I continue to search for insights into the Trump administration’s inability to accomplish the removal of Fannie Mae and Freddie Mac from conservatorship—despite Treasury Secretary Mnuchin’s post-election pledge in 2016 to “get them out of government control…reasonably fast”—and the Biden administration’s not appearing even to be trying to do so, despite the companies’ historically high profitability, historically low credit risk, and their centrality to a U.S. mortgage finance system that is struggling to provide adequate financing for low- and moderate-income homebuyers during a period of near-record-low housing affordability.

With this as my intention, on a recent flight from the west to the east coast I listened (on headphones) to an interview of former FHFA Director Mark Calabria by two analysts from Bloomberg Intelligence, on a podcast titled “Calabria on Fannie, Freddie Conservatorships” that had been brought to my attention. I nearly stopped listening when I heard Calabria tell his interviewers that Fannie and Freddie’s “losses from Covid came very close to wiping out all of their capital.” (To the contrary, both were profitable even in the first quarter of 2020, when they put $5.3 billion into their loss reserves to cover Covid-related losses, and they had $52.8 billion in combined profits over the next seven “Covid quarters” of 2020 and 2021, all of which was added to their capital.) But I stuck with the podcast, and afterwards was rewarded when Calabria said something I didn’t recall having heard or read about before: “PIMCO submitted a comment letter during the comment period [for FHFA’s May 2020 proposed capital rule] where they claimed—they never showed their math—but they claimed you would need 12 percent capital to create the equivalent of an explicit guaranty.” Later in the interview Calabria expanded on the topic of asset managers wanting an explicit guaranty or the equivalent on the companies’ debt and mortgage-backed securities (MBS), saying, ‘These asset managers also are large holders of Treasuries, and that is who Treasury hears from every day. And what they’re hearing is, ‘Oh, my God, if you let them out of conservatorship and you don’t give us an explicit government guaranty, everybody will be living in caves again’.”

This latter comment took me back to my days as a financial economist and “Fed watcher”—before I moved over to the business side at Fannie Mae in the mid-1980s—when a fellow economist from the now-defunct firm E. F. Hutton, Ed Yardeni, coined the term “bond market vigilantes,” which he defined as “Investors who watch over policies to determine whether they are good or bad for bond investors,” and whose potential to drive up interest rates by selling bonds in reaction to monetary or fiscal policies they didn’t like imposed significant constraints on policymakers. I knew that large MBS investors like PIMCO and Blackrock had been staunch advocates of an explicit government guaranty for Fannie and Freddie’s securities, but it hadn’t occurred to me that their posture on this issue might be creating a similar “MBS vigilante” reaction at Treasury, giving it another reason for not initiating any action to create a path for Fannie and Freddie out of conservatorship, while instead waiting for Congress to address the phantom issue of “reform” of the companies.

There is, of course, almost no chance that Congress will convey a government guaranty on Fannie and Freddie’s debt and MBS, so if the MBS vigilantes insist on one as a condition of the companies’ release, and Treasury takes them seriously, it would be highly problematic.

In his interview with Bloomberg Intelligence, Calabria greatly overstated the capability of FHFA to remove Fannie and Freddie from conservatorship without Treasury’s concurrence. He said that he and Mnuchin “ended the net worth sweep,” but they did not; they merely suspended it (while increasing Treasury’s liquidation preference dollar-for-dollar) until the companies can accumulate the (excessive) amount of capital Calabria’s “risk-based” capital standard requires of them, at which point it will kick in again. And Calabria’s cavalier claim that, “There is a fair amount the FHFA can do unilaterally…I had my own channels to the White House, and wasn’t dependent on Treasury to get stuff done,” ignores the agreement he signed with Mnuchin on January 14, 2021—five months before his removal as FHFA director after the SCOTUS ruling in the Collins case—that says: “Conservator, by its signature below, agrees that it shall not, without the prior written consent of Purchaser [Treasury], terminate, seek termination of or permit to be terminated the conservatorship of Seller [Fannie or Freddie]…unless, following the Litigation End Date [on which all litigation in excess of a ‘maximum total aggregate potential monetary exposure’ of $5 billion has been resolved], Seller for two or more consecutive calendar quarters has and maintains ‘common equity tier 1 [CET1] capital’…in an amount not less than 3 percent of Seller’s ‘adjusted total assets’.” That language can be changed only if Treasury agrees.

