will sell them into the secondary market, so they add a guaranty fee component to rates they quote to a potential borrower. (Typically they will add the ongoing guaranty fee to the interest rate they charge, and the LLPA to the upfront points they charge, although they have the flexibility to handle the LLPAs however they wish to.) That’s why the simple answer I gave in the first paragraph is the one to remember. And it’s also why the big-bank primary lenders support the overcapitalization of Fannie and Freddie; they add the higher Fannie-Freddie guaranty fees to the rates they quote to borrowers, but if they hold those loans in portfolio they can keep the extra basis points (priced in for the guaranty fee) for themselves.
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That clears up a lot for me. I had assumed these were just points at closing. Bad assumption.
Now I don’t understand why Democrats, and Biden in particular, are keeping these companies from being released, when that would so clearly help low-income home purchasers. But you’ve addressed that multiple times in your blog.
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With regards to the conservatorships of Fannie Mae and Freddie Mac (and specifically the NWS), no one is more disappointed or disheartened than I am with the system of justice in the United States. For nearly a decade, the courts have gone out of their way to defend the defendants’ indefensible behavior. And nothing proves this thesis more than the Federal Circuit’s despicable February 2022 opinion of Barrett’s shareholder-derivative Takings claim.
It’s most likely true that “[t]he power to exclude has traditionally been considered one of the most treasured strands in an owner’s bundle of property rights.” But let’s be clear here, no individual or entity under the jurisdiction of the United States (or the various states and municipalities) can exclude the government from their private property if it is taken for a public use. Except now, with the Federal Circuit’s ruling and SCOTUS’s denial of Barrett’s petition, the courts have successfully untethered our government from the constitutional obligation of providing just compensation to those citizens or their companies when such a seizure occurs.
And keep this mind. Judge O’Malley (who authored the opinion) specifically referenced our second amicus brief in an exchange with the Government during oral argument. She asked them about our assertion that there are no cases holding that Congress has stripped jurisdiction for a constitutional claim, and the Government couldn’t cite to any either – not to worry, the court will find one for you.
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Virtually everything done to Fannie and Freddie from the time Hank Paulson “bullied” them into conservatorship (without their meeting any of the specific criteria in HERA for it) has had no economic, financial or legal precedent. The legal precedents should have afforded the strongest protections, but in the case you cite, and others, judges have gone out of their way to invent reasons why precedent doesn’t apply to Fannie and Freddie. Unfortunately, I don’t see this changing.
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[Edited] Fannie Mae and Freddie Mac now have no pending litigation preventing the conversion of the [Treasury senior preferred] to common and exercising the warrants. The government can do this and move forward with recapitalization and release where JPS [junior preferred stock] dividends turn on to settle their pending litigation or convert to common. No pending legal challenges would object to this outcome.
Sorry that the judges did not stand up for your rights, but there is still a path forward. Biden admin can lock in its perspective on housing finance reform and allocate the proceeds that the Trump admin unlocked when it stopped the sweep (began retaining earnings).
Common have no security as there is no pending litigation against the net worth sweep anymore.
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I have accepted this comment (which required approval) in order to emphasize an important point about “Howard on Mortgage Finance”.
I began the blog seven years ago tomorrow, with the goal of providing a source of factual information and fact-based analysis about Fannie, Freddie and secondary mortgage market finance that I’d hoped might improve the prospects for the companies to be released from conservatorship in a way that maximized their value to their key stakeholders—homebuyers, shareholders, and the government.
I recognize, however, that some readers of this blog seem to have just one objective: to make money on their investments in the companies’ common or junior preferred shares. And it’s not difficult to identify the comments of those readers: they predict or advocate for actions that (conveniently) will produce the investment result they seek, but give little or no analysis as to why those actions are in the best interest of Fannie and Freddie’s other stakeholders (the government and homebuyers), or are likely to be taken.
In the past I have consistently deleted those comments, and I’ll continue to do so in the future. There are other forums in which people can “talk their book,” and try to convince other investors to agree with them. This is not the site for that.
And I’ll reiterate that there are no “taboo topics” for this site, including the conversion of Treasury’s senior preferred to common stock. If someone is able to present a cogent and credible argument for how and why such a conversion could help the administration achieve a defined and plausible resolution of Fannie and Freddie’s conservatorships, I’ll accept that comment, and probably respond to it. But I’ll also still reserve the right to delete (or not approve) comments that I believe have embedded misconceptions or misstatements of fact, and thus would not be of value to the broader reader base.
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Why wouldn’t the administration take this opportunity to impose its policy preferences on Fannie and Freddie while they have the opportunity?
I feel like I must not understand the political costs to doing so.
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The political cost of undoing the damage done to Fannie and Freddie over the last ten-plus years by the net worth sweep and the Calabria capital standard is that the big banks will oppose it. That’s why the status quo is appealing–it doesn’t “rock the boat.”
FHFA won’t lead the change because (a) I think Director Thompson believes the fictions about Fannie and Freddie being told by the members of the Financial Establishment who keep in close contact with her, and (b) everyone at FHFA likes the power they get from running Fannie and Freddie in conservatorship. And the careerists at Treasury will resist change in their posture towards the companies because they don’t want to admit that Treasury’s past policies towards them were based on falsehoods. That’s why I’ve said that it will take someone very senior on the Biden economic team stepping up and making it a personal priority to get Fannie and Freddie out of their policy-imposed straitjackets, and back to their roles of being the primary providers of affordable housing finance. Perhaps the rumored changes at the National Economic Council (with Lael Brainard replacing Brian Deese, whose name appeared frequently in the Treasury memos admitting that the net worth sweep was agreed to under false pretenses) and at the Council of Economic Advisers (with Jared Bernstein becoming chairman) will produce that person. If so, they would have the considerable advantage of having the facts, and market reality, on their side.
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Tim, the service you have done for those seeking factual information and a deeper, broader understanding of the GSEs and what has transpired is immeasurable. The comment you are responding to is relatively reserved in tone compared to the standard fare on other forums of those who are “talking their book.” Both common and preferred holders do so; it is an understandable by-product of those forums. I am grateful that you have blockaded such “speculation” on your blog, but even more grateful that you have let this one slip through for illustrative purposes. Many of these posters write with an implied authority or expertise which the dearth of supporting information in their posts clearly betrays. This is the very reason we turn to your forum. I think I speak for many who desire a logical analysis or response from a respected authority to combat the dilettantes. I gather that you don’t put much merit in the poster’s position, but greed and hubris are often the government’s not-so-secret mistresses which is why I do not discount the possibility of an attempted extreme “cramdown.” I believe there are obvious and damaging consequences to such an action, but who am I (rhetorical). Without receivership (or a true bankruptcy) it doesn’t seem sensible at this point to not treat both classes of shareholders equitably. I would like to believe “the government” will do something sensible and has played hardball only to eliminate the possibility of large, future damages or treasury obligations, but a sneaking suspicion tells me that may be naive. Let’s assume the decks are cleared of ALL litigation and the government is given free reign. Would you please address the poster’s claims, in general, if not in specifics. What is to stop the government from taking the greed route and treating the preferred and commons in the way presented in the post – legally, politically, or on principle?
