Response to FHFA Pricing RFI

~ jtimothyhoward

Yesterday evening I submitted my response to FHFA’s May 15 “Fannie Mae and Freddie Mac Single-Family Mortgage Pricing Framework Request for Input” though the agency’s website.

This RFI discusses how the transition to the Enterprise Regulatory Capital Framework, or ERCF, this year has affected the companies’ guaranty fees (which are too high) and return on capital (which is too low). The RFI asks for public input on ten “topics,” but only the final one can fix the problems FHFA identifies: “Should risk-based pricing be calibrated to the ERCF?” I believe FHFA’s current leadership understands that the answer is “no,” but wants the industry to tell them this in their responses to the RFI, to provide political cover for lowering a capital requirement set by a predecessor Director, which nearly everyone thinks is excessive.

My RFI response makes the case for why and how the capital required of Fannie and Freddie should be reduced to no more than 2.5 percent of total assets. I recognize, however, that arguments from me won’t cause FHFA to change; the arguments that do will have to come from key stakeholders within the mortgage finance industry that FHFA knows and respects. To that end, I have submitted my response well before the August 14 deadline, to give other potential commenters ample opportunity to review it thoroughly, and draw from it whatever they may find useful in preparing their own submissions.

My response appears in full below.

On May 15, the Federal Housing Financing Agency (FHFA) issued a request for input (RFI) “soliciting comment on [Fannie Mae and Freddie Mac’s] single-family pricing framework and the goals and policy priorities that FHFA, as conservator and regulator of the Enterprises, should pursue in its oversight of the pricing framework.”

This RFI appears to be a response to criticism from the mortgage industry of the changes made by FHFA to Fannie and Freddie’s loan-level price adjustment (LLPA) grids, effective May 1, through which it lowered the LLPAs on certain higher-risk mortgages to improve their affordability, then offset the cost of those decreases by raising LLPAs on many lower-risk mortgages. In its RFI, FHFA defended these non-risk-based offsets by citing the impact of the transition in 2022 to the Enterprise Regulatory Capital Framework (ERCF) on the companies’ return on capital, noting: “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.”

While FHFA does not say this outright, it is evident that Fannie and Freddie are not now able to meet either of the two most critical imperatives of their charters: setting guaranty fees on their higher-risk loans at levels that are affordable to the borrowers who typically take them out, or earning “commercially reasonable aggregate returns” on their capital. To aid FHFA in resolving this dilemma, its RFI “seek(s) 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 ERCF, set risk-based upfront guarantee fees for both Enterprises, and set a minimum threshold for an Enterprise’s return on capital.”

Taking these in reverse order:

Minimum return on equity capital

The one parameter for Fannie and Freddie’s return on equity (ROE) over which FHFA has full control is the target ROE they build into their credit guaranty pricing models. And while I and other commenters may have opinions about what that percentage should be, the only opinions that matter are those of the investors who will be asked to provide the new capital required for the companies to ultimately exit conservatorship, or raise new equity during periods of stress if necessary. The financial advisers of FHFA, Fannie and Freddie are in the best positions to determine what this competitive market ROE is, and FHFA must seek, and heed, their advice.

FHFA also must distinguish between target and realized returns on equity. While the former can be controlled by FHFA, the latter are unknowable when guaranty fees are set, because they depend on the degree to which actual mortgage prepayments and credit losses—the key determinants of credit guaranty profitability—diverge from the medians for these variables produced within the pricing models. Once set, guaranty fees cannot be changed, making targets for realized returns on equity a futile exercise.

Finally, FHFA should not “hard-wire” different target (or maximum or minimum) ROEs for specific loan products or characteristics. Company managements should be permitted to decide on relative rates of return for different subsets of mortgage loans in real time and based on market conditions, subject to the constraint of neither significantly exceeding nor falling short of the target total ROE over a given time period (no shorter than one quarter). FHFA as regulator and supervisor should review and provide feedback on managements’ choices in this area—and sanction them for noncompliance if appropriate—but not micro-manage them.

Upfront versus ongoing guaranty fees

The mix between the upfront (or loan-level) and ongoing components of the guaranty fees Fannie and Freddie charge on their mortgage-backed securities (MBS) is not a significant contributor to the economic challenges the companies or their borrowers are facing.

Both Fannie and Freddie set target total fees for the MBS they guarantee. After the portion of the total fee to charge as an LLPA has been determined, those LLPAs are valued, in basis points, using the expected prepayment rates generated in the pricing models (and assumed in setting the ongoing fee). The only difference in the two components is that an LLPA has a known dollar value at the time it is charged, whereas the dollar amount of an ongoing fee depends on the realized prepayment rate—the faster an MBS repays, the lower the dollar amount of the ongoing fee, and vice-versa. This asymmetry in prepayment sensitivity has the potential to make a larger proportion of upfront fees on higher-risk loans an effective hedge, since greater credit losses typically (but not always) occur during times of falling home prices and lower interest rates, hence faster mortgage prepayments. Yet the impact on total credit guaranty profitability of overweighting LLPAs on higher-risk loans is not certain, and in any event decisions on LLPA weighting should be left to management.   

The answer to “should upfront guaranty fees be eliminated” is straightforward. If FHFA means eliminate them entirely, total guaranty fees would fall by an equivalent amount, and move the companies’ achievable ROE even further below a competitive market return. And if FHFA means “replace upfront fees with an equivalent amount of ongoing fees,” as noted above this would not make a notable difference either to the companies or to borrowers of affordable housing loans.

Link to Enterprise Regulatory Capital Framework

With Fannie and Freddie’s “commercially reasonable” ROE determined by the market, and no meaningful economic distinction between the upfront and ongoing components of their guaranty fees, the remaining avenue of inquiry in FHFA’s RFI that might provide it with a path for simultaneously reducing the companies’ guaranty fees on affordable housing loans and giving them a realistic chance of earning a market return on their capital is “whether it is appropriate to continue to link upfront [and total] guarantee fees to the ERCF.”

Here the answer clearly is “no.” FHFA’s risk-based capital standard for Fannie and Freddie never has been truly risk-based, and the ERCF literally is not risk-based at all; as detailed below, more than all of its 4 percent-plus required “risk-based” capital is the product of a layering of unrealistic assumptions, minimums, cushions, buffers and add-ons. FHFA at some point must replace the ERCF with a true risk-based capital standard, but in the short term it can significantly reduce the companies’ capital requirements, with no compromise to the goal of achieving an exceptionally high degree of safety and soundness, by removing the most arbitrary and damaging of the non-risk-based elements of the ERCF.

History of FHFA’s risk-based capital requirements

Over the past five years, FHFA has proposed three risk-based capital standards for Fannie and Freddie—the June 2018 standard, the May 2020 preliminary ERCF, and the December 2020 final ERCF. Each of them appeared, to one degree or another, to have been engineered to produce a desired percentage result, which over time became higher and higher, even as the results of the companies’ Dodd-Frank severely adverse stress tests were improving markedly. (To avoid noncomparability, the discussion below uses total assets as a common denominator for all capital percentages. FHFA’s May 2018 standard expressed Fannie and Freddie’s required capital as a percentage of total assets and off-balance sheet guarantees, which at September 30, 2017 were 1.04 times their combined total assets, while the final ERCF expressed capital in terms of a complex measure called “adjusted total assets,” which at June 30, 2020 was 1.09 times Fannie and Freddie’s combined total assets; the results of the Dodd-Frank stress tests are given as percentages of total assets.)  

The average risk-based capital requirement for Fannie and Freddie produced by the 2018 standard was 3.37 percent of the companies’ total assets at September 30, 2017. This was considerably higher than would have been predicted by the results of the 2017 Dodd-Frank tests, which was a loss of $35 billion, or 66 basis points of total assets, without a valuation reserve on deferred tax assets (and $100 billion, or 1.87 percent, with such a reserve). Yet a quick review of the structure of this standard revealed the main reason for the difference: unlike the FHFA and commercial bank Dodd-Frank stress tests (or episodes of severe stress in actuality), FHFA’s 2018 capital standard did not consider guaranty fees on loans that remained outstanding during the stress test as absorbing any credit losses, thus greatly overstating the losses to be covered by capital. FHFA called this feature “conservative.”   

In two years, the risk-based capital required of Fannie and Freddie by the 2018 standard had fallen considerably, to 2.42 percent of total assets as of September 30, 2019. Some of this decline was the result of improvements in the credit quality of new mortgages being guaranteed by Fannie and Freddie, but most resulted from non-risk-based anomalies in the standard. And by then, incoming FHFA Director Mark Calabria had not only announced his intention to promulgate a new capital standard for Fannie and Freddie, but also signaled, well before that standard was proposed, what he thought the companies’ required capital percentage ought to be, saying in an interview on Fox Business, “I think our objective over time is that you have capital levels at Fannie and Freddie that are comparable to other large financial institutions,” and that 4.5 percent capital was “kind of in the neighborhood of where we’re looking at.”

When the ERCF was first proposed, Calabria had added a 1.5 percent “prescribed leverage buffer amount” to the 2.5 percent minimum capital requirement of the 2018 standard, bringing total required minimum capital to 4.0 percent. He also changed the structure of the risk-based standard to bring Fannie and Freddie’s average required risk-based capital as of September 30, 2019 up to 4.13 percent of total assets, or 3.85 percent of the “adjusted total asset” measure he preferred. After receiving criticism that his 4.0 percent minimum capital requirement (which he also applied to “adjusted total assets”) should not be above the risk-based percentage, Calabria’s response in the final December 2020 standard was not to reduce the minimum, but to add more non-risk-based elements to the risk-based component, raising it to 4.65 percent of total assets (or 4.27 percent of adjusted total assets) at June 30, 2020—nearly double the 2.42 percent required of the companies by the June 2018 capital standard just nine months earlier. Neither Fannie nor Freddie needed any initial capital to survive FHFA’s Dodd-Frank severely adverse stress tests run in 2021.

A true risk-based standard

The concept of a true risk-based capital standard is simple. It is based on a stress test, in which a company’s book of credit guarantees is subjected to a simulated environment of falling home prices (and interest rates) of some specified amount. In Fannie and Freddie’s case, FHFA has chosen a replication of the stress environment of the Great Financial Crisis, in which average home prices nationwide fell by more than 25 percent peak to trough. The stress test is run on a liquidating book of business, which is conservative, because in an actual stress environment a company would at a minimum be replacing its runoff with new business, at equal or higher guaranty fees and with minimal losses in their initial years. The stress test reveals the amount of initial capital required to survive it, and to produce the full risk-based capital requirement an amount is added to account for model risk, operational and other risks, and provide a “margin of safety”—although not so much as to override the risk-based sensitivities of the standard. Typically, a minimum capital, or leverage, standard is then set so that the risk-based standard is binding on the company most of the time. 

With the ERCF, this capital setting process was reversed. Director Calabria began with a pre-determined minimum capital requirement of 4.0 percent, then engineered the risk-based requirement to produce a result that first was close to (in the preliminary proposal) and then above (in the final standard) that minimum percentage.

It is possible, however, to use historical and current data to approximate the amount of initial capital Fannie and Freddie would require to survive the stress they experienced during the Great Financial Crisis, were it to occur again. In its June 2018 capital proposal, FHFA said that the credit loss rate of Fannie’s 2007 single-family book of business “using current acquisition criteria”—that is, without the Alt A loans, interest-only ARMs and risk layering that resulted in over half of that book’s losses—would have been only 150 basis points through September 30, 2017. Using the pattern of Fannie’s actual credit losses, this would translate into a cumulative loss rate of about 115 basis points after the first five years of stress (at which point, during the crisis, Fannie’s revenues were again sufficient to absorb all current-year credit losses). In 2022, Fannie and Freddie’s average single-family net guaranty fee (total guaranty fee less TCCA fees paid to Treasury and 7.8 basis points of average administrative expenses) was 39.4 basis points. As going concerns, and without any business growth, an average net guaranty fee of 39.4 basis points would produce 197 basis points of cumulative net guaranty fee income in five years—far more than required to cover 115 basis points of cumulative stress losses over the same period, with no need to touch capital. The companies’ recent Dodd-Frank stress test results support this analysis.