How long might it take the companies to accumulate enough CET1 capital for FHFA to be able to unlock the handcuffs Calabria imposed with this letter agreement, if Treasury does not want to change it? It’s estimatable. At March 31, 2024, Fannie and Freddie’s combined adjusted total assets were $8.335 trillion, making 3 percent CET1 capital $250 billion. Their actual CET1 capital on that date was a negative $110 billion, or $360 billion short of FHFA’s threshold for releasing them from conservatorship. Two years earlier, at March 31, 2022 (the first date the companies began publishing their new regulatory capital requirements), 3 percent in CET1 capital on Fannie and Freddie’s adjusted total assets of $8.139 trillion was $244 billion, while their actual CET1 capital was a negative $162 billion, for a “release shortfall” of $406 billion. At the rate at which the companies have been reducing their CET1 shortfalls over the past two years ($23 billion per year), FHFA would not be able to release them on its own until 2040, and even then, absent Treasury action, the net worth sweep would still only be suspended, not cancelled, and the requirement for the resolution of all material litigation would still need to be met.

This very adverse potential outcome makes it important to closely examine the merits of the arguments PIMCO makes for an explicit MBS guaranty in its comment letter on FHFA’s 2020 capital proposal. That letter is fairly long, and it includes a number of incorrect or exaggerated claims (including that “The GSEs are and always have been non‐economic buyers of mortgage loans”), but its thesis can be summarized in four excerpts that present PIMCO’s version of the history, interpretation, and consequences of the government’s 2008 seizure of Fannie and Freddie.

PIMCO gives the history as: “As you know, when the GSEs were teetering on financial insolvency in 2008, Congress and the Treasury Department took bold action to shore‐up the near insolvent institutions, injecting $191 bn in taxpayer money and placing Fannie and Freddie in conservatorship. At that point, Treasury Secretary Paulson was clear about the government’s intention: ‘Treasury took responsibility for supporting the agency debt securities and the agency MBS . . . effectively, a guarantee on GSE debt and agency MBS’.”

PIMCO’s interpretation is: “Put simply, from a market perspective, the government‐managed conservatorship combined with the extensive taxpayer support provided through the PSPAs, transformed the implicit government guarantee into an explicit guarantee (emphasis in original) in September 2008.” PIMCO then states: “We strongly believe that market participants will not view the release of the GSEs as a return to the implied guarantee model that prevailed before the financial crisis, but rather, they would view them as wholly‐owned private companies with no accompanying government guarantee.” And should this occur, PIMCO avers, the consequences would be dire: “many [investors] would no longer be able to buy, and in some cases, even hold MBS either by law or by their investment guidelines—or at least, they would be unable to do so in the size they can today given single‐credit concentration limits,” with mortgage rates soaring as a result.

Setting aside PIMCO’s repetition of the Financial Establishment’s (false) version of the background of the conservatorships, its doomsday scenario rests entirely on its assertion that the “government’s intention” was to place an explicit guaranty on Fannie and Freddie’s debt and MBS when it took them over. Yet what Paulson said when the conservatorships were announced was actually this: “Treasury and FHFA have established Preferred Stock Purchase Agreements, contractual agreements between the Treasury and the conserved entities.…These Preferred Stock Purchase Agreements were made necessary by the ambiguities in the GSE Congressional charters, which have been perceived to indicate government support for agency debt and guaranteed MBS. Our nation has tolerated these ambiguities for too long, and as a result GSE debt and MBS are held by central banks and investors throughout the United States and around the world who believe them to be virtually risk-free.” (Statement by Secretary Henry M. Paulson, Jr. on Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers, September 7, 2008.)

While Paulson clearly expressed dissatisfaction with the implicit guaranty he believed investors inferred from the “ambiguities” in Fannie and Freddie’s Congressional charters, he pointedly did not say that the mechanism he chose to replace that implicit guaranty, the PSPAs, constituted an explicit guaranty. That is PIMCO’s invention, and it is unwarranted.

I understand why Wall Street is lobbying for an explicit guaranty on Fannie and Freddie’s securities; it would raise their value, and make billions for the clients of asset managers. But an explicit guaranty is not just unnecessary, it is a bad idea, because of the precedent it would set. Moreover, there is a much more straightforward way to preserve the companies’ status as government-sponsored enterprises upon releasing them from conservatorship: keep the PSPAs in place, but have Fannie and Freddie pay for them (at a rate “mutually agreed by Purchaser and Seller, subject to their reasonable discretion and in consultation with the Chairman of the Federal Reserve,” per the original PSPA documents). And should investors need reassurance about what this means for the agency status of the companies’ debt and MBS, an affirming word from Treasury would provide it.