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While you’ve asked me to address the “merit of the poster’s position,” I can’t tell what that position is. The only specific thing Fanniegate Hero says is, “Biden admin can lock in its perspective on housing finance reform and allocate the proceeds that the Trump admin unlocked when it stopped the sweep (began retaining earnings).” Yet the Trump administration did not “stop the sweep;” it simply suspended it—while increasing Treasury’s liquidation preference on a. dollar-for-dollar basis—until Fannie and Freddie fully meet the (indefensible) requirements of Calabria’s ERCF, when the sweep will turn back on again. I also have no idea what “proceeds” Fanniegate Hero thinks the Trump administration “unlocked,” nor do I know what “perspective on housing reform” FH thinks the Biden administration would be “locking in” by taking the actions (converting the senior preferred to common and restoring the dividends on the junior preferred) he recommends. There’s too much that’s incorrect or incomplete, and too little that’s concrete, in the Fanniegate Hero comment for me to be able to evaluate it.
You also ask, “What is to stop the government from taking the greed route and treating the preferred and commons in the way presented in the post – legally, politically, or on principle?” My answer is that doing this may not align with the government’s objective for removing Fannie and Freddie from conservatorship.
Here I think you have to go back to the reality of where the companies are, and how they got there. Fannie and Freddie have been put in an enormous capital hole by the legitimization of net worth sweep by the Supreme Court, and they’ve been given a non-economic “risk-based” capital standard by a former FHFA director who thinks they shouldn’t exist. Their current books of business would permit them to survive a stylized repeat of the home price declines of the Great Financial Crisis with no initial capital at all, but it will take them two decades to get out of conservatorship with retained earnings alone.
THAT’s the problem that needs to be fixed, by some administration, before 2040. Whichever administration does so will get to pick the objectives it sets for Fannie and Freddie’s “recap and release.” Neither I nor anyone else can predict what tactics (including the treatments of the senior preferred, liquidation preference, and junior preferred) will be used before we know what the objectives to be achieved are.
My personal view, as expressed in the current post, is that it would be in the best interests of the Biden administration to switch from the fiction-based policies of past administrations toward Fannie and Freddie to fact-based policies going forward. Were this administration to do that, it would cancel the net worth sweep and Treasury’s liquidation preference—and not convert the senior preferred to common—have FHFA re-do the Calabria standard to make it truly risk-based, with a 2.5 percent minimum, then exercise Treasury’s warrants for future sale at a share price that reflects the earnings power of two companies without a huge net worth sweep hole, and with a capital standard that allows them to return to doing large volumes of profitable affordable business on terms borrowers can afford. This very likely will continue to be my position, and expectation, for the next two years. Then, if nothing has been done to change the status quo for the companies, I will try to gauge the likely policy objectives for Fannie and Freddie of the next administration, and set my new expectations for the treatments of the senior preferred, liquidation preference and junior preferred shares accordingly.
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Tim,
Can you provide examples of what companies are the “financial establishment”? Also, can you explain why they are injured by the business of Fannie and Freddie? How has their perception of the risk of the GSEs or the GSE model generally evolved since the great financial crisis to today? What damage(s) are they fighting so hard to prevent by keeping the GSEs in perpetual Conservatorship?
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My generic definition of the “Financial Establishment” (as I repeated in the current post) is “large banks and Wall Street firms, and their advocates and alumni at Treasury and elsewhere.” You can Google the top bank primary mortgage market lenders if you want the names, and the relevant Wall Street firms on the Fannie and Freddie issue are the ones who were (and would like again to be) involved in private-label securities (PLS) issuance.
The “injury” done to them by Fannie and Freddie, prior to the conservatorships, was being much more efficient in their provision of mortgage finance to borrowers with loans under their statutory loan limit than the bank portfolio lenders or PLS issuers could be. Keeping Fannie and Freddie in conservatorship and over-regulated and over-capitalized by FHFA forces the companies to have to set their guaranty fees artificially high, raising mortgage rates to levels that allow bank portfolio lenders to make more money on the whole mortgages they hold in portfolio, and also, at some point, possibly making PLS issuance viable again (although that hasn’t happened yet).
I suspect that the members of the Financial Establishment do know that Fannie and Freddie’s credit risk has fallen dramatically since the time of the financial crisis (the recent Dodd-Frank stress tests mandated by FHFA make that clear to anyone paying the slightest amount of attention), but it’s in their interest to pretend otherwise, to keep the conservatorships going for as long as possible. As I say in my most recent post, however, I don’t believe this yawning gap between the fictions put out by the Financial Establishment and financial market reality can be maintained for anything close to the two decades it will take for Fannie and Freddie to fully meet the requirements of the Calabria capital standard through retained earnings (which, as long as the net worth sweep and Treasury’s liquidation preference remain in place, is the only way the companies have to increase their capital).
If you’re interested in knowing more about the competitive motivation for the Financial Establishment to keep Fannie and Freddie in conservatorship, I suggest you read my post “Some Simple Facts,” which you can find under the heading “Top Posts” on the right-hand side of my blog.
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“Señor Calderon, as any true American will tell you, it’s the independence of our courts that keeps us free.”
President Martin Van Buren (played by Nigel Hawthorne, from the movie Amistad)
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Bryndon, do you have any litigation pending or any planned litigation?
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BTIG analysts are cited in this piece (https://www.nationalmortgagenews.com/list/why-the-gses-new-fees-may-be-tricky-to-implement) as saying:
“The FHFA estimates that it will release a proposal in February 2023. Our sense is that the core of the capital rule will remain unchanged, but there are a number of areas that are ripe for modest tweaks,” the BTIG researchers said. “For example, we will be focused on the potential for a change to certain risk weights which ultimately led to the imposition of the fee on commingled UMBS.”
Wondering if you had any thoughts on this (or the UMBS fee change generally), and if you expect GSE capital rule changing/tweaking to be a recurring exercise by the FHFA?
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This article is limited to subscribers, so I have no basis for commenting on it.