It thus is not an exaggeration to say that more than all of the “risk-based” capital required of Fannie and Freddie by the ERCF at March 31, 2023—4.07 percent of total assets, or 3.70 percent of adjusted total assets—is a non-risk-based cushion of some sort, whether from highly conservative assumptions, imposed minimums, or add-ons. FHFA therefore has choices as to which of the non-risk-based aspects of the ERCF it can eliminate or pare back, in an amount sufficient to materially lower overall guaranty fees, permit efficient cross-subsidization between lower-risk and higher-risk loans, and allow Fannie and Freddie to earn market returns on the much lower, but still very conservative, amount of capital they will be required to hold. The four most significant elements of conservatism (or unrealism) in the ERCF, and their sources and degrees of conservatism, are addressed briefly below. 

Ignoring guaranty fee absorption of credit losses

Fannie and Freddie’s single-family stress tests are run on a liquidating book of business. Fannie has put out data that enables us to track the prepayment rates of its December 31, 2007 single-family mortgage book that experienced the stress of the Great Financial Crisis. (Freddie has not published comparable data.) Were Fannie and Freddie’s combined $6.51 trillion single-family books at March 31, 2023 to experience these same stress prepayment rates, their 39.4 basis-point average net guaranty fee would produce approximately $132 billion as those books liquidated over their lives. That equates to 175 basis points of the companies’ $7.54 trillion in combined total assets at March 31, 2023, and none of those fees are considered as absorbing credit losses in the ERCF version of the stress test (nor are any multifamily guaranty fees). Counting no guaranty fees as absorbing credit losses in a stress test is equivalent to assuming a 100 percent prepayment rate. That is not “conservative;” in a stress test, it is indefensible.

A conservative approach to the stress test would be to speed up the prepayment rate on Fannie’s 2007 single-family book from its observed average of 20.9 percent per year to, say, 25.0 percent per year. But even this still would produce $115 billion in net guaranty fees, or 153 basis points of the companies’ March 31, 2023 total assets. If the loss-absorbing value of these guaranty fees is ignored, it must, at a minimum, be acknowledged in assessing the merits or validity of any other elements of conservatism added to the risk-based standard.

Stress capital buffer

A similar point about ignored guaranty fees applies to the stress capital buffer, which the ERCF also refers to as a “going concern buffer.” This buffer is 75 basis points of adjusted total assets (79 basis points of total assets for Fannie and 86 basis points for Freddie at March 31, 2023), and its intent is “to ensure that the Enterprise would, in ordinary times, maintain regulatory capital that could be drawn down during a financial stress and still be regarded as a viable going concern after that stress.”

The concept of a going concern buffer is a valid one, but the ERCF misapplies it. If Fannie and Freddie are to be capitalized so as to remain going concerns—and they should be—then the ERCF needs to reflect the fact that their required capital has been determined on the basis of a liquidating book, without the replacement business a going concern will have. In an analysis I did of Fannie’s 2008-2012 stress experience, the company needed almost 100 basis points less initial capital to survive a going concern stress test compared with a liquidating book stress test, because the going concern stress period lasted only five years (until going-concern annual revenues exceeded annual losses), rather than thirty. And of course in a going-concern stress test guaranty fees must count as offsets to credit losses, since those fees will be there. Stating this point somewhat differently, because Fannie and Freddie’s risk-based capital requirement is based on a liquidating book of business, it already has a “stress capital buffer” built into it. There is no justification for a second one.

Capital minimums for lower-risk loans

The application in the ERCF of a minimum capital requirement of 1.6 percent to all loans, no matter how little credit risk they have, is not only unjustified (in light of all of the other conservative elements in the standard), it is particularly damaging to Fannie and Freddie’s abilities to assist low- and moderate-income homebuyers through cross-subsidization.

Without this minimum, the guaranty fees on the companies’ lowest-risk mortgages would have expected returns much higher than their overall target ROE, and those excess returns could be used to (invisibly) cross-subsidize higher-risk loans. But a capital minimum of 1.6 percent raises the required ROEs on lower-risk loans to the point where virtually all of the possibilities for effective cross-subsidization disappear. Cross-subsidization works very well when there is a close relationship between mortgage credit risk and required capital: the overall level of guaranty fees is reasonable, and a moderate degree of overpricing of lower-risk loans generates surplus fees that can be deployed to reduce the fees on certain higher-risk loans by significant amounts. But all of the non-risk-based cushions in the ERCF (including this minimum) cause guaranty fees on the lowest-risk loans to be set very high to begin with, which makes raising them further to cross-subsidize higher-risk loans much more likely to be perceived, and criticized, as happened with FHFA’s recent LLPA changes.

Stability capital buffer

The stability buffer is a non-risk-based, undisguised, capital penalty on Fannie and Freddie for doing more than a minor amount of business. It increases their capital by 5 basis points of adjusted total assets “for each percentage point of market share exceeding the threshold of 5 percent of total residential mortgage debt outstanding.” The stability buffer added 104 basis points of total assets (or 99 basis points of adjusted total assets) to Fannie’s capital requirement, and 71 basis points of total assets (66 basis points of adjusted total assets) to Freddie’s, as of March 31, 2023.

Fannie and Freddie are the only two companies in America who guarantee the credit of conventional residential mortgages. Their guaranty makes residential mortgages attractive to contractual investors like mutual funds, pension funds and insurance companies, who lack the ability to manage the credit risk of individual mortgages but are well suited to manage the interest-rate risk of 30-year fixed-rate mortgages in MBS because they do not use leverage; the sources of their funding are stable and predictable. The main alternative to a contractual investor managing the interest-rate risk of a Fannie or Freddie-guaranteed MBS is a commercial bank holding an unsecuritized mortgage in its portfolio. For at least the past three decades, FDIC data show that banks’ serious delinquency and default rates on residential mortgages average about triple those of Fannie and Freddie, and periodically many banks fail because of funding 30-year fixed-rate mortgages and other long-term assets with short-term consumer deposits and purchased funds—most recently, Silicon Valley Bank, Signature Bank and Republic Bank. It simply is incorrect to assert that higher “market shares” of Fannie and Freddie increase systemic risk, and must be discouraged by imposing a capital penalty linked to their size. The misnamed “stability capital buffer” in fact encourages the opposite outcome.

Recommendation

Fannie Mae and Freddie Mac’s guaranty fees—particularly on loans to affordable housing borrowers—are far too high, and their current and prospective returns on equity are far too low, for one blatantly obvious reason: their “risk-based” capital required by the ERCF is in no sense risk-based. At some point, FHFA must scrap the overly complex ERCF, and start over in a way that deals with the original weaknesses of the 2018 standard (including not counting guaranty fees as offsets to credit losses, using current rather than original loan-to-value ratios to determine risk-based capital, and treating credit-risk transfer securities too generously). But in the short term, the two critical problems FHFA identifies in this RFI of unaffordable guaranty fees on higher-risk loans and an insufficient return on Fannie and Freddie’s capital can be solved quickly and simply if FHFA changes the ERCF to:

  • Eliminate the prescribed leverage buffer in Fannie and Freddie’s minimum capital requirement, reducing it to the 2.5 percent in FHFA’s 2018 capital proposal, but as a percentage of total assets, and
  • In the risk-based standard, eliminate the stability capital buffer and the 1.6 percent capital minimum, and if necessary lower the stress capital buffer by enough to reduce Fannie and Freddie’s required risk-based capital to or below the 2.5 percent minimum, leaving more than enough of the ERCF’s remaining conservatism and cushions in place to ensure an unquestionably high level of safety and soundness for taxpayers.

110 thoughts on “Response to FHFA Pricing RFI”

  1. During your time at Fannie, was counting a portion of guarantee fee revenues as capital the norm? Echoing Urban’s and CRL’s support of the notion, wouldn’t that help Fannie + Freddie reach cap requirements? What would be FHFA’s reservations against the idea? Thanks!

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    1. No, Fannie was never allowed to count a portion of guaranty fees as capital when I was CFO at Fannie Mae. But I need to elaborate on that. We had a risk-based capital standard proposed for us in our 1992 capital legislation that was based on stress tests run on our business, for both interest rate and credit risk. The credit risk stress tests subjected our loans to a specified amount of credit losses over a period of time, to see how much initial capital we needed to survive them. Those credit risk stress tests did count guaranty fees as absorbing credit losses; had guaranty fee revenue on loans that did not prepay during the stress test not been counted, our risk-based capital requirement would have been much, much higher than it was during the time I was CFO.

      As I said in my comment on FHFA’s request for input on Fannie and Freddie’s credit pricing, FHFA never has counted ANY guaranty fees as absorbing losses when it does the stress tests to determine the companies’ required credit risk capital (although FHFA does allow guaranty fees to be counted as income in their annual Dodd-Frank stress tests). Not counting any guaranty fees is really not defensible, as all objective commenters, including the Urban Institute and the Center for Responsible Lending (CRL) have pointed out.

      The correct way to fix that is to re-do the stress test in FHFA’s current capital standard, the ERCF, in a way that counts at least some guaranty fees (and to disclose the methodology explaining how the amount of included guaranty fees was determined). But re-doing the test will take some time. Pending that, the Urban Institute proposed explicitly counting some portion of Fannie and Freddie’s guaranty fees as capital to offset the fact that their risk-based stress tests do not. CRL wasn’t that explicit, instead saying that FHFA should “reconsider…the ERCF’s definition of what constitutes capital.”

      If FHFA doesn’t want to do this, I’m sure it will cite the fact that banks can’t count the present value of any of their income as capital. But that excuse would be misleading, because bank capital isn’t based on a stress test that (improperly) excludes the loss-absorbing properties of revenues from loans that remain outstanding during a stress test. Counting a portion of Fannie and Freddie’s guaranty fees would be a short-term fix for a legitimate problem identified in the companies’ risk-based standard, that doesn’t exist in banks’ Basel II capital standard.

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    1. By itself, not that much, but when you add in all the other trade groups, such as the Mortgage Bankers Association and the National Association of Realtors, now saying the same thing, the ICBA’s voice is amplified.

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      1. Is there any important lobby remaining that prefers “wind-down” or perpetual conservatorship over a utility-model release?
        I thought it is interesting ICBA advocates in the detail mechanisms to “declare seniors paid back”.

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        1. I don’t know of any important trade group that still is advocating for “winding down and replacing” Fannie and Freddie–probably because after ten years of trying, no one had been able to come up with a better alternative to them (and several of the alternatives proposed were comically bad). Nor are any publicly supporting perpetual conservatorship, although their postures of “making the perfect the enemy of the good” ends up with that as the result.

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    1. I saw the announcement of Hornung’s promotion to Deputy Director at the National Economic Council (under Lael Brainard) from his prior position there of Special Assistant to the President for Economic Policy–which he had held since the beginning of the Biden administration–but I had not heard of him before. His NEC bio says he has undergraduate degrees in economics and politics and a law degree from Yale, and that he worked at OMB and the White House (as “Special Assistant to the President and Senior Policy Advisor, focused on climate policy, economic policy and judicial nominations”) during the Obama administration, then clerked for Merrick Garland on the U.S. Court of Appeals for the D.C. Circuit before joining the NEC. That’s a broad and eclectic background, but since it does encompass economics, politics and the law, he may be in a better position than most to disentangle what’s been going on with Fannie and Freddie, and help the NEC get to the right place on a policy posture for these companies going forward.

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  5. Tim, how much overpayments have been done with compound interest to date? Also why did FnF have to pay the 10% dividend and all of their net worth as liquidation preference even though they were and are undercapitalized (CET1), because that violates the cited FHEFSSA guidelines? Does that make sense? Taking out even a penny while undercapitalized should be illegal, let alone 10% and taking all of their net worth in perpetuity in the form of liquidation preference. Is that some other law that they are using? Has this been brought up in courts? Thank you!

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      1. John–Excellent suggestion. I urge you and all of Tim’s fans to do just that. And don’t forget to add your local business media.
        Everyone reading your idea has one Congressman/woman and two US Senators representing them in Washington.
        Most won’t know or understand the GSE issues, so you’ll have to help them.
        Tee up those communications with some of TH’s earlier work (links found on the blog page).

