Unsealed Court Documents Reflect Upon The Government's Plans for "GSE Reform"
"Fannie and Freddie are doomed according to the Washington way of thinking about it," said Peter Wallison. "We’re going to get rid of them somehow, so why even bother thinking about things like this." Wallison, from the American Enterprise Institute, addressed a conference hosted in September 2013 by a newly launched conservative think tank at NYU Law School. The panel discussion was titled, "The Reorganization of Fannie and Freddie."
Wallison mentioned "things like this" in reference to the legal claims asserted by GSE shareholders, who argued that a revision to the Senior Preferred Stock Purchase Agreements, the notorious Third Amendment earnings sweep designed to drain all corporate equity by way of cash dividends to the U.S. Treasury, was illegal.
What independent regulator?
On paper, all decision-making about the GSEs was vested in an independent regulator, the Federal Housing Finance Agency, which had appointed itself conservator of Fannie and Freddie. But Wallison believed that the Department of Treasury and the White House were the ones calling the shots. Back in August 2008, when the GSEs' problems became apparent, "Treasury then stepped in, [and] directed their regulator which is called the Federal Housing Finance Agency, to take them over under a conservatorship," he said. According to Wallison, Hank Paulson opted for conservatorship instead of receivership, a winding down of both companies, because of concerns about sending the wrong signal to foreign investors.
Wallison recounted Hank Paulson's version of events, with one notable difference. In his memoir Paulson says he unilaterally decided in mid-August 2008 that GSE receivership was "the only option." Days later, he relayed his decision to Ben Bernanke, who said, "We're with you 100 percent." And then days later he informed FHFA director James Lockhart of his fait accompli. But a few days subsequent, on August 23rd, lawyers informed Paulson that receivership would trigger early terminations under the GSEs' ISDA agreements. According to Paulson, it was the ISDA problems, not market perceptions, that compelled him to stop pursuing the receivership option and accede to conservatorship instead.
As I've written before, Paulson's story strains credulity, because anybody with half a brain could figure out that receivership would trigger panic in the housing markets. In 2008, when all other private players had exited, so that the GSEs were the only major source of liquidity in new mortgages, the idea, that the GSEs might not be around to finance new home purchases a few years down the road, would wipe out confidence in home values. So Wallison's broader point was correct; then and now, GSE receivership, in the absence of some other well-established venue for financing $5 trillion in mortgages, would erode confidence, if not cause a panic.Determined to kill the beast
Wallison then proceeded to explain the Washington way of thinking about the 100% earnings sweep, which had been announced 13 months earlier, on August 17, 2012. He said:
Why did they do this? Now I’m not privy to all the internal discussions, but the reason that many people like me thought they did it is that the then-Secretary of the Treasury Tim Geithner was always a strong opponent of Fannie and Freddie, and he was afraid that if they became profitable as they have now, if they became profitable and began to have earnings, they would recapitalize themselves. And the more capital they had, the more they looked like a profitable, a successful, corporation, the more likely it would be that Congress would be pressured into letting them out of the receivership and to return to the market probably as government-sponsored enterprises again.
Wallison was clued in to White House way of thinking about things, as we now know from newly released court documents. James Parrott, a senior economic advisor who counseled the President and the cabinet on housing issues, reached out to Wallison and his AEI colleagues, Ed Pinto and Alex Pollock, at 8:30 a.m. August 17, 2012. "Hey guys," Parrott emailed. "If you're interested, be glad to talk you through the changes we're announcing on pspas today. Feel like fellow travelers at this point so I owe it to you...I'm also looping Tim [Bowler of the Department of Treasury], who runs the capital markets show over at Tsy and is more adept at the mechanics should we want to go there."
Subsequent emails reflect the sloppy way in which many people conflate the terminology of debt and equity. To recap, it's oxymoronic to say a company "pays back" an equity investment; a company only pays back a debt, which is extinguished upon repayment. If a stockholder wants to recover his initial principal, he must sell his stock. If the corporation is willing to buy, a shareholder can sell his shares to the corporation, and thereby extinguish his claim on future profits.
The only thing a company owes a preferred shareholder is a stream of dividends; and the only thing an insolvent or undercapitalized company owes a preferred shareholder is a stream of dividends in kind. As anyone who ever completed an accounting course can tell you, cash dividends reduce equity; whereas dividends in kind, or dividends in arrears, leave corporate equity unchanged. If FHFA had acted like any other conservator under U.S. law, it would have preserved equity prior to release from conservatorship. The Senior Preferred dividends to Treasury would have been paid in kind, so that GSE equity would now exceed a quarter trillion dollars.
In his email sent Parrott later that night, Wallison focused on "repayment of principal," by which he really meant a repurchase of Senior Preferred Stock. "Do the dividend payments amortize principal, and if so how?" he asked. "For example, if the 10% dividend rate were in effect, a payment of more than 10% would amortize principal, but from the press release it sounds as though the profits that are swept into Treasury are replacing the 10% dividend."
"No principal is written down no matter what the quarterly payment is," replied "fellow traveler" Parrott. "Dividend is variable, set at whatever profit for quarter is, eliminating ability to pay down principal (so they can"t repay their debt and escape as it were)."
"Reform" = GSE abolition
So indeed, Wallison's comments at NYU were spot on. Fannie and Freddie are doomed according to the Washington way of thinking about it. Most of the time the term "GSE reform" is doublespeak for GSE abolition or GSE replacement. There is a virtual omertà that prohibits any empirical analysis of GSE loan performance in the context of the rest of the market. Many latch on to Wallison's historical fantasies or some vague references to GSE "failure," which are unsupported by empirical data. Which is how "reformers" maintain a veneer of credibility as they dismiss the concept of GSE rehabilitation out of hand.
Parrott is now a senior fellow at the Urban Institute, which published over a dozen recent papers for its Housing Finance Reform Incubator. Parrott helped draft a proposal with four other housing finance heavyweights: Mark Zandi, Lewis Ranieri, Gene Sperling and Barry Zigas. Their proposal, titled, "A More Promising Road to GSE Reform," traverses essentially the same path set by Ben Bernanke in October 2008.
Back then, Bernanke suggested that the U.S. government should offer express guarantees covering private mortgage securitizations. The guarantees would cover the "tail risk," i.e. all credit losses above a certain 6%-10% threshold. And the private sector finances the first loss on each pool, the same way that deeply subordinated tranches finance the first 10% loss on each private label securitization. If you're familiar with the Corker-Warner or Johnson-Crapo bills, "A More Promising Road" is like deja vu all over again.
Most of these proposals ignore two immutable rules of housing finance: 1. Timing is everything; and 2. If you don't understand subordination, you are clueless.
Real estate has always been highly cyclical. Market timing, in terms of positive or negative home price appreciation, is the biggest driver in loan recovery. The GSEs, and balance sheet lenders, diversify their market timing risk, unlike private label deals or the new securitizations contemplated under most reform proposals. The GSEs have played a countercyclical role, as evidenced by the last crisis and by the two earlier S&L crises, each time picking up the slack in the face of private market failures.
The pitfalls of subordination, as they pertain to Johnson-Crapo types of reform, should be obvious to anyone who understands how CDOs caused a meltdown in September 2008. But those lessons seem to be lost on these "reform" advocates.
So yes, after all these years, the Washington way of thinking about GSE reform is, for the most part, based on Wallison's false history of the GSEs and the false presumption that conservatorship equals nationalization, as a stopping point before abolition.
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