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Here is the non-paywall link: https://web.archive.org/web/20230124102217/https://www.nationalmortgagenews.com/list/why-the-gses-new-fees-may-be-tricky-to-implement
Interesting quote: “Even more changes may be on the way given that the FHFA is considering amending the capital rule that governs the financial buffers Fannie and Freddie must have… The FHFA estimates that it will release a proposal in February 2023.”
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This article mainly is about the recent implementation by FHFA of a new set of Loan Level Pricing Adjustments (or LLPAs) for Fannie and Freddie’s credit guarantees. I’ve addressed this already in a comment below (dated January 19), but I’ll add a few more comments here.
I don’t have high expectations for articles that attempt to explain the details or nuances of Fannie and Freddie’s business, but this one didn’t meet them. It’s hard to blame the author, though. When FHFA, as conservator, is saying and doing things that don’t make economic sense, it’s very difficult for a generalist reporter to write an intelligible article about them.
The President of the Mortgage Bankers Association, Bob Broeksmit, had the right take on FHFA’s new LLPA grid: “The granularity is excessive and it’s also confusing…If you ask me to explain to a borrower why his price differs from his neighbor’s price, it’s just really hard to do.” But I’d bet that even Broeksmit doesn’t understand why FHFA is doing what it’s doing. It’s both simple, and maddening.
Fannie and Freddie’s regulatory statute, HERA, requires FHFA to create a risk-based capital standard for the companies. A proper risk-based standard would have logical and understandable pricing differentials for all of the different product and risk features discussed in the article (and more). But former FHFA Director Calabria didn’t want a real risk-based standard; he wanted a standard that would require Fannie and Freddie to hold 4.0 percent (“bank-like”) capital irrespective of the amount of risk of the loans they were guaranteeing. To get that, he put cushions, add-ons, minimums and buffers into his ERCF, thus breaking the link between ERCF pricing and risk. The fix for this should (and I believe eventually must, and will) be to scrap the ERCF, and re-do the Calabria standard so that it DOES reflect real loan risk. But Director Thompson doesn’t seem to understand this, and/or be willing to do anything about it. Instead, she is putting arbitrary–or to use Broeksmit’s terms, excessive and confusing–LLPA adjustments on top of the hairball Calabria created with the ERCF, and pretending that THIS will make it risk-based. It would be comical if it wasn’t causing $6.6 trillion in single-family mortgages–most of them to lower- and moderate-income family–to be severely mis-priced.
As to FHFA’s decision to cut the 50 basis-point fee it imposed for commingling Fannie MBS and Freddie PCs in a UMBS to 9.3275 basis points, that’s risible. The risk to Fannie of guaranteeing a UMBS that includes Freddie PCs (as well as its own MBS)–and vice versa–is zero. The original 50 basis point fee was roundly and correctly criticized, but for FHFA to lower it to a spuriously precise 9.375 basis points, instead of simply eliminating it, is more evidence of a bureaucracy run amok, as if any were needed.
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“It would be comical if it wasn’t causing $6.6 trillion in single-family mortgages–most of them to lower- and moderate-income family–to be severely mis-priced.”
Tim, would you elaborate on that? How much is the mis-pricing costing some folks? Would you give an example.
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Robert–I made an attempt at quantifying the impact of the mis-pricing caused by the Calabria standard in the post I did before the current one, titled “Mind the Gap.” I described this post as a “‘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.”
You (and others), should read the entire post, but in it I estimate that forcing Fannie and Freddie to (unnecessarily) price to 4.0 percent capital leads them to have to put a target fee of 95 basis points on the riskiest quarter of their business in order to earn an after-tax return of capital of 9.0 percent (the minimum ROC I view as competitive for investors). I also estimate that were the companies’ average capital requirement to be a little over 3.0 percent (307 basis points to be exact, and you’ll need to read the post to understand why I picked that percentage), they could use cross-subsidization to lower the fee on that riskiest quarter of their loans to 52 basis points. That’s 43 basis points less than what’s required with the “Calabria standard.” And were FHFA to do a true risk-based standard with a 2.5 percent minimum, as I recommend, the current quality of their book would enable Fannie and Freddie to set an even lower fee on those loans, probably no higher than 45 basis points, or 50 basis points less than what I estimate they have to charge now. That’s a lot, and as we can see by the low percentage of credit guarantees the companies are doing on loans with credit scores under 700, the high fees do seem to be pricing many affordable housing borrowers out of the market, and denying them access to homeownership. It’s a scandal that should be receiving much more attention than it’s getting.
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Tim
I always thought that a lawsuit against FHFA claiming that the ERCF is an invalid administrative rule implementing the statutory requirement of a risk-based capital standard had some merit. There has been substantial success lately challenging administrative agency rule making that goes beyond statutory authority. I wonder if one can convincingly argue, based upon the F/F stress test results that best indicate risk levels, that the capital rule bears no rational relationship to the risk to be insulated against. The stress test results indicate that a much lesser capital standard would suffice…leading to the statutory requirement being imposed of 2.5%
now the most logical plaintiffs with standing would be F/F themselves, but they are not going to bring this suit. but there should be sufficient injury on the part of homeowners with mortgages guaranteed by F/F arising from this administrative rule that would support their standing to bring suit. A class action suit for damages might even be worth examining.
rolg
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@ROLG,
I had the same thought. In my world (Environmental Consulting), Sierra Club and River Keepers entities are always filing lawsuits against EPA, Fish and Wildlife Service, Army Corps of Engineers and other agencies claiming their rules are arbitrary and capricious. Many go to SCOTUS and seem to get shot down at that point, but some do prevail. I had to find a new job when the EPA rule covering 316b of the Clean Water Act was struck down by the 2nd circuit in NY, resulting in suspension of my projects at the time. That playbook seems relevant in this scenario as well.
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Tim, I’ve read and continue to read all your content so I’m aware of your datapoints like, “or 50 basis points less than what I estimate they have to charge now”. What I don’t know, because I’m not an accountant or mortgage professional, is what that actually means to the borrower. How much these poor practices by FHFA are costing folks.
50 basis points is .5%, so on a $250K outstanding loan (insured by FnF) it’s costing them $1250/year? That’s what I’d like to understand – how painful are these policies in real life.
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One doesn’t need to be an accountant or a mortgage professional to understand that. The “extra cost” depends on the loan amount and the interest rate. Just pick a loan amount, Google the prevailing rate on a 30-year fixed-rate mortgage, add 50 basis points to it, and then use any one of a number of applications available on the internet to obtain the monthly payment on that loan balance at those two mortgage rates. Multiply the difference by twelve and that’s the annual cost to the borrower of FHFA’s excessive capital requirements on affordable housing loans.