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    2. It is not easy to make economic or legal sense of the terms imposed on Fannie and Freddie by the Senior Preferred Stock Purchase Agreements (SPSPAs) if you are thinking of the SPSPAs as a legitimate attempt to help the companies get through the financial crisis. If, on the other hand, you view them as an effort by Treasury Secretary Hank Paulson to use the financial crisis as a pretext to put under government control two companies Treasury historically had opposed—and that, with the private-label securities market having imploded, and banks cutting back sharply on their mortgage lending, Paulson did not want to have to rely on as private companies to get the U.S. through the mortgage meltdown that was in process—the SPSPA terms you are describing make much more sense. They were designed to allow FHFA and Treasury to use temporary or estimated non-cash expenses, non-repayable senior preferred stock, and a 10 percent after-tax dividend (albeit with an option to not pay those dividends in cash, but instead add to Treasury’s liquidation preference in the companies at 12 percent per annum) to create and maintain a mammoth payment obligation to Treasury from which Fannie and Freddie would find it difficult to emerge before the companies’ opponents and critics could convince Congress to replace them with an alternative more to their liking. When that hadn’t happened by the time Fannie and Freddie’s non-cash expenses began to reverse and return as net income in 2012, Treasury and FHFA imposed the net worth sweep, taking all of their net income in perpetuity.

      You are correct that Fannie and Freddie’s regulatory guidelines [FHEFSSA] would have prohibited them from paying cash dividends while severely undercapitalized, but FHFA suspended those guidelines because it wanted the companies to have to draw more senior preferred stock from Treasury to pay the annual dividends in cash, to balloon their outstanding senior preferred and increase their required annual dividends by still more. It was only after it was obvious that the companies were about to enter a “golden age of profitability” (because of the end and then the reversal of the non-cash expenses put on their books by FHFA), that FHFA and Treasury claimed to be concerned about a “death spiral” of borrowing to pay the senior preferred dividends in cash—and their solution was not the 12 percent annualized accrual of Treasury’s liquidation preference specified in the SPSPAs, but to impose the net worth sweep.

      I can sympathize with your inability to make sense of Fannie and Freddie’s dividend obligations if you’re thinking of them as having been done for the reasons Treasury and FHFA say they were. But they were not.

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      1. FHEFSSA Guidelines cannot be suspended. FHFA does not make laws or have power to suspend. Are you right that FHEFSSA was suspendeded and legal ?

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        1. You are correct about the term “FHEFSSA guidelines,” which I used because that was the phrasing used by the questioner. Instead I should have clarified what I meant: FHFA suspended the capital classifications for Fannie and Freddie mandated by FHEFSSA (and not changed in HERA), and still has not reinstated them.

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  6. Tim

    Do you think this jury win slows down any possibility of admin reform ? Not that it was progressing even at a tortoise pace… But if at all there is any slim chance of admin reform, I feel it has gone to a back burner… Would like to hear your thoughts on the same if you feel aligned or on the contrary, if you feel this makes it more compelling to act now. (And of course on top, you have the ECRF rule amendment opportunity as well.)

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    1. I have no way of telling whether the jury verdict in the Lamberth trial might slow down (or speed up) any administrative initiative to release Fannie and Freddie from conservatorship, but I do think it opens up a path for doing so more quickly than may have been the case prior to the verdict.

      For me, the biggest stumbling block to administrative reform always has been how to deal with the net worth sweep and Treasury’s liquidation preference in a manner that restores Fannie and Freddie’s access to the capital markets. We read in Mark Calabria’s book that in the summer of 2020 Treasury and FHFA had agreed on a plan to end the net worth sweep that would have involved converting Treasury’s senior preferred stock to Fannie and Freddie common, although Calabria gives no details about the terms of this conversion, or how Treasury was thinking about the sequencing of the exercise (or cancellation) of the warrants, the conversion of the senior preferred (and its impact on the federal budget), Treasury’s sale of its holdings of Fannie and Freddie common, and why–after all of these developments adverse to the companies’ common shareholders–Treasury or its and FHFA’s investment bankers thought any rational investor would agree to participate in any new equity offerings from Fannie or Freddie.

      In my view, Treasury’s insisting that the monies it collected from Fannie and Freddie following its imposition of the net worth sweep did not count as repayments of the draws the companies had taken–and therefore they should have to repay Treasury twice before they could exit conservatorship–was an open declaration to potential future purchasers of Fannie and Freddie equity that these two companies face political risks unique to them. Remember that the clause in HERA that justice Alito claimed allowed FHFA to act in its own interest (and thus made the net worth sweep legal, in his opinion) was taken word for word from the FDIC’s statute. Treasury has never told the FDIC to give the net income of any bank in conservatorship to Treasury in perpetuity; only Fannie and Freddie have faced that fate. What investor would voluntarily subject themself to similar adverse treatment in the future? (I suspect this may be why the Mnuchin-Calabria “restructuring plan” was never carried out, despite allegedly being ready several months before the 2020 election.)

      Prior to the Supreme Court’s June 2021 ruling that the net worth sweep was legal, I had said on multiple occasions that I thought there needed to be a ruling against the legality of the net worth sweep before Treasury would be willing to admit that Fannie and Freddie’s draws of Treasury senior preferred had in fact been repaid (with interest), and thus could be canceled, and the liquidation preference eliminated. The jury verdict in the Lamberth case is certainly a much weaker “catalyst” than a verdict for the plaintiffs in Collins would have been, but I wonder if it might ultimately serve the same purpose. A jury verdict that Treasury and FHFA “wrongly amended the PSPAs” in agreeing to the net worth sweep does undermine Treasury’s contention that it is right not to count net worth sweep remittances as repayments of draws of senior preferred, and thus to insist on virtual full ownership of the companies (through conversion of at least its outstanding senior preferred stock, and possibly its entire liquidation preference) before they can be released.

      I’m not predicting that this will happen–or that it might happen soon–but I do view it as a significant positive that’s been added to the landscape by virtue of the jury verdict in Lamberth.

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      2. “. . . why, after all of these developments adverse to the companies’ common shareholders–Treasury or its and FHFA’s investment bankers thought any rational investor would agree to participate in any new equity offerings from Fannie or Freddie.”

        I’ve said this for years. Either government officials end the conservatorships the right way or not at all.

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        1. I bought the e-version of Mark Calabria’s book in the hopes of gaining some insight into his efforts with Treasury Secretary Mnuchin to release Fannie and Freddie from conservatorship in 2020. Here is how he described the problem he thought they were trying to solve: “Despite some creative, but legal, accounting that allowed the companies to present financial statements in which the two sides of the balance sheet were in balance, the reality was that the liability side presented a huge overhang in the form of Treasury’s preferred equity.” And he described the solution to the problem this way: “To grossly oversimplify, cram down the liabilities to match the assets and then presto, you are good to go.”

          Ignoring the reference to “creative, but legal, accounting” that implies (unspecified) nefariousness on the part of the companies, there was no “huge overhang” on the liability side of either company’s balance sheet “in the form of Treasury’s preferred equity”; the Treasury senior preferred was (and is) reported not as a liability but as a component of the companies’ shareholders equity. (Did Calabria not know that?) And saying that the solution is to “cram down the liabilities to match the assets and then presto, you are good to go” is nonsensical. In the summer of 2020, the value of Fannie’s and Freddie’s assets comfortably exceeded the value of their liabilities (with the difference being their net worth). The problem for both companies was (and continues to be) that the dollar amount of their Treasury senior preferred was much, much greater than the dollar amount of their net worth.

          If that is the problem, before attempting to solve it you need to ask, “How did it happen?” We know the answer. First, Treasury made its senior preferred non-repayable without its permission (which it had done for no other company it “assisted”), so there was no way for the companies to get it out of their equity account on their own. And second, once the non-cash expenses put on Fannie and Freddie’s books by FHFA to force them to take the Treasury senior preferred (that they didn’t otherwise need) ceased and then began to reverse, Treasury and FHFA agreed to the net worth sweep, taking virtually all of Fannie and Freddie’s retained earnings between December 31, 2012 and June 30, 2019. For Fannie, that was $146.3 billion–$69.9 billion more than would have been paid on the outstanding senior preferred at a 10 percent annual dividend—and for Freddie it was $95.7 billion, $49.1 billion more than was owed at a 10 percent per year dividend. Had it not been for the sweep and the non-repayment provision of the Treasury senior preferred, the companies would have been able to use their torrents of retained earnings after 2012 to pay down their senior preferred, and then begin to build the capital necessary to allow them to exit conservatorship.

          Both contributors to what Calabria called the “huge overhang in the form of Treasury’s preferred equity”—the non-repayment provision of the senior preferred and the net worth sweep—were the result of decisions made by Treasury, not the companies. So why should the companies’ equity holders be required to bear the cost of undoing the consequences of those decisions, particularly in light of the jury verdict in the Lamberth case that Treasury and FHFA “wrongly amended the stock purchase agreements” by entering into the net worth sweep?

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          1. Tim,
            Excellent summary. The thing that’s scary about a 2nd Trump Administration is if Calabria is bought back as FHFA Director. He truly does not understand what the real problem(s) were, and many of us who are right of center have suffered from his sheer ignorance since intelligence and competence were sorely needed back in 2019-20. Your comments about the ‘creative, but legal accounting’ are right on. A senior this past year at Georgetown University went into depth about the questionable F&F accounting issues, and highlighted/exposed them as a sham. Would be neat if you could get ahold of his Senior Thesis paper.

            Thank you for the summary, agree 100%.

            Quick market comment (MHO) — it is shocking that the F&F Commons have been shooting up dramatically over the past several days, while the structurally senior JPS languish. The ‘Robinhood/meme effect’ seems to be playing out while we ‘speak.’
            VM

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          2. VM—You misinterpreted my reference to Calabria’s mention of the companies’ “creative, but legal, accounting.” I was reacting to his use of innuendo, instead of identifying for his readers which accounting practice (or practices) by the companies he found questionable. The only aspect of Fannie and Freddie’s accounting I’ve had any question about is the recording of retained earnings technically still owed to Treasury under the terms of the net worth sweep as net worth on their balance sheets, then saying in a footnote that these increases in net worth are matched by equal increases in Treasury’s liquidation preference (an accounting treatment I suspect was at the initiative of Treasury or perhaps FHFA, but not the companies).

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          3. Tim, If Treasury and FHFA cannot take cover with the outcome and unanimous verdict in the Lamberth jury trial–with the ideology revealed by DeMarco in conjunction with his testimony that there was no analysis done on net worth sweep, and that taking out $300 billion isn’t conserving and preserving–I don’t know what will make FHFA and Treasury untangle this and do the right thing. Do you?

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          4. To move Fannie and Freddie off the path that former FHFA Director Calabria and former Treasury Secretary Mnuchin put them on with their letter agreement of January 2021—one of economic inefficiency and indefinite conservatorship—some group of people in this or a future administration will have to first agree on what the companies’ governance and capital structures should look like, and then take the initiative to make the changes that will produce those results.

            I have written often about why I believe it would be in the best interests of the senior economic officials in the Biden administration to undo the damage caused to Fannie and Freddie by the net worth sweep and Calabria’s arbitrary and punitive capital standard (the ERCF), by acknowledging that Treasury’s senior preferred stock has been repaid with interest and that the net worth sweep should be canceled and the liquidation preference eliminated, and by replacing the non-risk-based ERCF with a true risk-based capital standard. Doing so would allow the companies to return to their historical position of providing ample, low-cost mortgage credit to low- and moderate-income homebuyers and, by making the companies more valuable, give significant value ($100 billion or more) to the warrants Treasury gave itself for 79.9 percent of Fannie and Freddie’s common stock. Historically, Democratic administrations have supported giving Fannie and Freddie a prominent role in the nation’s mortgage finance system (in contrast to Republican administrations, which have not), and for administrations of both parties $100-plus billion would be a large amount to have for its policy priorities.

            The developments of last week—the jury verdict in the Lamberth trial that FHFA and Treasury “wrongly amended” the senior preferred stock agreement, and the widespread, severe and well documented criticism of the ERCF in the comments made on FHFA’s request for input on Fannie and Freddie’s capital and pricing—both make it easier for the Biden administration to justify and then carry out the badly needed recapitalization and release of the companies. Will it now choose to do so? I wish I knew. I do think, though, that if a change in the status quo towards Fannie and Freddie is to happen before the next election, the impetus for it will need to come from outside FHFA and Treasury—i.e., from some group that includes CEA chair Jared Bernstein, NEC director Lael Brainard and White House chief of staff Jeff Zeints. FHFA Director Thompson and Treasury Secretary Yellen both seem too invested in the fictions about Fannie and Freddie that have dominated their institutions since the conservatorships for them to suddenly become the “change agents” required to pull off a task as ambitious and difficult as recapitalizing and releasing Fannie and Freddie.