In making its case for a guaranty on Fannie and Freddie’s securities, PIMCO also weighed in on another issue that complicates the release of the companies from conservatorship—the amount of capital they are required to hold in order to be deemed adequately capitalized. To be perceived by investors as the equivalent of an explicit guaranty, PIMCO insists, this amount must be extremely high: “Implicit in the FHFA’s proposed capital rule is that the recommended capital framework is sufficient to replace the now‐explicit government guarantee. We fundamentally disagree with this premise and do not believe any reasonable level of capital can replace an explicit government guarantee…Indeed, absent an explicit full‐faith‐and‐credit guarantee of the U.S. government, common equity tier 1 capital should be sufficient to unquestionably cover all GSE MBS guarantee obligations; moreover, our estimate of unquestionably sufficient capital to meet these obligations is more than three times what is recommended under this proposal.”

With that, PIMCO added its name to those putting forth strong recommendations about the correct level of Fannie and Freddie’s capital without making any reference to the credit risk of the only product the companies are allowed to insure—residential mortgages. And the FHFA capital recommendation PIMCO wanted to at least triple (to 12 percent or more) was the 4 percent minimum proposed by Calabria, which was arbitrary as well. Here is how Calabria defended this figure in his interview with Bloomberg Intelligence: “If you’re trying to create an objective where you’re having a foundation where the companies can survive a stress period then, you know, to me, 4 percent is on the low end.” He was increasing the companies’ minimum capital from the 2 ½ percent that had been in effect since 2018, and his comment on that in the interview was equally speculative: “If we had gone with the two and a half—which is what some people wanted—I mean you’re almost certain that the shareholders will get wiped out in the future, because there’s just no way the companies would survive over a long period of time with just 2 ½ percent equity.”

PIMCO’s wild capital recommendation was excusable, but it was surprising, and very disappointing, to hear Calabria talk about Fannie and Freddie’s risk and capital as if their annual Dodd-Frank stress tests either did not exist or were of no significance. And neither his comments to Bloomberg Intelligence nor the PIMCO letter revealed any awareness of the fact that mortgage credit risk is one of the few financial risks that can be reasonably well quantified and modeled in a stress test, because of the massive amount of data that exists on it. Nor was there any acknowledgement from either party of the importance of striking a balance between having enough capital to protect taxpayers (and debt and MBS holders) while not requiring so much that Fannie and Freddie’s ability to carry out their chartered missions is unnecessarily impaired.

There is a Congressional requirement for Fannie and Freddie’s risk to be measured with a stress test, but it has been distorted. Calabria simply was not being truthful (perhaps with himself) when he said in the Bloomberg Intelligence interview, “The second I took the oath [as FHFA director] my views or preferences went out the window…. I wasn’t pursuing my own agenda; I was pursuing the agenda that Congress placed upon me” …which was that “the risk-based capital standard should make sure that the companies had a positive going-concern value during a stress environment.” As I’ve noted in several prior posts, Calabria brought with him to FHFA the notion that Fannie and Freddie should be subject to the same 4 percent capital minimum as had been required of banks’ residential mortgage holdings (on which they take short-funded interest rate risk, and which have a historical credit loss rate triple that of Fannie and Freddie), and then, while professing to be complying with the Congressional mandate to implement a risk-based capital standard, he cynically employed enough conservative assumptions, cushions, buffers and add-ons to make its results come out even higher than his pre-determined 4 percent minimum capital amount.  

The insistence of the MBS vigilantes on an explicit government guaranty for Fannie and Freddie’s securities, a net worth sweep that has left the companies with a negative $110 billion in CET1 capital even after twelve years of consistent and now record profitability, and a March 31, 2024 “Calabria capital requirement” averaging 4.28 percent of total assets for two entities that for the past two years have required no initial capital to withstand a repeat of the 2008 financial crisis as imposed upon them by the Dodd-Frank stress tests all share a common attribute: they are based on falsehoods, not facts. To exit conservatorship, Fannie and Freddie do not need to be “reformed” by Congress; they need Treasury and FHFA to not base their policy determinations on things like PIMCO’s attempts to achieve a windfall for its investors, fictions about the origins and legitimacy of the net worth sweep, or the personal preference of former Director Calabria as to what the companies’ required level of capital ought to be. There are actual, unassailable and readily accessible facts that address each of these issues. It is shameful that no administration has yet had the wisdom, will or courage to use those facts to end the nearly sixteen-year conservatorships of two companies who, if allowed to operate their business as privately-managed entities on an economic basis, could meaningfully lower the cost of mortgage finance for millions of low- moderate- and middle-income Americans, at a time when they sorely need it.