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$250k loan amount 30YR @ 7.051% = $1, 019.40 more per year. If correct, I wonder if that’s one of the reasons for the slow-footing. Initial rate, insurance, and CR more impacting.
Anyways, thank you.
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Do you think the departure of Ron Klain will help or hurt administrative reform?
https://www.cnn.com/2023/01/21/politics/ron-klain-white-house-biden-steps-down/index.html
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If Klain does leave, I would view that as a setback for the chances of a change in the Biden administration’s policy towards Fannie and Freddie in the near term, and perhaps for the full second half of the President’s first (and possibly only) four-year term.
A Chief of Staff does not make policy, but he (or she) does help the President and his senior leadership achieve a consensus on what the most important policies to pursue are, and then how to implement them effectively. What’s wrong with Fannie and Freddie now is that they are on Treasury and FHFA “institutional auto-pilot,” heading in a non-sensical direction that is doing great harm to a key constituency of the Democratic party, low- and moderate-income homebuyers. As I’ve been saying for some time, to fix that will require some senior member of the Biden economic team to step up and make thoughtful secondary mortgage market reform a high personal priority. I wasn’t thinking that Ron Klain would be that person, but he certainly could have been a big help in making a change in policy toward Fannie and Freddie successful. As a former senior advisor to Fannie’s Office of the Chairman (of which I was a member for the last five years I was there), Klain knew the company and its business in a way that very few in government do. And of course he had great credibility and clout among Biden’s senior economic policy team, and with the President himself. We’ll have to see who Biden picks as his next COS (of the names I’ve heard bruited about, the only one I know to have some familiarity with Fannie and Freddie is Steve Ricchetti), but in my view not having Klain in that role will make getting the companies out of conservatorship in the next two years a tougher lift than it already was shaping up to be.
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Tim
I have the opposite view. I think Klain’s leaving is a positive, or at least not a negative, for possible F/F reform. Klein appears to me to be a Beltway professional, and I never expected him to do anything that would negatively impact his next career stop, post-Chief of Staff. Being an administration alum will play well for his next consultancy position, at least for the next two years. There would be very few highly remunerative landing spots that would view F/F advocacy as a feather in the cap. I dont know what or who might kickstart F/F reform, but I never expected anyone in the revolving door of a Beltway career to be that person.
rolg
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just saw that Jeff Zients will be next chief of staff. I have only a few degrees of separation from him, and he is very smart, organized and competent (sometimes these things dont go together). for one thing, he has no need for another paycheck, so he is not playing the Beltway game. while I dont know if he has any particular housing finance experience, he has very deep experience with the regulated health care industry, having helped to found the Advisory Group. and he has experience with government finance, as head of OMB. so I find his presence as chief of staff to be a decided upgrade over Mr. Klain. just imo
rolg
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I certainly hope you’re right. As I said, I didn’t expect Klain to take the lead on getting Fannie and Freddie out of conservatorship, but I did think he would have been valuable in getting any agreed-upon policy change defined properly and accomplished skillfully and effectively. I don’t know Zients, but I’ve read and heard good things about him, so hopefully he can be as or more useful a steward of this process as I thought Klain would have been.
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Tim,
The costs of the extremely high capital requirements are becoming glaringly apparent. Today FHFA announced changes to the LLPA matrix for purchases, rate/term refi’s and cash-out refi’s. They added new credit score tiers for 760-779 and >=780. All the adjustments across the board are increasing.
https://www.fhfa.gov//Media/PublicAffairs/Pages/FHFA-Announces-Updates-to-Enterprises-SF-Pricing-Framework.aspx
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FHFA is just carrying through on what it announced it would do earlier: it’s increasing upfront fees (Loan Level Price Adjustments, or LLPAs) on products or loan features it thinks Fannie and Freddie should be doing less of–such as second homes, investor properties, cash-out refis and even rate-and-term refis–while also lowering LLPAs for features it associates with affordable housing loans. In making these changes, FHFA claims it’s “developing a pricing framework to maintain support for single-family purchase borrowers limited by wealth or income…fostering capital accumulation, and achieving commercially viable returns on capital.”
FHFA’s not doing any of those things. The biggest change FHFA could (and should) make to help Fannie and Freddie support affordable housing is to get rid of all of the conservatism, minimums, cushions and buffers in their “risk-based” capital standard, which cause them to have to put unnecessarily high guaranty fees on ALL their loans (as I discussed in my August 2022 post, “Mind the Gap”). But Director Thompson won’t do that. Instead, she hopes to achieve a very rough form of cross-subsidization by raising LLPAs on some (mainly lower-risk) loans while lowering them on affordable housing loans.
Aside from the fact that this doesn’t solve the overall pricing problem caused by gross overcapitalization, it’s also likely to LOWER Fannie and Freddie’s returns, because the LLPA cuts on affordable housing loans still leave the total guaranty fees (base guaranty fee plus amortized LLPA) on these loans much higher than warranted by their risk–thus not attracting that much more volume–while the huge jumps in LLPAs for low-risk refi business will drive much of that business to the banks, and may even prompt a restart of the hugely inefficient private-label securitization process. So with Fannie and Freddie doing less lower-risk business at higher fees, and more higher-risk business at lower fees, their overall mix of credit guarantees will shift more to loans that are underpriced relative to the Calabria standard, at the same time as that same standard will require a greater percentage of capital because a significant volume of lower-risk loans will have gone elsewhere. The result will be a lower, not a higher, return on the companies’ “Calabria capital.”
This, unfortunately, is what you get when you have politicized bureaucrats running complex, sophisticated, market-based institutions like Fannie and Freddie: simple solutions that look good–and can be turned into a great press release–but won’t work. And we will likely have to wait until it is “glaringly apparent” that these LLPA changes are NOT doing what Thompson thought they would before FHFA feels compelled to try something different–unless, that is, the Biden administration wakes up to what’s going on and replaces Thompson with someone who understands Fannie and Freddie’s business, and values the role they could play if removed from the straitjackets former Director Calabria put them in.
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You may have read this article by Roger Pilon. I wonder what he thinks of the Fannie Mae and Freddie Mac debacle.
https://www.cato.org/cato-handbook-policymakers/cato-handbook-policy-makers-8th-edition-2017/property-rights-constitution
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No, I haven’t read it. But my experience with economists at conservative think tanks like Cato, the Heritage Foundation and AEI is that while they agree with the principle on issues like private property rights (and compensation for taking it), they also find reasons why the principle doesn’t apply to Fannie or Freddie, or why the remedy the companies seek for violation of that principle shouldn’t be granted in their case.