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          5. “Had it not been for the sweep and the non-repayment provision of the Treasury senior preferred, the companies would have been able to use their torrents of retained earnings after 2012 to pay down their senior preferred, and then begin to build the capital necessary to allow them to exit conservatorship.”

            Exactly. And, if the redemption of the senior preferred stock was done on a quarterly basis, beginning 1Q2013, both companies would have completely retired this obligation by 3Q2017 while simultaneously paying the originally agreed upon dividend. Moreover, this quarterly redemption process would have allowed the companies to keep approximately $220.4 billion more in retained earnings ($135.5 billion for Fannie and $84.9 billion for Freddie) than what actually occurred under the net worth sweep.

            https://drive.google.com/file/d/15978NWfDcTtuClMBnwgWFmoPnwK94vWn/view?usp=drive_link

            What Dr. Calabria and the “conversion crowd” don’t seem to understand (and I’m being kind with that characterization) is that converting the senior preferred stock to common shares does absolutely NOTHING to resolve the negative balance in each company’s retained earnings (i.e., accumulated deficit). The glaring accumulated deficit numbers will, at the very least, cause rational investors to question how and why these billion-dollar companies have these adverse amounts on their equity statements. Raising additional funds in the capital markets will be virtually impossible if the government follows the vaguely illustrated path outlined in Dr. Calabria’s book.

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          6. Bryndon—While you are correct that converting Treasury’s senior preferred stock to common “does absolutely nothing to resolve the negative balance in each company’s retained earnings,” it WOULD increase their regulatory capital by the amount of the converted senior preferred, thus bringing them much closer to their required capitalization (since common stock, even if owned by Treasury, is classified as regulatory capital by FHFA, whereas the Treasury senior preferred is not). But I agree with you that this conversion would very likely make it quite difficult, if not impossible, to attract new investor equity into the companies–or to allow Treasury to monetize the value of its virtually 100 percent ownership of Fannie and Freddie by selling its shares to third parties (while raising no net new capital).

            You reference the “vaguely illustrated path [for exiting conservatorship] outlined in Dr. Calabria’s book.” There was literally no useful information in that book to indicate what Secretary Mnuchin might have been contemplating, and whatever it was, it seemed obvious that Calabria had not been in the loop on it (otherwise, he would not have described it so befuddlingly). Which makes me wonder: WAS there an actual plan, that the companies’ investment bankers thought could be executed successfully, and if so, what was it, and why wasn’t it carried out? The excuses Calabria gave for not doing so—first the impending election, then the fact that the Trump administration lost that election—are not convincing, since the timing of the election was known to everyone working on the alleged plan, and the possibility of losing it also would have been taken into account.

            I’ve never understood how Treasury could continue to insist counterfactually that it had rescued Fannie and Freddie (as opposed to effectively nationalizing them for policy reasons, as the evidence shows it did), and that this rescue was of such value that full ownership of their earnings forever was fair compensation, while at the same time expecting them to ever be able to raise any significant amount of new equity again. If Treasury does want to “stick with its story” about a rescue of Fannie and Freddie of incalculable (and non-repayable) value, it seems its only real choice for their futures is formal nationalization. I suspect Mnuchin may have realized that—and wasn’t willing to just cancel the net worth sweep—so he pulled the plug on “recap and release” without ever telling Calabria, or anyone else, why.

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          7. Tim

            no one in this administration will want to take ownership over “canceling” the senior preferred, even though they have been more than paid back. certainly not someone like a very capable J. Zients who, like anyone else in his position, will stay in his lane. this is Thompson’s and Yellen’s brief, and they are without portfolio.

            I am interested to see how the class action judgment plays out. by one reckoning, it is the second largest cash damages judgment against the US government in history. it is not what we all deserve, ie an injunction against the NWS, but it is a propitious starting point at long last that may grow more cancerous for the government as time passes

            rolg

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          8. ROLG– No one would be “canceling” the senior preferred; they would (accurately) be deeming it to have been repaid, in order to facilitate the release of Fannie and Freddie from conservatorship and their return to effective functioning as low-cost providers of affordable housing finance. Deeming the senior preferred repaid would have no dollar cost to Treasury, since it is not now receiving any dividends from it, and at “current course and speed” is not scheduled to for close to two decades. Moreover, getting Fannie and Freddie out from under the net worth sweep and Treasury’s liquidation preference would open up a path to making the companies much more valuable, allowing the Biden administration–if it moves quickly enough–to derive significant revenues from the sale of Fannie and Freddie common stock associated with the conversion of the warrants. Not giving up any dividends, getting a housing policy “win,” and potentially being able to harvest over $100 billion for use on other policy priorities makes deeming Treasury’s senior preferred stock in Fannie and Freddie to be repaid less politically radioactive than you’re making it out to be. (The move would, of course have to be “sold” properly, but I’ve identified the elements involved in doing that.)

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          9. Tim,

            Re: senior pfds forgiveness, what do you make of Calabria’s comment from his book, where he said, “Treasury claimed that it could not legally do so” – in reference to Treasury forgiving “all or part of its claim”.

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          10. I had three reactions to Calabria saying in his book that “Treasury could not legally [forgive all or part of the senior preferred]”. The first was that Calabria saying this is not the same as a senior official at Treasury saying it. The second was that, as I’ve noted before, Treasury would not be “forgiving” its senior preferred; it would be deeming it to have been fully repaid with interest, as it has been. If Treasury could amend the SPSPA to change the senior preferred stock dividend from ten percent per annum to all of the companies’ net income, it’s not clear why it also couldn’t amend the SPSPA to change the non-repayment provision of the senior preferred. Finally, it was not legal for Treasury to have directed FHFA to put Fannie and Freddie into conservatorship when neither company met any of the specific criteria in HERA to justify this step, but that did not stop Secretary Paulson from doing so.

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        2. Can you elaborate on the Charter Act? It appears this is the law that governs Fannie and Freddie and was violated. These PSPA contracts are not law.

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          1. The Charter Acts are Fannie and Freddie’s enabling statutes. FHEFSSA (enacted in 1992) and HERA (enacted in 2008) are regulatory statutes, governing the companies’ regulators (OFHEO in FHEFSSA, and FHFA in HERA). All are laws passed by Congress. The Senior Preferred Stock Purchase Agreement (SPSPA) was an agreement made in September 2008 between Treasury and FHFA as conservator of the two companies. It is not a law, but at this point any legal challenge made to it would be time-barred by the statute of limitations.

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  7. Tim

    David Stevens, always quotable:

    “The victory in Berkley v. FHFA is sweet for shareholders, notably in that it’s their first one since the beginning of conservatorship,” said David Stevens, a former Federal Housing Administration commissioner and Mortgage Bankers Association president.

    “Whether this sets the tone for a new direction for the conservatorship is yet to be seen,” Stevens said. “But without question, a political leadership that oversees these two companies in Washington will be likely focusing on options ahead. While the jury awarded less than what was asked for by the plaintiffs, it is without question victory for the shareholder interest. What happens next will be interesting.”

    https://www.housingwire.com/articles/fannie-freddie-shareholders-awarded-612m/

    this is a judgment that will almost certainly prevail on any appeal. the jury is the arbiter of fact questions, and the determination whether the facts supported a finding that the legal standard (implied covenant of fair dealing) was violated is not something that an appeals court can overturn. now, appeals of a factual determination can be successful if an appellant asserts, for example, that the judge’s jury instructions were improper under the law (and therefore led to an improper factual determination), but my sense was Lamberth was very cautious in his jury instructions, usually favoring the government over the plaintiffs in motions with regard to witness testimony and jury instructions.

    which leads to my point: whether or not one may think this judgment is sufficient in amount given the law and facts, the government isnt used to getting black eyes at the hands of the courts, and doesn’t want to pay this judgment. the government engaged in the same type of contractual malfeasance in the AIG case, was found to have violated the law, and plaintiff Starr was able to receive exactly $0 as damages. this is what the government expected with the GSEs as well.

    I believe that this judgment has the potential to lead to the government’s engagement on the GSEs in a way that arguments regarding proper housing finance policy lack. Cash on the barrelhead can focus even a faithless bureaucrat’s mind.

    rolg

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    1. I wonder. An award of 1.57 to 2.0 percent of the par value of the junior preferred–and pennies on the Freddie Mac common–is a very cheap way to close off this claim for damages. How much better could the government do through an “engagement with the GSEs” on this litigation? Or do you think it might be willing to pay more to avoid the “black eye” of an adverse verdict? To me, accepting the verdict as is, and neither appealing nor attempting to negotiate a settlement, is the best of the bad options the government now has on this claim.

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      1. Tim

        I expect the government to appeal, and I wonder (too) if FHFA has even the wherewithal to make this payment. as I recall, HERA prescribes FHFA to fund itself from GSE fees, not congressional appropriation or the Treasury general account. by appealing the government should be able to defer the payment reckoning date.

        rolg

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        1. ROLG- I don’t know if you saw it, but in an article in the American Banker Tim Pagliara said, “If the government appeals the verdict, it could backfire and the $612 million verdict could balloon to over $30 billion because the government would be forced to pay 100% of the preferred stock that they’ve breached the contract on….There is controversy surrounding the damage model that the jury was allowed to consider in the trial that was just completed.”

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          1. Tim

            did not see the Pagliara AmB article, since behind a paywall.

            the evolution of the trial and the only claim (breach of implied covenant of fair dealing) that Lamberth would let go to trial (twice) was a Dickensian tale…..meaning, principally, long (but also reminding one of the most quotable of Dickens’ legal references: “…the law is an ass!”). so apologies in advance for not spending the week it would require to get my head fully back into it.

            having said that, I do recall Lamberth being very chary regarding the claim. you will recall at first he granted a motion to dismiss the claim, interpreting Delaware law incorrectly in the view of the DC Circuit Court of Appeals. There have been only a few Delaware Supreme Court cases on the implied covenant of fair dealing claim, and I do not recall (but will look again to see) if they discuss at any length the damages recovery available…as I recall they focused on what the claim entails and whether the facts of the case merited a denial of a motion to dismiss that the lower court granted in the case. so damages discussion would have been cart before the horse.

            Lamberth was quite unwilling to engage in “speculation” regarding what the future would entail post-NWS, in terms of lost dividends and liquidation rights. perhaps Mr. Pagliara has talked to local Delaware counsel who believe that the breach damages theory should be measured against reality…ie what has actually transpired since the NWS which, of course, would validate a greater damage recovery theory…and this could be the basis for an appeal by the plaintiffs class.

            rolg

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          2. ROLG—The government’s willingness to appeal the jury verdict in the Lamberth case may be affected by the fact that FHFA isn’t on the hook for these damages; Fannie and Freddie are, as both made clear in their second quarter 2023 10Qs. Fannie said this, in Note 13: “In the [July 24, 2023] trial, plaintiffs requested $779 million in damages from Fannie Mae and prejudgment interest on the amount of any damages. We estimate that prejudgment interest, if awarded in the new trial, would be calculated at a rate of 5.75% and expect plaintiffs to seek such interest from August 17, 2012. Prejudgment interest calculated from August 17, 2012 through June 30, 2023 based on the amount of damages plaintiffs requested would be approximately $485 million…. At this time, we do not believe the likelihood of loss is probable; therefore, we have not established an accrual in connection with these lawsuits.” And Freddie said this about the Lamberth case in its second quarter 2023 10Q: “The retrial started on July 24, 2023 and is ongoing as of the date hereof. At this time, we do not believe the likelihood of loss is probable; therefore, we have not established an accrual in connection with these lawsuits. However, it is reasonably possible that the Plaintiffs could prevail in this matter and, if so, we may incur a loss up to $832 million plus pre-judgment interest as discussed above. We estimate that pre-judgment interest, if awarded, would be calculated at a rate of 6%.”

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          3. Tim

            if the GSEs in conservatorship in 2023 are required to make payment for a decision made by FHFA as conservator in 2012, then I have to believe that a new cause of action will arise in 2023.

            rolg

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  8. Great work Tim. Any idea at how the jurors came up with the amounts that they did. Believe the claim was for $1.6B, so jurors awarded approximately 37.5%.
    ROLG, thought post-judgment interest rate was fixed at 6% per annum simple interest.
    VM

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  9. Tim,
    Today was the last day to comment on the Enterprises single family mortgage pricing framework and as you can imagine 20+ organizations filed their comments today. Without reading anyone’s particular comment, what organizations in your opinion likely would carry the most weight? Basically, what top 3 organizations comments are you most curious to read?