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In direct reference to the article you linked, Bryndon, I just emailed and posted the following on Twitter to Roger Pilon: “What do you think of the Fannie Mae and Freddie Mac debacle in regards to property rights? Should HERA allow the US Treasury to sweep all the profits of the company in perpetuity? Are the GSEs an exception to the rule?”
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I just received an email response from Roger Pilon: “I have no particular expertise on Fannie or Freddie Mac, to say nothing of the massive HERA, so I’ll say nothing.”
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Interesting. That’s a little like saying “I care deeply about the constitutional right to free speech, but I have no particular expertise on Twitter or Tik Tok, to say nothing of the massive social media enterprise, so I’ll say nothing.”
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Poor Roger Pilon, when in doubt, cop out!!!
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[Edited for length] Tim, first, thank you for your enlightening insights. I realize it is time consuming to address all the questions you receive. In my opinion all the what-if scenario questions on recap-release timing, funding, warrants, SPS, etc. are too bewildering, unwieldy, and premature to be fruitful at this point; besides, you’ve already provided an excellent framework in this current blog post. If you have the time or the inclination it would be interesting to read your thoughts on the combination of thoughts below.
I cannot reconcile the “federalist society” types’ decisions on the court to weaken or damage the GSEs position with the fact that these decisions are now giving wide latitude to a Democrat Administration with, at least historically, decidedly un-federalist society type policies.
Bloomberg news ran a story today that the Biden Administration urged SCOTUS to deny the Fairholme case, whether or not this urging had any real impact one would think the urging was accompanied by some reasoning that would appeal to the court’s sensibilities of justice, but more importantly, some sign that the administration is working to resolve the conservatorship. (I could be wildly off on these “assumptions.”)
Often, we mistakenly believe that presidents and their administrations have the power to make the big decisions and drive action when, in fact, it is often the more long-lived agencies (e.g., US Treasury in this case) that have more influence.
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Let me start with the Bloomberg story saying that “the Biden Administration urged SCOTUS to deny the Fairholme case.” It wasn’t the administration; it was lawyers from the Justice Department, arguing that the Supreme Court should not grant certiorari on a case that Treasury (and FHFA, through its lawyers at Arnold and Porter) have been fighting since it was first filed nine and a half years ago. And you’re right that it’s not the President who’s making this decision, it’s Treasury as an institution, which as I said in the post, has been pushing a false story about the conservatorships and the net worth sweep since 2008, and getting its way.
That’s the reason I said in the post that “someone in the administration is going to have to step up and call the leaders of the Financial Establishment and the Federalist Society on their fictions about the two companies, and be willing to voluntarily cancel the net worth sweep without a judicial ruling saying it must do so.” And it will have to be someone very high up, with significant clout and the explicit approval of the President, because the big banks and Wall Street will fight back.
And this is where, and why, a broader perspective on the issue is so important. What started Treasury on this whole set of fictions about Fannie and Freddie (FHFA just went along, and then saw it gave them more power) is that it sought to use non-cash expenses to bury the companies under an avalanche of non-repayable senior preferred stock dividend obligations for long enough to give Congress time to replace Fannie and Freddie with a more bank-centric secondary market alternative. But when that didn’t happen quickly enough (because the companies’ opponents kept coming up with ideas that didn’t work), their non-cash expenses began reversing, and Treasury had to impose the net worth sweep to keep them from recapitalizing. Then Calabria–who had been a fervent critic of Fannie and Freddie long before he became Director of FHFA–imposed his bank-like capital standard, SCOTUS ruled the net worth sweep to be legal, and here we are. Treasury and FHFA continue on the track they’ve been on for the last fourteen years because it’s worked for them, and neither has any incentive to change, nor any plan for what to do next.
That’s why we’ll need an “adult,” in some administration, to step up and fix this; it’s not going to fix itself. As Democrats, the leaders of Biden economic team should be ideologically disposed to view government-chartered special-purpose entities like Fannie and Freddie as good things–in contrast to the members of the Federalist Society, who see them as an abomination–and they also should appreciate the companies’ potential to make a difference in housing affordability, if the consequences of the net worth sweep are reversed and they are capitalized properly. And if that’s not enough, there are the warrant proceeds, which would be dramatically more valuable if and when the government gets its foot off the companies’ air hoses (which in my view a Republican administration is less likely to be willing to do).
This still will be an uphill battle, with the Financial Establishment fighting back. But as I said in the post, the current “counter-factual limbo” will not continue for another 20 years. Why shouldn’t the Biden administration end it now, and reap the benefits for itself?
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I know you don’t have time to respond to everything, but can you explain why in any case 2028 is not the end of the road? As you so adequately put It, the court cases are a dead end, the administrative action would take an “adult,” and the status quo seems like the most likely and easiest option for any administration because it requires them to do nothing. But doesn’t the expiration of the warrants in 2028 end this as a worst case scenario? If they go beyond that–a consent decree or not–the gov’t loses its ability to lay claim to the equity in the shares, and by that point they would have retained earnings of another $40 billion. What am I missing here?
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You’re missing the fact that 2028 is not a real deadline. If we get to September 2028 and Treasury has not exercised the warrants, it will ask FHFA to extend their expiration date, and FHFA–which always has done whatever Treasury has asked of it–will agree. Then we’ll have a later deadline, also extendible.
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Thank you for clearing that up..what a travesty to think that they were given two decades to exercise Penny warrants worth over 100 billion and they waste all the time just to extend it out…sounds like of kind of crazy but certainly consistent with the timeline so far….if that worst case scenario did happen would you think you would get a fresh round of lawsuits for takings, or do you think that court case stuff would all be played out by then..
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It’s possible that someone may sue if the warrants are extended, but it would be a waste of legal fees. The Supreme Court has said it is legal for FHFA as conservator of Fannie and Freddie to give all of their net income to Treasury in perpetuity, so it also must be legal for FHFA, as conservator, to extend the exercise period of Treasury’s warrants for 79.9 percent of the companies’ common stock.
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SCOTUS just denied cert on the takings cases. So it seems the government can take, and do whatever it wants. From my point of view this is insanity.
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From my point of view, the denial of cert in the takings cases is consistent with the implications of the SCOTUS ruling in Collins, as discussed in this post.
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Tim,
Thank you so much for your continued input on this issue! It really is a disgrace! Many have said that a catalyst is needed to get this resolved. It was believed that the courts would be such a catalyst, but clearly this hasn’t happened. Others have posted articles in financial publications, but clearly these haven’t had a significant impact. Now, it seems we are left with nothing but hope that the Biden administration (or a future administration) will take action. Personally I would think that the greatest catalyst is mass public awareness of the conservatorship and those that have perpetuated it – and I can think of no better means of achieving this than a (Netflix) documentary. One that is presented with true (untainted) facts from yourself and other professionals. One that exposes the truth and those that are responsible for this disgrace. One that helps end this conservatorship and prevent similar events in the future.
Have you ever considered such an idea or been approached by any filmmakers regarding this?
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You’re asking two separate questions. As to whether I’ve ever been approached by anyone about a documentary or other form of broad publicity about the issues with Fannie and Freddie, the answer is no. On the question of whether I’ve ever considered this idea, the answer is a “soft” yes. On several occasions I have reached out to financial journalists I know who I consider to be objective and whose work I admire about doing a general interest piece about the plight of Fannie and Freddie, but have never had success. Everyone I’ve contacted has been polite and seemed receptive, but there always has been a reason not to take this on, whether it’s “not the right story for my audience, “not ‘top of mind’ for anyone, so not something my editors will accept,” “too complicated a story,” or, “I’m working on something else at the moment.”
I also should confess to the readers of this blog that I don’t view getting Fannie and Freddie out of their captive conservatorships as a personal crusade. While I do own Fannie common and preferred stock, at their current prices it’s a very small investment (it didn’t used to be!) so in that sense I’m not a major stakeholder. From the beginning of this blog, I’ve viewed my role as providing facts, context, solid analysis and a “connecting of the dots” to those who ARE major stakeholders–large investors (including those funding the lawsuits), affordable housing groups, and “good government” types–but I’ve left it up to them to be the advocates and activists pushing for a resolution of the issues. And I think that’s the right posture. If those with the most at stake either won’t or aren’t able to do what’s necessary to get the result they want–even with whatever help I’m able to provide–I’m not going to try to do THEIR job.
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There are a finite number of reasons to believe that when this travesty finally unfolds it will reveal a good and justifiable ending ….
And of those reasons, you sit near the very top
Thank you
Alvin Wilson
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Look for Michael Lewis or someone involved with “The Big Short” movie.
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Thank you very much for this write up, Tim. I saw a Brookings presentation in which Aaron Klein intimated (hinted?) that this issue should move to the top of the Administration’s agenda if the Ds no longer hold both branches of Congress. Now that we’re here, we’ll see if he’s right.
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Why take such a reasoned and pragmatic approach on the capital requirements being too high (as evidenced by the stress tests) and then tack a different course on the senior preferred?
As you point out, like it or not (I hate it), the courts have validated the senior preferred. The government is now the steward of securities worth hundreds of billions. Yet you recommend they get sent to the shredder!
Yes, 80% of the value would be preserved via the warrants but that also means they give the remaining 20% away. Why propose cancellation instead of something that retains more value for the government, is more palatable to someone in a stewardship role, and therefore avoids all the problems/issues that come from “leakage”?
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I think I’m taking a “reasoned and pragmatic” (and fact-based) approach on both the capital requirements and the senior preferred stock (SPS).
I am not recommending that the senior preferred “get sent to the shredder.” I am proposing that the net worth sweep–which was entered into deceptively, with Treasury and FHFA claiming it was to prevent a “death spiral” of borrowing to pay SPS dividends when Treasury knew (based on documents produced in discovery for the cases in the Court of Federal Claims) that the opposite was about to occur–be cancelled retroactively, as if it had never been imposed. Doing so would lead to the sweep payments Fannie and Freddie made each quarter that were in excess of the 10 percent annual dividend on the outstanding SPS balance being re-characterized as paydowns of SPS principal, which would result in both companies’ senior preferred being fully repaid (not “shredded”), with interest, and leaving Treasury owing each company about $12.5 billion, which it could make good on by giving them credits for future Federal income tax payments in that amount.
Recognizing the reality that Fannie and Freddie’s SPS has been repaid still leaves Treasury with the warrants for 79.9 percent of the companies’ common stock that Treasury gave itself. That’s far more compensation than Treasury deserves, but since the warrants have never been challenged in court, and unlike the net worth sweep did not arise from a deception (Secretary Paulson was upfront with Fannie’s board in telling them he would not reveal the terms of the conservatorship he was forcing them to accept), there is no “reasoned and pragmatic” way to request their cancellation. And if I take your reference to “giving the remaining 20 percent away” as a meaning that Treasury should convert its SPS to common stock, that would be indefensible, as it would be requiring Fannie and Freddie to repay their senior preferred stock twice.
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Tim, I understand your reasoning why the current shareholders have to take whatever they can and move on. It made perfect sense to me. The fact that the companies need to raise additional capital from other private investors is what I can not incorporate in the above line of thought. I hope you wouldn’t mind giving us your thoughts on the below.
How would the government entice new private shareholders to invest 140 billion when they are looking at the following:
1. FHFA is controlled by the Administration.
2. The companies’ board of directors are insulated from any shareholders lawsuits by law and do not owe any fiduciary duty to the shareholders.
3. The Net Worth Sweep is legal and authorized by law.
4. When the companies are in conservatorship, the shareholders do not have direct or derivative claims.
How would the government sell the above to future investors? I would think that they have to give up ground just to be able to get out of their position in the companies. I am interested to hear what you think.
Thank you
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SimSla–I think you’ve misinterpreted what I’m recommending.
My recommendation to the Biden administration is that, to restore Fannie and Freddie’s abilities to provide large scale, low-cost, financing to their targeted borrower groups, the administration would (a) cancel the net worth sweep and Treasury’s liquidation preference, and (b) require FHFA to replace the Calabria capital standard–which is ludicrously contrived to produce 4.0 percent-plus risk-based capital on books of business that can survive a Dodd-Frank stress test with NO initial capital–with one that actually does reflect the risks of the loans the companies are guaranteeing, accompanied with a 2.5 percent minimum (which, as I said in my post, would be binding for the foreseeable future, given the very high quality of their books). With that, the companies’ (now negative) core capital would jump up to where their net worth now is–$94 billion–while their required total capital, at 2.5 percent of total assets, would be only $187 billion. The resulting shortfall of $93 billion could then be made up through a combination of retained earnings over time and new issues of equity.
I agree that even with these changes, it would be difficult for Fannie and Freddie to raise any new capital while they still are in conservatorship. That’s why I recommend that the administration agree to release the companies under a consent decree after they hit a capital milestone short of 2.5 percent. If that milestone is 1.5 percent, that’s only $112 billion, which they should be able to reach through one year’s retained earnings. If the “consent decree release point” is 2.0 percent capital, that’s $150 billion, and the companies would have to do large equity issues to get there, even with a year’s worth of retained earnings. The consent decree would specify that the companies would be released from conservatorship–under whatever restrictions are included in the decree, which would remain in effect until full capital compliance–as soon as the equity issues settle; that way, investors in this equity would know exactly what they are “buying into” when they purchase it.