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    1. I’ve been downloading the comments as they’ve come in today, and have quickly read them all. The ones I was most interested in seeing were from the Mortgage Bankers Association, the Homebuilders and the Realtors (the first two did submit comments, but nothing yet from the Realtors). I also was interested in assessing the general content and tone of the comments from the affordable housing groups, and seeing whether the Center for Responsible Lending might comment (so far, not yet). I wasn’t expecting either Fannie or Freddie to comment, and they have not (as of now).

      I’ll give my overall reaction to the collective submissions tomorrow, after I see what else (if anything) comes in between now and midnight.

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      1. [Tuesday a.m. update]. No other comments on FHFA’s pricing and capital RFI were posted yesterday evening.

        After reading the Urban Institute’s comment a week ago, I had been hopeful that the interested parties with the most potential influence over FHFA might take a similar, holistic, approach to their comments, and give clear direction to FHFA as to how it could make progress on both of the problems it identified in its RFI—guaranty fees that are too high on average, and returns to Fannie and Freddie that are too low to attract the private capital necessary to allow them to exit conservatorship. That was not the case. While most commenters did point out the need for FHFA to review the impact the ERCF was having on the companies’ guaranty fees, that aspect of their comment tended to be relatively general, while their more specific comments were on issues that most directly affected their particular interests. Perhaps I shouldn’t have been surprised by that, but I view it as a missed opportunity to have argued for an easy way to make the pie larger, rather than make the usual special interest and trade group arguments for having THEIR piece of the pie be larger.

        I thought that was particularly noticeable in the comments from the affordable housing groups. They were very supportive of the recent changes FHFA had made to the loan level price adjustments (LLPAs) on loans to first-time homebuyers and lower-income borrowers, and argued for those changes to at least be preserved and if possible enhanced. That’s all well and good, but it doesn’t address the problems of too high overall fees and too low overall returns; the implied, and sometimes stated, posture of the affordable housing groups was that it was up to FHFA need to figure out how to do these, without rolling back the improvements they supported.

        I was very interested in what the Mortgage Bankers Association would say, since it had been a high-profile critic of FHFA’s decision to offset the cost of lower LLPAs on higher-risk loans with higher LLPAs on lower-risk loans. The MBA also took the tack of general comments on the ERCF and specific comments on issues important to it. On the ERCF, the MBA first said, “The ERCF is unnecessarily complex, with risk-based capital requirements implemented through various grids and multipliers or internal models, combined with multiple buffers, floors, and punitive minimums that ultimately make the ERCF more opaque and create more noise than signal,” but it then immediately added, “Taken together, these multiple, complex, overlapping constraints are likely to frustrate FHFA’s goals of providing clearer signals to the Enterprises—and to the broader market—regarding how much capital is actually required for the Enterprises to manage risk and conduct their business safely and soundly.” No, these problems with the ERCF force Fannie and Freddie to grossly and unnecessarily mis-price their credit guarantees, but the MBA won’t say that. Instead, it simply calls for “periodic evaluations of [the companies’] pricing framework.”

        Towards the end of its comment, the MBA reveals how it’s thinking about Fannie and Freddie’s capital when it says, “In the longer term, MBA recommends FHFA consider further revisions to the ERCF to improve effectiveness and transparency, pending the finalization of the proposed Basel III rule in the US. That rule is expected to impose a 15 to 20 percent increase in capital requirements for larger institutions, and MBA strongly opposes the proposal…Revising the ERCF post-Basel III finalization will give FHFA the opportunity to address compatibility, provide transparency, and lower complexity, which will allow the Enterprises to more accurately and effectively determine capital requirements based on actual risk.” In other words, the MBA still wants FHFA to set Fannie and Freddie’s capital with respect to bank capital requirements, even though there is no economic reason for it to do so. Fixing the ERCF for the benefit of homebuyers, rather than banks, will have to be done over the objections of the MBA.

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        1. Isn’t the line “the level of compatibility between the ERCF and Basel III is not clear” before pointing to …”capital requirements based on actual risk” more conductive with your line of thought that the framework needs to be simplified and can be decoupled from bank like capital standards more in line with a utility model? Maybe it’s a Rorschach test letter where it’s safe enough to extract whatever meaning the reader prefers?

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          1. That’s not how I read the MBA’s comment. The sentence you quoted (and I omitted from my excerpt)–“the level of compatibility between the ERCF and Basel III is not clear”– seemed to me to be a throwaway line: there’s no reason for the two approaches to be “compatible,” since as the Urban Institute pointed out Basel III “is a misguided approach to managing the risk the GSEs pose.” And on the other hand, there also is no reason to wait to address the (obvious) problems of the ERCF until the finalization of Basel III (which may raise bank capital requirements), other than to preserve the flexibility to keep (or add more) non-risk based elements in Fannie and Freddie’s required credit guaranty capital to make it more “bank-like,” to homebuyers’ detriment.

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          2. I was wrong; the National Association of Realtors DID file a comment on FHFA’s pricing and capital RFI—they slipped it in late on Sunday, the day before the deadline, and I missed it. I’ve now read it, and it is very strong and useful, leading off with the statement that “we strongly believe that some of the inputs to the pricing process, in particular non-risk related additions to the Enterprise Capital Rule Framework (ERCF) are inefficient, undermine pricing, run counter to the Enterprises’ charter duties, and should be eliminated.” The NAR said it specifically “objects to the minimum risk weight of 15% [actually 20%] and the stability capital buffer.” The NAR also believes that Fannie and Freddie should have return on equity targets comparable to public utilities, noting that with those, and fewer non-risk-based elements in the ERCF, the companies’ guaranty fees could be lowered, to the benefit of all homebuyers.

            The comment from the third of the “Big Three” housing groups (along with the MBA and the NAR), the National Association of Homebuilders, was less useful. While the NAHB also lists non-risk based elements of the ERCF—”(i) a risk-weight floor minimum requirement for single-family mortgage exposures, (ii) a countercyclical adjustment to single-family credit risk capital requirements that elevates single-family requirements when real single-family house prices are significantly above their long-run trend, and (iii) capital buffers, which include capital buffers for stability and stress”—instead of calling for the reduction or removal of these elements, it says, “only FHFA has the detailed data and models to explain fully how the Enterprises’ current loan-level risk-based pricing aligns loan-level risk with the ERCF” (which isn’t really true), and that “We urge FHFA to provide transparency in the data and decision making that determines the pricing across the loan-level risk categories relative to the ERCF capital standards.” Finally, the NAHB’s exhortation to FHFA of “caution before [it] considers further changes and increases to guarantee fees” is weak gruel compared with the NAR’s advice that the warranted revisions to the ERCF would enable FHFA to LOWER fees.

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          3. This morning I checked the FHFA comment site for its RFI on Fannie and Freddie’s pricing and capital, and there were five comments that weren’t posted when I last accessed the site on Tuesday. Three were from entities that had made informed and thoughtful comments on FHFA’s capital and pricing in the past—U S Mortgage Insurers, the National Housing Conference and the Center for Responsible Lending. Each of these comments was excellent, and I commend them to readers of this blog.

            USMI cited the changes that have occurred in the mortgage insurance industry since the Great Financial Crisis to make a compelling case that FHFA’s capital standard for Fannie and Freddie, the ERCF, penalizes low- and moderate-income homebuyers by “systematically understating expected returns on low down payment mortgages with private MI coverage.” And the NHC and CRL both were highly, and persuasively, critical of the excessive conservatism in the ERCF, and strongly urged FHFA to fix its obvious flaws.

            The CRL said, “The case for reconsidering the Enterprise Regulatory Capital Framework (“ERCF”) is clear and compelling. At the time of the 2020 proposal, CRL–along with a number of consumer advocacy and civil rights organizations–identified the framework’s multiple flaws. We collectively noted that the framework was flawed due to: (1) its adoption of the Basel structure, which was developed for depository organizations with a very different business model and risk profile; (2) its overly pessimistic stress assumptions and multiple subjective buffers; and (3) its failure to count a portion of guarantee fee revenue as capital since in a stress scenario it would be normal to expect that revenue not needed to cover expenses and ordinary, expected losses would be available to cover extraordinary losses and would do so before capital was drawn down.”

            The NHC said, “We agree with the authors of the Urban Institute report that the current capital framework is a ‘misguided approach to managing the risk [Fannie and Freddie] pose,” and it cited the glaring discrepancy between the capital required by the ERCF and the results of the companies’ recent Dodd-Frank stress tests, noting, “As FHFA’s most recent report shows, the worst-case scenario assumes a total comprehensive loss of income of $8.4 billion. Yet the ERCF, ‘based on their financial condition as of September 30, 2021, the Enterprises together would be required to hold approximately $319 billion in adjusted total capital.’ Even if the losses from a future crisis with five times the impact of the 2008 financial crisis were to occur, costing the Enterprises a total of $42.25 billion, under the ERCF they would be required to hold $276.75 billion in unnecessary capital.”

            The initial set of comments on FHFA’s RFI had caused me to express disappointment that more had not been willing to be candid about the problems with the ERCF, and the benefits that could be passed on to homebuyers were FHFA to address them. But the latest set of additional comments from the NAR, USMI, CRL and the NHC have changed my reaction decisively. Coming from respected sources, their consistency, scope, depth, and specificity of prescriptive remedy will be very hard for FHFA to ignore. I am, therefore, now more confident than I’ve ever been that former director Calabria’s counterfactual and ideologically inspired ERCF is being seen for what it is, and will eventually—and hopefully sooner rather than later—be replaced with a risk-based capital standard based on facts and economics, to homebuyers’ benefit.

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  10. Post
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    Katie Buehler
    @bykatiebuehler
    BREAKING: A DC federal jury found the @FHFA wrongly amended stock purchase agreements related to the governments bailout of @FannieMae
    & @FreddieMac and awarded shareholders $612.4 million in damages, broken out as follows:

    Fannie Junior Preferred: $299.4 million
    Freddie Junior Preferred: $281.8 million
    Freddie Common: $31.2 million

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    1. It’s very good that in a trial on the facts of the net worth sweep a jury did find in favor of the plaintiffs. But this trial in Judge Lamberth’s court was only for damages, and the “damage model” he accepted was quite modest. While I don’t know exactly how the damages will be distributed, the award on Freddie common is 4.8 cents per common share; the award on Freddie junior preferred is 2.0 percent of par value, and the award on Fannie junior preferred is 1.57 percent of par value (I’m not sure why the difference between the two). Fannie common was not part of the suit.

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      1. Tim

        until now, government inertia preventing the government from dealing properly with the GSEs was costless. now, not so much. the government now has skin in the game.

        rolg

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      2. Tim–Somewhat of a pyrrhic victory after all these years, but it might open a few minds and eyes around the Beltway to what you and other truthtellers have been saying.

        For me, I’ll take any win we can get.

        Do you believe this decision opens any other routes for shareholders?

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        1. With my usual “not a lawyer” caveat, the jury finding that FHFA “wrongly amended” the PSPAs could well form the basis for new preferred and common shareholder lawsuits asking for damages, since these wrongly amended PSPAs continue to inflict great economic harm to these shareholders (above and beyond the limited scope of damages permitted by Lamberth). But I’d be interested to hear others’ opinions about this.

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          1. Tim

            the bar to any new lawsuits arising out of the NWS is the 6 year statute of limitations. IF there are continuing shareholder injuries that arise with the passage of time (ie the damage did not occur once and only to unsuspecting shareholders in 2012, but there is a continuing breach of the implied covenant of fair dealing by the government since 2012 to present day inasmuch as the NWS continues to the present day), then the fresh claims could be asserted as time passes with no S/L bar. I have no opinion yet on the merits of such an assertion.

            rolg

            Liked by 1 person

          2. Tim,

            How do you think this plays politically? It seems to me that the media can no longer continue to repeat the government issued “Death Spiral” narrative and that this provides additional motivation / cover to move toward recap and release if the White House felt any was needed.

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          3. I think it’s too early to assess how the verdict in the Lamberth case will affect the media’s reporting on Fannie and Freddie’s conservatorships. The government’s (false) version of the history and current status of them is very deeply entrenched.