I think something like this is eminently doable, and in fact should be done.
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Thank you Tim. I understand the financial engineering neeed to be done to solve this equation. It is the legal standing of the shareholders that bothers me. Money invested in the GSEs is not protected by any law. The government can take over the companies on a,whim and there is nothing you can do about it.
Thank you again.
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I agree that the legal standing is an issue, given the net worth sweep and Justice Alito’s ruling on it in Collins. But because the “Incidental Powers” section in HERA was taken almost word-for-word from the FDIC Act, Alito’s interpretation of it also means that any BANK could be taken over on a whim, too. But that doesn’t seem to be a problem for investors in banks, because they think (correctly, I believe) that it won’t ever happen to them. I suspect that if the Biden Treasury cancels the sweep and the liquidation preference, investors in Fannie and Freddie would view that as a strong indication that Treasury now thinks the sweep was a mistake, and that it is highly unlikely to be repeated. In that event, while the memory of the 2008 sweep may depress the companies’ P/E ratios (the modern version of what was termed Fannie and Freddie’s “political risk” back in the 1990s and early 2000s), it shouldn’t deter investors from purchasing new equity issues.
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Do you know that someone in the Biden Administration has seen your recommendation?
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As I’ve said a few times over the years, I have a policy of not commenting on my private interactions with or knowledge received from principals in the Fannie/Freddie saga. (I get better receptivity and knowledge from these sources by adhering to this policy….)
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Tim,
Great article. Thanks for fighting the good fight.
Can you envision a scenario of release in conjunction with consent decree and full recapitalization through retained earnings toward a revised 2.5% capital standard. It’s positive for warrants due to no additional dilution from ipo, though I’d think not good for dividends and consequently preferreds more acutely.
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Yes, I can envision the possibility of the companies meeting a 2.5 percent capital requirement through retained earnings alone, although I don’t think it’s very likely. It would take them close to five years (without growth), and I doubt that either would want to stay in conservatorship that long just to avoid issuing new equity. But the decision on equity issues versus retained earnings also would depend on at what “capital milestone” (in my example above, 1.5 or 2.0 percent) release under a consent decree would take place, and what conditions are imposed on the companies in that decree. So there are a lot of unknowns or moving parts to this. And in any eventuality, it will (or should) be Fannie and Freddie’s decision as to what tools to use to hit their full capital requirements, over the time periods they elect.
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Thanks Tim for your unparalleled truth telling. If it only had the power to overcome the misinformation and ignorance of those who should know better. Happy New Year and all the best.
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Well said Tim. You definitely advocate for the ‘grab the warrant compensation’ and make a compelling case to do just that.
However, what one gets the sense is that the USG/Biden Administration ‘wants it all.’ Even to a foolish endeavour of driving everything into dust, or as you point out, potentially leaving it to the next Admin. Then again with a Republican House, money will get tight and this could be another ‘off-balance sheet’ method of obtaining $$$ for low income housing.
Glaringly, you do not address the ‘moral hazard’ issue of Hedgies and other sundry folk making out through the JPS being made ‘whole.’ This issue has been a yuge overhang, and IMHO cannot be discounted. To wit, the (FHFA/Treasury/Admin) MAY do what you say, but let’s say ‘offer’ a 10-20% (or more) haircut to the JPS holders…..just to ‘grease the wheels’ so to speak. I would if I was Treasury (& to a lesser extent FHFA). Can’t see another way around this issue, if u can, would luv your opinion.
Interested on your thought(s) regarding this issue:
1. Do you believe/advocate for the JPS to be left outstanding and the Preferred dividends to be ‘turned back on’?
2. Do you believe/advocate for the JPS to be converted to new or existing GSE equity?
3. Existing JPS to be converted to newly-issued Preferred?
There is no doubt that the ‘Rule of Law’ is a complete and utter joke…….HERE in America. Not China, not Russia, not Ukraine, Venezuela, Cuba, Nicaragua, et al. That is the real shame of the Federalist Society and SCOTUS. You are right to point this out.
Is the Biden Admin CAPABLE of seeing the big picture and doing what you say? Who would advocate this? Would not just be ST and JY. Ron Klain and Susan Rice would no doubt be in the mix. Have my doubts, but anything is possible.
VM
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VM–Let’s start with what you term the “glaring” issue of the “hedgies” being rewarded if the junior preferred stock is made whole or has its dividend turned back on. That’s the boogeyman raised by the Financial Establishment in an attempt to justify keeping Fannie and Freddie in indefinite conservatorship. The reality is that when Paulson nationalized the companies, the prices of both of their common and preferred shares dropped precipitously, and many holders of those shares sold. Some of the shares were bought by opportunistic investors (including “hedgies”), which is how our financial system works. Perhaps the original owners shouldn’t have sold, but a disinclination to allow the buyers of those shares to profit from their investment shouldn’t drive the policy or economic decision about what to do with Fannie and Freddie going forward.
I’m a holder of both Fannie common and Fannie preferred, but if I were in charge of getting the companies out of their “debtors prison” and back to being functioning entities again, I would leave the issue of what to do about their junior preferred stock up to them. I understand that the Mnuchin-Calabria letter requires that all major litigation (with more than $5 billion in damages at stake) be settled before the companies can issue any common, but if I were acting for the administration, I would tell Fannie and Freddie, “We will cancel the net worth sweep and Treasury’s liquidation preference, and give you a true risk-based capital standard with a 2.5 percent minimum–and let you out of conservatorship under a consent decree after you have 1.5 (or maybe 2.0) percent capital–but YOU figure out what to do after that.” The junior preferred shares are their obligations, so they can either turn their dividends back on, redeem the shares at par or at some discount, or offer to convert them to common (with or without a haircut) as they think best.
As to who in the Biden administration would be able to pull this off, I believe Ron Klain would need to be involved in some way. He was, as you may know, a senior advisor to Fannie at the time I was the company’s Vice Chairman, and he has both the subject matter knowledge to wade into this and the clout to move it forward if he so chooses.
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Thanks, Tim!
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Superbly stated, Tim.
Thanks for the outstanding analysis you continue to provide. It’s more appreciated than words can express.
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Didn’t the liberal justices also vote with the conservative justices in Collins. Perhaps- not a vigorous debate was had to change the minds of Alito and company.