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          4. Tim

            Lamberth in his denial of the motion to dismiss the claim for breach of implied covenant of fair dealing (in 2018) assumes that such a breach (applying Delaware law) frustrates the reasonable expectations of contracting parties (did the shareholders prior to the NWS think that the NWS would have been permitted by the preferred stock agreement). Under this reading, the NWS constituted a single breach in 2012, so that all shareholders thenceforth were on notice of the contractual effect of the NWS, and therefore all subsequent shareholders’ expectations cannot be reasonably frustrated.

            so I think it is fair to say that no “follow on” suits for breach of implied covenant of fair dealing would be entertained by Lamberth. I think it likely that the DC Circuit court of Appeals would agree.

            It should be pointed out that plaintiffs should be entitled to prejudgment interest on this damage award. the jury didn’t award interest in its verdict, but I believe that this is for the judge rather than jury to compute, once the jury settles on the judgment amount. there is no prescribed federal rate for pre-judgment interest. the post judgment interest federal rate is basically the one year treasury bill rate.

            rolg

            Liked by 1 person

    2. Tim–re FHFA comments….MBA still shilling for the big banks.

      The MBA has been disappointing since it decided the GSEs were the “bad guys.”

      I hope it and its leaders are embarrassed by what the NAR, ICBA, and others contributed.

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  11. Tim,

    FHFA published the GSEs 2023 stress tests this week (https://www.fhfa.gov/AboutUs/Reports/ReportDocuments/Final_2023-Public-Disclosure_FHFA_SA.pdf).

    While the results are similar to last year’s (they show the GSEs making a combined $9.9b over 9 Q’s in the stress test period), I noticed FHFA decided to crank up the draconian assumptions vs the 2022 stress test. For example, they now assume residential housing prices decline 38% in 2023 vs 29% in 2022 (as well as commercial real estate declining 40% in 2023 vs 35% in 2022). That is an extremely conservative assumption considering the largest residential housing price decline in our nation’s history was during the GFC (-27.5% according to the S&P/Case-Shiller U.S. National Home Price Index).

    It’s almost like they are trying to game the stress test to show the GSEs can’t make TOO much in a stress environment.

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    1. I was a little surprised by the results of the 2023 Dodd-Frank stress tests run on Fannie and Freddie, released yesterday, until I dug into the details. While the companies’ combined net income throughout the test was down modestly–from $15.6 billion in the 2022 test to $9.9 billion in this year’s–the credit losses produced by the test more than doubled: from $17.1 billion or 0.25 percent of the average portfolio balance last year to $34.9 billion or 0.46 percent of the average portfolio balance this year. But then I saw the reason; as you noted, the assumed peak-to-trough decline in home prices in the 2023 test was “about 38 percent,” well above the decline assumed in the 2022 test of “almost 29 percent,” and far above the range of home price declines (25 to 30 percent) assumed in all previous Dodd-Frank stress tests run on Fannie and Freddie since 2014.

      The reason for this much greater home price decline was not, however, that “FHFA decided to crank up the draconian assumptions vs the 2022 stress test.” The parameters for each year’s Dodd-Frank severely adverse stress test come from the Federal Reserve. They are published in mid-February, and are used for the stress tests conducted by the Fed on large domestic and foreign banks, as well as the tests FHFA runs on Fannie and Freddie. The Fed did not explain why this year’s assumed decline in nationwide U.S. home prices was so much greater than any of its previous severely adverse scenarios.

      For Fannie and Freddie both to now be able to survive a stylized 38 percent decline in nationwide home prices without the need for ANY initial capital (let alone the 4 percent-plus mandated by the Calabria capital standard) should be a headline finding. But FHFA said nothing about it; it just published the result without commentary, as if ignoring this important reality would make it go away, leaving the fiction of grossly undercapitalized companies needing to be kept in indefinite conservatorship as the only story worth telling.

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  12. Tim,

    Urban Institute posted its input on the GSEs pricing model. At the end of it they recommend some changes to lower the capital requirement that I believe you would tend to agree with. (https://www.urban.org/sites/default/files/2023-08/How%20to%20Think%20about%20Fannie%20Mae%20and%20Freddie%20Mac%E2%80%99s%20Pricing.pdf)

    “Together, these and other features in the capital requirements lead to minimum levels that are above what is reasonable to require the GSEs to hold, given their risk. To address these shortcomings, we recommend some combination of the following steps:

    ◼ Reduce the risk-invariant stability buffer, which shows up in both the risk-based capital requirement and the leverage ratio, from 0.88 percent to 0.44 percent. This change would make the risk-based capital requirement more risk-sensitive and the risk-invariant leverage ratio less often binding.
    ◼ Reduce the minimum risk weight for loans from 20 percent to 10 percent, so that it is more in line with the coverage needed to cover the model risk.
    ◼ Adjust the assumptions used in estimating unexpected losses to reflect the policy measures taken since the financial crisis.
    ◼ Allow the GSEs to count some portion of their guarantee fees as capital, appropriately
    discounted for the uncertainty and variability of the revenue stream. Conservatively, we
    estimate that this could add more than 1 percent to capital.

    Any of these changes would better align the GSEs’ capital requirements with their risk and reduce the excessive upward pressure the current rule is putting on pricing.”

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    1. I saw, and have read, the Urban Institute’s publication “How to Think about Fannie Mae and Freddie Mac’s Pricing,” which came out yesterday (although as of this morning it had not yet been posted on FHFA’s website as a response to its RFI on the “Enterprises’ Single-Family Mortgage Pricing Framework,” which it clearly is).

      This is an excellent piece, and I commend it to readers of this blog. The Urban Institute authors have knowledge of, and experience with, the determinants of risk-based pricing for Fannie and Freddie’s credit guaranty business that the promulgator of their “Enterprise Regulatory Capital Framework” (or ERCF), former director Mark Calabria, did not have when he created it (and I suspect still does not have). The UI team directly takes on Calabria’s uninformed choice of imposing the Basel III bank capital framework on two companies that have no business in common with banks. It correctly describes the Basel framework as being “the result of a compromise reached among dozens of international regulators to handle the wide range of activities and complex set of risks the world’s largest banks assume,” before noting that, “The framework is a misguided approach to managing the risk the GSEs pose, however. Banks assume interest rate risk, credit risk, and funding risk on mortgages alone, not to mention the many other lines of business in which they operate. The GSEs, on the other hand, primarily assume only credit risk. And they assume that risk on millions of loans over several years, making returns relatively stable and predictable. The [Basel III] capital framework’s strong mix of risk-invariant features is thus unnecessary for the GSEs. And it comes at a significant cost, forcing the GSEs to hold more capital than their risk warrants.”

      THAT is the primary problem with the ERCF, and I’m glad the Urban Institute has pointed this out. The ultimate fix is for FHFA to scrap the ERCF entirely, but in the short run the Urban Institute authors and I agree that an interim fix is to remove many of the non-risk based buffers, add-ons and elements of conservatism of the ERCF that force Fannie and Freddie to price their credit guarantees at levels that are unwarranted based on their risk, and unaffordable to the majority of the borrowers the companies were chartered to serve.

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        1. Alec– A couple of things, one more important than the other.

          The less important is that Parrot teamed up on this article with his business partner for the last four years, Bob Ryan, who had extensive executive experience at Freddie Mac (and also was special advisor to Mel Watt at FHFA), as well as Ed Golding (also ex-Freddie) and Laurie Goodman (a recognized expert in the world of mortgage securitization from the Urban Institute). You can’t work with those three people and not have some of their expertise affect the way you think about Fannie and Freddie. This is overly simplistic, but since the late 1990s days when FM Watch sprang into being, the senior officials at Treasury who deal with Fannie and Freddie have exchanged stories with each other about the companies that have little basis in fact, and often are simply wrong. And Treasury makes policy based on those fictions. I have little doubt that since he left Treasury Parrot has done a lot of substituting fact for fiction, and his views about the companies have genuinely changed (for the better) as a result.

          More importantly, though, I sense that the more thoughtful leaders in the mortgage finance industry have come to the realization that what I call the Financial Establishment has gone much too far with the financial straitjacket it’s been able to impose on Fannie and Freddie, with the net worth sweep and Treasury’s liquidation preference digging a regulatory capital hole that will take them two decades to get out of, and the “Calabria capital standard” both unnecessarily extending their timeline to adequate capitalization and forcing them to set their guaranty fees at levels that are far higher than justified by the risk of the loans they are acquiring, and not affordable to potential borrowers. The “wake up call” on that was FHFA’s recent change in the companies’ LLPA grids, that gave rise to the RFI the Urban Institute was responding to. These grid changes made no economic sense, and engendered strong opposition from primary market lenders. People like Dave Stevens, and perhaps Jim Parrot, now seem to understand that imposing unnecessary non-economic burdens on Fannie and Freddie will cause them to continue to have behave in ways that are not in the best interests of either mortgage borrowers or lenders, and that this behavior won’t change until the non-economic burdens imposed upon the companies are significantly alleviated.

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          1. Thank you Tim!
            Although I should say that this paper has a Return on Capital section at the end that lists three options:
            1) competing freely in the market = 12-14%,
            2) privately owned and controlled utilities = 9-10%, and ominously
            3) government-controlled utilities (not worrying about investors) = 6%, the rate of return they earn now.

            So if the Biden Administration wants to own the companies and run them as it is doing now, it doesn’t have to do anything, the 6% ROE will suffice as the Gov’t will take this low return.
            Do you have any insight on what the writers mean by ‘whether only while in conservatorship or also after their release (how can the gov’t own them after releasing the co’s from conservatorship without putting the debt on the Gov’t bal sheet?), the appropriate rate of return is likely lower still, primarily reflecting economic policy considerations such as protecting the taxpayer and systemic stability rather than investor expectations. Although this rate is more difficult to quantify, some models have placed it around 6 percent, roughly where it stands today.’?

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          2. There would be circumstances where Treasury would have so much common stock in Fannie and Freddie–acquired thorough conversion of the outstanding Treasury senior preferred to Fannie and Freddie common–that it could end up owning a very large majority of the companies, although I believe, as you mention, that in this case the companies’ debt would have to be added to the federal debt (which in my mind makes this option unlikely to be selected). But I also note that the footnotes to the “Return on Capital” section of the current UI paper reference two earlier papers–one by Parrot et al in 2016, and a second by Stein and Ryan in 2020–that discuss ownership options for Fannie and Freddie post-conservatorship. I think I kept an electronic copy of the Stein and Ryan paper, and may also have the 2016 Parrot et al piece as well; I’ll look for those tomorrow, and see if anything in them gives any insight into how the authors may be thinking about the government-owned option for Fannie and Freddie post-conservatorship.

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          3. Tim/Alec

            Treasury needs to make a decision whether it prefers the status quo (indefinite conservatorship) or an exit from conservatorship that curries favor with the financial markets (which is the only way to exit conservatorship). As it stands Treasury is not deriving any income from its senior preferred and common stock warrant holdings, and it cannot monetize these holdings in any way. All else flows from this simple decision.

            Exiting from conservatorship into a government owned entity (UI third option) makes no sense (hard to finance going forward except through additional governmental funding, and as stated this would require debt consolidation onto US debt account). As I have said before, inertia is the strongest force in the universe. Doing nothing is easier than doing something, especially for a bureaucrat. So failure to act has been not only the past but also likely prologue to the near term future.

            If this or the next administration opts for exit into a financially viable private entity, there are alternative paths, with a quasi-regulated utility being the most likely politically. I do believe that a necessary condition to exit is a sensible capital standard, and it is good to see more commentators jumping on the anti-ERCF bandwagon.

            If a sensible capital standard is adopted and the exit is pursued with elimination of the Treasury senior preferred, equity financing of F/F post exit will be the easiest part of the process. F/F enjoy very profitable near monopoly market positions, and investing in them will be at or near the top of every investor allocating money to investments in financial institutions.

            rolg

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          4. I have the March 2020 paper by Bob Ryan and Eric Stein (published by the Center for Responsible Lending) referred to in the footnotes to the current Urban Institute piece on Fannie and Freddie’s pricing, but not the 2016 paper by Parrott (I was not in the habit of saving articles by Parrott back then…). But the Ryan and Stein paper isn’t about the government-owned option for the companies post-conservatorship; it’s about releasing them under a utility model, with regulated returns. I support that option, and was glad to be reminded (in re-reading the piece) that the authors agree that regulated returns for Fannie and Freddie out of conservatorship can’t be imposed by FHFA as regulator; they would need to be negotiated as one of the terms of release, for some type of consideration.

            So of the Urban Institute’s three alternatives for the companies post-conservatorship–“competing freely in the market” at ROE’s of 12-14%, privately owned with regulated returns of 9-10%, and formally nationalized utilities with returns of 6%–I think the privately-owned utility option is by far the best, and most likely, “end state.” But I also agree with ROLG that the inertia of the bureaucracy at Treasury and at policy levels within the Biden administration argues for the continuation of the de facto government-run utility alternative of indefinite conservatorship (at a 6% return). Still, I will continue to make the case that it is in the best economic and policy interest of the Biden administration to take the initiative to fix Fannie and Freddie’s obvious problems now–in a manner consistent with its values and priorities–and to take public credit for doing it.

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      2. Tim,

        I’m curious as to your opinion on the following Urban Institute capital recommendation as I havent seen it proposed before:

        “Allow the GSEs to count some portion of their guarantee fees as capital, appropriately discounted for the uncertainty and variability of the revenue stream. Conservatively, we estimate that this could add more than 1 percent to capital.”

        Do you believe this G-Fee stream would effectively count as capital for net worth purposes? I ask because today Fannie currently built a ~1.5% capital buffer (excluding the senior preferred liquidation balance), and implementing this recommendation would get them to 2.5%+ overnight, leaving the senior preferreds as the last remaining obstacle to exit.

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        1. Let me unpack this issue of counting (or not counting) guaranty fees in setting Fannie and Freddie’s required capital a little differently.

          In my response to FHFA’s RFI on pricing and capital, I state that “more than all of the ‘risk-based’ capital required of Fannie and Freddie by the ERCF at March 31, 2023—4.07 percent of total assets, or 3.70 percent of adjusted total assets—is a non-risk-based cushion of some sort, whether from highly conservative assumptions, imposed minimums, or add-ons.” I then go on to identify “the four most significant elements of conservatism (or unrealism) in the ERCF,” the first of which is “ignoring guaranty fee absorption of credit losses.”

          Fannie and Freddie’s required risk-based capital is supposed to be based on the results of a stress test. In that test, the companies’ books are assumed to be subjected to an environment of sharply declining home prices and interest rates (comparable to what was experienced in 2008-2012), with required risk-based capital being calculated by subtracting projected stress credit losses from cumulative net guaranty fee income (guaranty fees less administrative expenses) on the liquidating book. Intuitively, that makes sense. Most of your credit losses will be covered by current-period guaranty fee income, but you’ll need some initial percentage of capital to cover the rest of the losses (and add a margin of safety).

          FHFA, however, has never run Fannie and Freddie’s risk-based capital stress tests this way (although it does allow guaranty fee income to absorb losses in the annual Dodd-Frank stress tests, which is why the companies have been able to pass those tests with no initial capital since 2021). And as I said in my comment to the RFI, “Counting no guaranty fees as absorbing credit losses in a stress test is equivalent to assuming a 100 percent prepayment rate. That is not ‘conservative;’ in a stress test, it is indefensible.”

          The question then becomes, how do you fix that? In the long term, you scrap the ERCF, and re-do the risk-based component of Fannie and Freddie’s required capital by running the stress test properly. But what about the short-term fix? The Urban Institute says, “Allow the GSEs to count some portion of their guarantee fees as capital, appropriately discounted for the uncertainty and variability of the revenue stream. Conservatively, we estimate that this could add more than 1 percent to capital.” I didn’t go that far, because there always has been great regulatory reluctance to count future income as capital. What I did in my comment instead was calculate (a) how much cumulative net income, as a percent of initial mortgage assets, would be produced if in the next stress environment mortgages prepaid at the same average rate (20.9%) as for Fannie during 2008-2012–which is “175 basis points of the companies’ $7.54 trillion in combined total assets at March 31, 2023”– and also (b) the cumulative net guaranty fee income produced with a more conservative prepayment rate of 25%, which is 153 basis points of initial mortgage assets. I stopped short of calling these amounts “capital,” however, and instead said, “If the loss-absorbing value of these guaranty fees is ignored, it must, at a minimum, be acknowledged in assessing the merits or validity of any other elements of conservatism added to the risk-based standard.”

          The Urban Institute authors and I agree that not counting the ability of guaranty fees to absorb losses in determining Fannie and Freddie’s risk-based capital is a serious flaw in the ERCF, and we both put values on the impact of that flaw–with me using prepayment rates of 21 to 25 percent to say 1.5 to 1.75 percent capital, and UI being more conservative in saying “more than 1 percent to capital” (without specifying an assumed prepayment rate). And we also agree that whether directly (by counting the present value of these fees as capital) or indirectly (by acknowledging them as a reason not to include so many other add-ons and buffers to the ERCF), FHFA must adjust its required ERCF risk-based capital percentage to correct this obvious problem.

          Since this comment already is too long, I’ll leave the impact of counting guaranty fee income on Fannie’s capital position–and path for exiting conservatorship–for another time; it’s more complicated than you imply in your question.

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  13. Fannie redid its 2021 stress test and the results are in: https://www.fanniemae.com/media/40731/display

    “Fannie Mae would recognize $10.8B of cumulative comprehensive income over the [Severely Adverse] hypothetical stress scenario.”

    this is the case without creating a valuation allowance for DTAs…which makes the more sense to me than establishing a valuation allowance since one assumes that Fannie is and will be a going concern that will have future taxable income.

    Does FHFA even care to acknowledge these results at this point?

    rolg

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    1. ROLG– I’m just finishing up a 24-day jaunt through seven western and eastern European countries, and haven’t been paying much attention to mortgage-related developments during this time. (We get back tomorrow evening, so I’ll re-engage next week.)

      This 2021 stress test re-do (which I didn’t know FHFA and Fannie were doing) is a follow-on to the redo Fannie did of its 2022 stress test a month and a half ago. That re-do–which I discussed briefly in a comment dated June 13–showed slightly better results than the original test ($13.2 million in comprehensive income income without a DTA reserve, compared with $9.5 billion in the original test). This 2021 redo shows a comparable improvement: $10.8 billion in comprehensive income without a DTA reserve, compared with the original result of $8.1 billion.

      Creating a reserve for deferred tax assets during a stress test that results in positive comprehensive income throughout is nonsensical (and also not GAAP), but FHFA has always shown its Fannie and Freddie stress test results that way, and it continues to do so. As to FHFA not acknowledging the recent stress test results, it doesn’t acknowledge much of any reality-based result for Fannie and Freddie that conflicts with their 4-plus percent regulatory capital requirement, or FHFA’s mandate that they keep issuing money-losing credit-risk transfer securities that its own consultant reported cost the companies $30 dollars in interest payments for every $1 of credit losses transferred in a normal environment, and $3 in interest for every $1 dollar transfer during an environment of severe stress.

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        1. Thank you, Bill. (And yes, I WAS celebrating a birthday on this trip, with one of the stops being in Budapest, where my wife and I were joined by 14 other members of our immediate and extended family for the Formula 1 Grand Prix of Hungary, and a large celebratory birthday dinner following the qualifying session.)

          The $5.0 billion Fannie reported in second quarter after-tax earnings was considerably stronger than I was expecting. There were two reasons for that–one temporary and one that will continue. The temporary boost came from a shift from a $132 million (negative) provision for credit losses in the first quarter to a $1.266 billion (positive) benefit for credit losses in the second quarter. This benefit was entirely driven by a change in Fannie’s actual and forecasted home prices, which affect the company’s estimate of its lifetime credit losses. Home prices rose (seasonally) by 3.4 percent in the second quarter, and have risen by 5.o percent during the first half, resulting in Fannie reducing the amount of reserves it believes it will need cover its future credit losses. But Fannie also said that it expected home prices to decline in the second half, and if that happens the company will again change to recording a more normal (negative) provision for losses in the next two quarters.

          The surprise boost in Fannie’s second quarter earnings that will carry through was much higher net income from its mortgage and liquidity portfolios. What’s happening here is a combination of higher interest rates–particularly on liquid assets, where the secured overnight financing rate (SOFR) now exceeds 5.0 percent–and a growing amount of stockholders equity, which hit $69.0 billion last quarter. Financing a mix of mortgages, investment securities and liquid assets at rates ranging between 3 and 5 percent with $69 billion of zero-cost equity adds $2 to $3-plus billion (pre-tax) to Fannie’s bottom line annually, compared with less than $1 billion in 2021, when short term interest rates were close to zero and Fannie’s retained earnings were lower. As long as interest rates stay high, this net income will continue to boost Fannie’s profits, and grow as its shareholders equity grows.

          Another welcome surprise in Fannie’s second quarter results was the continued low level of credit losses it is experiencing. Fannie’s net single-family credit losses during the first half of this year totaled only $74 million, or 0.1 basis point of its mortgage assets, and the company currently believes it can cover all future expected single-family credit losses with just $8.0 billion in loss reserves, or 22 basis points of mortgage assets (which it has on its balance sheet). Those $8.0 billion in lifetime expected loss reserves are less than the $9.5 billion in pre-tax net income Fannie’s single-family credit guaranty business earned in the first half of 2023 alone. These data show how strong Fannie’s credit position now is, and stand as further proof that the company needs nowhere near the $184 billion being required of it by the (wholly invented) Calabria capital standard to operate safely and soundly.

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          1. Tim, why does Fannie report $69 billion as Net Worth? Isn’t 100% of that still technically and legally going into government coffers ?

            Stress test and earnings show they don’t need any more money, so why are they being kept hostage? When and how does this end?

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          2. As of June 30, 2023, $69 billion WAS Fannie’s net worth, defined as total assets less total liabilities. And that amount is not “technically and legally going into government coffers.” Under an agreement between FHFA and Treasury that temporarily changed the terms of the Net Worth Sweep imposed on Fannie and Freddie in August of 2012, Fannie is allowed to retain its earnings until it fully meets its applicable risk-based capital requirement (it’s currently short by $247.8 billion), but those increased retained earnings are matched by a dollar-for-dollar increase in Treasury’s liquidation preference. It’s also important to recognize that Fannie’s net worth is different from its regulatory capital. FHFA’s definition of regulatory capital subtracts Treasury’s senior preferred stock ($120.8 billion) and Fannie’s deferred tax assets ($12.0 billion), turning its $69 billion in (positive) net worth at June 30, 2023 into a negative $63.8 billion in “adjusted total capital” as of the same date. Fannie’s required risk-based capital of $184 billion as of June 30, 2023, together with its negative $63.8 billion in regulatory capital, are what produce its current $247.8 billion risk-based capital shortfall.

            Under the terms of the January 2021 letter agreement between former FHFA Director Calabria and former Treasury Secretary Mnuchin, Fannie will not be eligible for release from conservatorship–in spite of its very strong earnings and very low credit losses–until it holds “tier 1 capital” (basically common equity, excluding junior preferred) equal to 3.0 percent of its adjusted total assets. As of June 30, 2023, Fannie’s tier 1 capital was a negative $82.9 billion, and 3 percent of its adjusted total assets was $136.9 billion, so it still needs $219.8 billion more tier 1 capital before it can be eligible to be released.

            Does that make any economic or political sense? Of course not. But that’s the hole Calabria and Mnuchin dug for Fannie (with a comparable one for Freddie), and until someone in the current or a future administration (or, less likely, Congress) cancels or changes the January 2021 letter agreement, that’s where Fannie, and Freddie, will remain.

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    2. BF

      I credit your persistence. thank you.

      it is an interesting legal theory, that SCOTUS in a case that has relevant applicability to the GSEs’ taking claims, has sub silento reversed the Fed Circuit holding. the lower court may not want to touch this (likely thinking it is bound by the appellate court’s prior affirmance), but there should be a way for the question to reach the appellate court. the problem I foresee is that judges are “overworked and underpaid,” in the words of a judge I talked to over drinks long ago. will they take your well-pled argument seriously when they have so much on their plate and your case has already been decided? on the merits, of course, but in reality?

      rolg

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      1. Thank you, Christian. As usual, you make some very good points; and, I suppose, only time will tell what legal avenue (if any) will prevail.

        I will say, however, that unlike Collins our two cases are (and have always been) very straight forward and very easy to understand – a return of excess funds to the companies through a quarterly unwinding of the NWS. I have articulated that (and the recapitalization and return of the firms) here:

        https://drive.google.com/file/d/1LNWzb9QhI1GiOk8W_2MYgERyE4yNRU04/view?usp=drive_link

        All the calculations have been done and supported, so no one will be caught off guard if a judge (like Justice Thomas did during oral arguments in Collins) asks “How will we unscramble this egg?” It’s simply math your Honor, science will have nothing to do with it.