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Yes, the SCOTUS ruling in Collins was unanimous. But as I said in my post about it (“An Unexpected Ruling”), “I believe this version [from the Financial Establishment and the Federalist Society] of Fannie and Freddie as problems is the only one the Supreme Court justices have ever heard…[a]nd it’s likely that even the liberal justices have not heard a kind word (or a real fact) about the companies throughout their careers.”
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Thank You. My thought has been that Scotus was more concerned about the precedent that would be sent by aligning with the Plaintiffs, and less about the truth. Unwilling to do the heavy lifting.
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Thank you, as always for shedding light on a complicated subject.
I hate to hear “exercise warrants” because it is more stealing on top of theft. They were there to ensure payment, now the big banks get a piece of the IPO and I lose more money.
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I hear you on the warrants–they are unjustified and an outrage, but unfortunately they never were challenged in court, so they are a reality that has to be dealt with in any constructive solution to the conservatorships to the benefit of existing shareholders (common or preferred) or other stakeholders of the companies.
I believe it will be difficult enough to get the administration to voluntarily give up the net worth sweep (which also was unjustified and an outrage); asking it to give up both the sweep and the warrants is a bridge (much) too far, and is the definition of “making the perfect the enemy of the good.” By offering nothing to the side that (unfairly) holds all the cards, a demand to relinquish the warrants would be doomed to fail.
Beyond that, I have felt for some time that the best solution for existing investors in Fannie and Freddie (again, both common and preferred) is to make their shares more valuable by making the companies more valuable, even if that entails allowing the government to retain its (ill-gotten) ownership of them. A 12 percent ownership (assuming, very roughly, that reaching full capitalization at 2.5 percent of total assets would dilute existing common shareholders by another 8 percent) of a company trading at ten times earnings would still yield a much higher stock price than anything we’ve seen since the conservatorships began, and also would pave the way for the junior preferred to either have their dividends turned back on or be redeemed and replaced with new preferred structures.
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You are so right. It would be nice to get some of my retirement back. I made my first investment in fannie in June of 2012, and it has been devastating.
I was unaware just how bad the situation was until your article today and it has me livid. Thank you so much for your continued insight and support for our cause.
I keep trying to let everyone know (on Twitter, the only place I can be seen) that the NWS and the courts ruling on it have left us all with significantly less private property rights.
Ps. We need a publicity stunt to bring this matter to elon’s and America’s attention.
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TBTF banks were allowed to buy back their warrants. Why not Fannie & Freddie?
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Treasury also gave most of those banks repayable loans at 5 percent pre-tax interest, while ignoring the fact that their balance sheets, marked-to-market, had negative equity (there was a name for that–“extend and pretend”) at the same time as it and FHFA were creating book losses for Fannie and Freddie and requiring them to take non-repayable senior preferred stock against artificial negative net worths, at an annual dividend of 15.3 percent pre-tax (the “concrete life preservers”). Fannie and Freddie have not been treated fairly since the mortgage meltdown. We are hoping to change that somewhat going forward, but as I said earlier, asking for too much means we will get nothing.
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Great information. Thank you so much!
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Tim
Thanks for another clear and compelling analysis. the political impetus to monetize the treasury’s warrants for low income housing initiatives, as well as halting and possibly reversing the rise in the guarantee fee, makes perfect sense for the Biden administration to implement the political solution. perhaps in the last half of its tenure without Democrat control of congress, this might become a priority item. unfortunately, inertia is the strongest force in the universe.
rolg
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Tim,
Thank you for the great and informative post! I hope the Biden admin gives this serious consideration, especially now that they lost control of Congress.
[Edited for length and clarity] The only clarification question I have for you is regarding this, “… and before they can be considered adequately capitalized under the standard made final by former FHFA Director Calabria in December of 2020, they must attain a level of “adjusted total capital” that as of September 30, 2022 was $301 billion, or 4.0 percent of total assets …”
Is it not true that in order to be adequately capitalized (and therefore exit c-ship), the GSEs simply need need to meet the higher of the 1) risk based capital adjusted total (2.3% for Fannie, 1.8% for Freddie) or 2) minimum leverage tier 1 capital requirement (2.5% for both)? Any incremental requirement on top is simply a buffer, which you accurately describe in this post, “… and they will have constraints on their executive compensation and dividend-paying abilities until they fully meet “all of the capital requirements and buffers” of Calabria’s ERCF.” There is no language in the final capital rule that states the buffers must be 100% full in order for the GSEs to be adequately capitalized or exit c-ship, they are simply meant to restrict dividends and executive compensation (on a scale) as you noted.
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The language in the January 14, 2021 Mnuchin-Calabria capital agreement is quite clear and explicit that the threshold for exiting conservatorship for the companies is that they hold 3.0 percent common equity tier 1 capital for “two or more consecutive calendar quarters.” That is the binding constraint, and the one that will take (by my estimation) until 2040 for Fannie to meet, and 2041 for Freddie to meet. The other key milestone in the letter is the point at which they have “capital equal to or in excess of all of the capital requirements and buffers under the Enterprise Regulatory Capital Framework [ERCF],” at which point the net worth sweep kicks in again. The intermediate steps or capital ratios you cite do not have much, if any, practical consequence.
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Superb job, Tim.
Excellent analysis.
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Thank you for all you have contributed.
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Question….Tim, do you see Sandra Thompson as being a knoledgeable enough FHFA head to guide this to a release? Yellen has been lips sealed, has never mentioned the GSE’S to my knowledge.
I always thought that if Trump had his second term, that Calabria and Mnuchin would have been our best chance at a resolution. I think Calabria set the capital standard high and hid the stress tests just before the election for ulterior reasons.
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I don’t know Ms. Thompson, but from what I’ve heard and read about her, I would not count on her to be the one in the administration who takes the lead in reversing prior (misguided and bank-centric) government policies towards the companies. I suspect that the Financial Establishment-Federalist Society version of the companies is the only one she knows, and that her sense of whether or not she’s doing a good job regulating Fannie and Freddie is derived from whether she’s getting positive feedback from the “serious people” (and pillars of the Financial Establishment) who keep in close contact with her.
As for Yellen, she has been the least visible Treasury Secretary in my now nearly 50-year association with the U.S. financial system. I have no idea what she knows, or thinks, about Fannie and Freddie.
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while I have no particular brief against either Ms. Thompson or Ms. Yellen, neither strike me as being governmental/political “actors”. while the positions they hold entitle, and I would argue require, them to develop considered viewpoints on many questions under their purview, I have gotten the sense that they both look for rather than provide direction.
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ROLG–True that!!!
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Thanks for the update.
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Excellent rundown, as always. Investors are lucky to have your in depth knowledge and analysis on this….thank you
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Outstanding article and insight. None better.
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