        Thank you, again, for your kind words and thoughtful input.

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        1. I am impressed, Bryndon. Using Tyler vs Hennepin County, Minnesota, to anchor your case was brilliant. Please keep us posted on developments.

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          1. Thank you, Jeff. All the credit goes to our legal team; they are steadfast and excellent.

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  15. Has Tim closed down the comments section for summer break? Tough to believe that there is no question after June. Let me ask one.

    Tim – What do you see happening between now and the time everyone starts focusing on elections? Do you see the comments window playing any effect in ECRF Capital reduction? The window closes by Aug 14. Or would that be another lip service?

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    1. EP– No, I haven’t closed the comments section; there just haven’t been any recent comments. That may be because it’s summer, DC is essentially shut down until Labor Day, and many readers are on vacation (as am I; I’ve been in Europe for ten days, and won’t return to the states until the end of the month).

      I hope the large mortgage-related institutions and trade groups do comment on FHFA’s request for input (RFI) on Fannie and Freddie’s guaranty fees and the ERCF. Typically they time their comments for close to the deadline (in this case, August 14), so we’ll have to wait nearly another month to see what happens here.

      Anyone who would like to see the companies’ activities restored to anything close to their former level of effectiveness should be advocating for two things: much more realistic capital requirements for them, and a sensible resolution to their exile from the capital markets because of the net worth sweep and Treasury’s liquidation preference. FHFA’s RFI on guaranty fees is a perfect vehicle for doing the former.

      The latter will very likely have to be initiated by someone outside the Treasury Department. Secretary Yellen does not appear to have taken an interest in the issue, and I suspect that most of what she knows about Fannie and Freddie’s plight isn’t true, because she’s gotten that knowledge from the careerists at Treasury, who continue to tell the same false story about the companies that they invented when their goal was to “wind down and replace” them with an alternative more to their liking, rather than the now-consensus objective for them of recapitalization and release. I think it will take some combination of Council of Economic Advisers chair Jared Bernstein and National Economic Council director Lael Brainard (on the policy side) and White House Chief of Staff Jeff Zeints (on the political side) to get “recap and release” on the table, and the work to do that, if indeed in commences, almost certainly will be done behind the scenes before there is any public indication that it may be going on.

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    1. It depends on what you consider to be “public knowledge.”

      Many people have written about the Jason Thomas memo, including me, first in my book and then in the three amicus briefs I did for the Perry Capital and Jacobs-Hindes (Delaware) cases, and the SCOTUS appeal in Collins. And I think it’s safe to say that the large majority of those who have been working to get Fannie and Freddie out of conservatorship know about the memo as well. But it’s also true that many who would benefit from knowing about not just the Thomas memo but also many other facts about how Fannie and Freddie ended up where they now are do NOT know these things–Treasury Secretary Yellen among them. And this arguably is the most important obstacle to changing the status quo for the companies.

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  17. Tim

    Calabria’s insistence that the GSEs maintain “bank like” capital even though the GSEs dont incur “bank like” risks has taken on a new data point: the GSEs dont enter into $290MM settlements regarding their conduct facilitating underage female sex trafficking like America’s preeminent bank does.

    rolg

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    1. This was a “re-do” of the FHFA Dodd-Frank stress test run on Fannie in 2022. Last November, Fannie reported that it had discovered an error in the model used to run this test, and that it would correct the error and re-run the test. Fannie published the result of that corrected test yesterday.

      When the company made the announcement of the error, I had two thoughts: first, the error probably wasn’t large, since Fannie’s 2022 test results weren’t out of line with Freddie’s (and Freddie hadn’t said anything about an error), and second, the error probably was an overstatement of stress income. I was right about the first, but wrong about the second–the result of the revised test was $13.2 billion of “total comprehensive income,” versus the originally reported $9.5 billion. That’s three consecutive years in which Fannie has either required no capital to survive the “severely adverse” Dodd-Frank stress test (2020), or generated positive income throughout it (2021 and 2022). One might have expected FHFA to have acknowledged this by now.

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  19. Does anyone have a link to the docket where the comments are saved? I am curious if other important players are posting and what.

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      1. FHFA has not made it easy to find these submissions.

        After clicking on the link above, you then need to look near the top of the page, to the box on the right of the heading “Request for Information Submissions.” Click on the downward arrow on the right of that box, then scroll down until you find the topic “Enterprises’ Single-Family Mortgage Pricing Framework.” Click on that title and it will bring you to the submissions for this RFI.

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    1. Bill–I did see this.

      Dave was one of the vocal critics of FHFA’s increasing LLPAs on Fannie and Freddie’s lower-risk loans to pay the cost of (modestly) reducing the LLPAs on some higher-risk loans, and his and others’ objections to these price changes were what triggered the request for input (RFI) I just commented on.

      I deliberately focused my RFI comment only on the capital standard, and left the release from conservatorship part for another time (and of course I’ve given my thoughts on that subject, in detail, before). I do believe that FHFA’s decision on LLPAs was driven by its wanting to lower the cost of affordable housing loans, but then being constrained by the ERCF so that it felt it had to raise the LLPAs on lower-risk loans as an offset. The solution to THAT problem–and the questions in the FHFA RFI–is to make Fannie and Freddie’s capital standard less arbitrary, and more risk-based. Looking at the same problem, Dave sees it more as FHFA being the one making decisions for the companies, so to him the solution is to bring them out of conservatorship.

      I don’t think he and I are far apart on this, however. In several places in his article Dave stresses the importance of linking guaranty fees to loan risk (for example, saying that while at the MBA he was “against any price disparity based on anything but the actual risk of the loan”), but he spends more time talking about recent actions FHFA has taken as conservator of the companies that he believes are policy- rather than business-driven, and inconsistent with the economics of their business. I think he’s right on this. We’re both right. Indefensibly high capital requirements are causing FHFA, as conservator, to make decisions in running Fannie and Freddie’s businesses that are harmful to their customers and to primary market lenders as well, while having FHFA run the companies in conservatorship is insulating them from market realities and incentives.

      Dave’s article is the first I’ve seen from anyone aligned with what I call the “Financial Establishment” that strongly objects to the status quo for Fannie and Freddie. This, to me, is a positive sign that policymakers won’t be able to continue to ignore what’s been happening with them for much longer.

      Notably, Dave’s article does not say HOW he’d like to get Fannie and Freddie out of conservatorship. There are conflicting views on that, and not all of them are informed or workable. But his article is at least a step in the right direction to get the issue on the table, and get policymakers talking about it.

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      1. Tim

        there was one comment from Stevens’ piece that caught my eye, to the effect that because the GSEs no longer are able to buy low income housing mortgages in bulk and keep in a retained portfolio, it is harder for the GSEs to achieve their desired LIH percentage targets without constraining the mix of what they can buy from mortgage sellers in they market…in effect, the GSEs are buyers of less high credit mortgages than they might otherwise want to buy from a purely business point of view. (of course, sellers of these high credit mortgages might also have Stevens on retainer as a consultant.)

        my question is whether these LIH percentage targets would change, or become easier to achieve, once the GSEs exit conservatorship…I suppose because Stevens would think the FHFA would become a lighter touch regulator then. I wonder if the fat political FHFA thumb shrivels into a pinky upon conservatorship exit. do you have a sense of how much larger, if any, the GSEs’ books of business, attributable to non-LIH mortgages, would be were the GSEs to exit conservatorship?

        rolg

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        1. I would just be speculating about how FHFA might handle Fannie and Freddie’s housing goals post-conservatorship (compared with now).

          Setting percent of business housing goals for secondary market companies like Fannie and Freddie, instead of for primary market originators, never has made much sense to me. Fannie and Freddie only can guarantee the loans primary market lenders originate, so if the regulator sets their goals too high they end up having to play the numerator/denominator game (which is what Stevens is pointing out). Primary market lenders with LIH goals actually could originate more of what the regulator wanted. But primary market lenders don’t want to be in that position, and Congress has never opted to put them there.

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  21. Tim, totally rational and analytically sound arguments. It’s always been a balancing act for the GSE’s to attract capital and deliver market based returns while meeting their mission. I find your arguments persuasive as should any rational thinker. The key for policy makers is to get politics out of the equation. Sadly in today’s partisan environment it’s doubtful anything will occur. With over a decade in conservatorship for the GSEs I don’t see the political will to fix this situation. I’m thankful that there are still knowledgeable employees that are managing these companies. I’m not sure how much longer that will be the case.

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  24. Tim,

    Thank you for the great and informative piece. It should be very difficult for any “honest” individual to rebut your analysis re: the changes needed to address the over-inflated risk-based capital requirements + buffers.

    Regarding your first recommendation, “Eliminate the 1.5 percent prescribed leverage buffer in Fannie and Freddie’s minimum capital requirement, reducing it to the 2.5 percent in FHFA’s 2018 capital proposal,” didn’t Sandra Thompson already change this in March of 2022? https://www.fhfa.gov/SupervisionRegulation/Rules/Pages/Enterprise-Regulatory-Capital-Framework%e2%80%93-Prescribed-Leverage-Buffer-Amount-and-Credit-Risk-Transfer.aspx

    As you can see, her updated rule “Replace(d) the fixed leverage buffer equal to 1.5 percent of an Enterprise’s adjusted total assets with a dynamic leverage buffer equal to 50 percent of the Enterprise’s stability capital buffer as calculated in accordance with 12 CFR 1240.400.” As a result, the PLBA buffer for Fannie is now 50bps, and the PLBA buffer for Freddie is now 30bps. In combination with the 2.5% minimum leverage requirement for both GSEs, the total minimum leverage requirement + buffer today for Fannie is 3.0%, and 2.8% for Freddie . These figures can be confirmed in the GSEs more recent Q filings.

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    1. Yes, you’re absolutely correct on the prescribed leverage buffer; I’d forgotten about the amendment that was made last year (since it had so little effect on the companies’ overall capital requirement). The important thing is to get the leverage ratio down to 2.5 percent of total assets, and then get the revised risk-based standard below that level unless the companies are taking higher-than normal credit risk. I’ll amend the post to remove the reference to “1.5 percent”– and just say eliminate the prescribed leverage buffer–and get a corrected version of my response to FHFA (although I don’t think it’s made any of the responses to this RFI publicly available yet). Thank you for pointing this out.

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  25. Tim–Fabulous, fabulous, comprehensive comments.

    Your fans need to circulate them far and wide and get them in the hands of anyone close to this process (Hill, media, and government). I have started, already.

    I believe you are being too kind/gentle to Director Thompson and her staff, who helped Calabria produce this disaster.

    I remind your readers of a previous pithy comment, “Only termites have done more housing damage than FHFA’s capital regulations.”

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  26. Why would Sandra Thompson need cover to address (and / or revise) a prior Director’s (Mark Calabria) capital requirement if nearly everyone thinks it’s excessive? It’s beyond frustrating that our conservator / regulator has to CONTINUALLY ask for input on how to conserve / regulate the entities. It’s akin to hiring someone to do that job, and then that person has to continually ask other people how to do their job.

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    1. It’s important to remember that Thompson was appointed Director of FHFA after key members of the Financial Establishment objected to the pending nomination of Mike Calhoun to that position. Previously, she had been FHFA’s Deputy Director of the Division of Housing and Mission Goals. She does not have a background in or experience with the unique financial aspects of Fannie and Freddie’s business model, and I doubt she has formulated an independent view of what to do about what I call the “Calabria capital standard.” I also suspect that the careerists at FHFA who worked on formulating this standard are defensive about it, and argue that its 4 percent “bank-like” capital requirement is fair, and promotes safety and soundness (and assume, incorrectly, that Fannie and Freddie can just keep raising their guaranty fees until they hit whatever ROE target FHFA sets for them). Thus I don’t think it’s realistic to expect Thompson to advocate for a change to Fannie and Freddie’s risk-based capital standard that her staff is reluctant to make (since it would be an implicit criticism of their prior work), unless the “serious people” in the mortgage industry she looks to for approval are in support of it.

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      1. Thank you for commenting early. I am hopeful others in the industry will view and give some thought to your recommendations, but I have a hunch each have their own self interests in mind to guide their comments before reading yours. Let us hope FHFA and others in the industry are not so territorial, defensive, or envious so as to be prejudiced against your expertise.

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