Fiderer on GSEs, etc. - Home Page

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Sun, 29 Dec 2024 23:12:00 +0000

RNC Suggests GSE Recap & Release is a Viable Option

Fri, 15 Sep 2017 17:27:00 +0000

In its, “Resolution on Protecting Taxpayers by Restoring Safety and Soundness to Government-Sponsored Enterprises,” the Republican National Committee came close to endorsing a recapitalization of the GSEs and a release from conservatorship. The resolution says:

The Republican National Committee recognizes that the United States Treasury has recouped all of the money that it invested in Fannie Mae and Freddie during the 2008 financial crisis, plus over $80 billion in profits to date, and that the Treasury can generate an estimated $100 billion in additional cash profits by monetizing its warrants for 79.9% of each company’s common stock;

Treasury cannot sell common stock to the public until the Senior Preferred Stock Purchase Agreement is terminated and the GSEs are released from conservatorship.

More specifically, the GSEs cannot issue common stock unless investors believe they have a reasonable chance of capturing a future dividend stream paid after the companies have accumulated sufficient capital needed to weather a downturn. The senior preferred stock dividends— paid at a 10% rate or under the net worth sweep—would effectively prevent the companies from ever accumulating the requisite capital.

Also, common stock cannot be sold to the public if FHFA remains conservator, because the conservator “steps into the shoes of” the directors, officers and shareholders. So far, the conservator has agreed to the net worth sweep and other actions that seriously compromised the GSEs’ financial health. Common shareholders would insist on a return to the checks and balances of traditional corporate governance.

Finally, the public would not buy common shares while shareholder litigation—brought by owners of the junior preferred and the pre-existing common—remained outstanding. The uncertainty of the outcome would be unacceptable to most investors.

The RNC may be tipping its hand in its description of the lawsuits:

RESOLVED, The Republican National Committee recognizes the sanctity of property rights in America, and acknowledges the need to resolve the outstanding claims of Fannie Mae and Freddie Mac shareholders in a manner that honors and respects the rule of law governing the rights of corporate stockowners;

Ordinarily, “the rule of law governing the rights of corporate stockowners,” refers to state corporate law, not the Housing Economic Recovery Act of 2008

Are credit risk transfers fatally flawed?

Sun, 06 Aug 2017 22:00:00 +0000

“One part of GSE reform is already working,” writes Mark Zandi of Moody’s Analytics. He refers to credit risk transfers, wherein Fannie or Freddie pay outsiders to assume certain levels of credit risk in various static mortgage pools. CRTs are, he says, “an unheralded success story.

That assessment is premature, because the viability of CRTs can only be tested during a cyclical downturn, which seems far off.

Indeed, CRTs have a serious flaw that is best illustrated in Fannie Mae's latest chart on, Cumulative Default Rates of Single-Family Conventional Guaranty Book of Business. Loans originated over a 15-year time span, from 2002 up through the second quarter of 2017, are segmented by year. As we can see, most vintages—2002, 2003 and 2009-2017— were highly profitable because of nominal default rates over time.

Default rates for years preceding and following the mid-2006 peak of housing prices, vintages 2005 through 2008, are of an entirely different order of magnitude. Without the defaults and consequent losses suffered by loans booked in 2005 through 2008, Fannie would not have faced financial duress. The credit risk transfers for vintages 2005 - 2008 would have reduced the losses borne by Fannie Mae.

But the CRTs sold before and after that four-year period—2002-2003, 2009-2017—would have done nothing to reduce Fannie's financial distress. In fact, Fannie would have been better off had it not sold CRTs during those years and simply kept the interest and fee income. Up until now, the GSE model diversified of credit risk of its all of its mortgages in a single pool. The profitable vintages offset the losses from the unprofitable vintages. CRTs upend this tried-and-true system for diversifying market timing risk.

Zandi discusses how CRTs would protect Fannie and Freddie if they faced another severe downturn:

If a similarly severe downturn occurred today, the agencies would suffer smaller losses given that the mortgage loans and securities they own are of much higher quality. But more important, because of the capital market risk transfers now in place, approximately two-thirds of the losses would be borne by private investors, not Fannie and Freddie. And given how much capital the agencies would be holding if they were private institutions, they would avoid insolvency and another government takeover.Perhaps. It all depends on whether the GSEs would be able to sell credit risk on loans originated in 2006 through 2008. In early to mid-2006, California delinquencies spiked and prices began to level off. This would have signaled to anyone who is familiar with housing cycles that prices were very close to a cyclical peak. Remember, residential mortgages represent the only major credit market that relies on asset appreciation. And every housing boom has been followed by a multi-year period of stagnant or slumping prices. So investors, anticipating an end to the boom, would simply stop buying CRTs until housing began to emerge out of a cyclical trough.

Which is why an assumption, that Fannie and Freddie can sell CRTs during a downturn like that of 2007, should be viewed with skepticism.

BlackRock document refutes Hank Paulson's story about GSE capital

Thu, 03 Aug 2017 17:00:00 +0000

As reported in Howard on Mortgage Finance and elsewhere, the government's story—that it had no choice but to place the GSEs in conservatorship in September 2008--is undermined by contemporaneous documents unearthed in discovery in Fairholme v. US.

One document, a slide presentation about Freddie's capital presented by BlackRock, appears to refute Hank Paulson's story about placing the GSEs in conservatorship. In his memoir, On the Brink, he writes:

While I was away [prior to August 15, 2008] Fannies and Freddie’s books had been analyzed by the Fed; the OCC; our adviser, Morgan Stanley; and BlackRock, the New York money manager that had a long-term relationship with Freddie. They agreed that the organizations were sorely undercapitalized. And the quality of their capital was suspect: some of it consisted of intangible items, such as deferred taxes, that would not have been counted to the same degree as capital by financial institutions overseen by the banking regulators. What’s more, the GSEs had not adequately written down the value of guarantees provided by private mortgage insurers that had been downgraded by the rating agencies. Each of the companies looked to have true, economic capital holes amounting to tens of billions of dollars.

Paulson's calculation of "true, economic capital," was based on a methodology that was different from that used by the regulator, FHFA. FHFA director James Lockhart testified that," [Fannie Mae] was adequately capitalized the day we put them into conservatorship."

BlackRock’s slide presentation, dated August 25, 2008, echoes FHFA’s finding and refutes Paulson's claims. BlackRock stated that, "Long-term solvency does not appear to be endangered - we do not expect Freddie Mac to breach critical capital levels even in stress case." It said that, as of June 30, 2008, the company was adequately capitalized. And, though there was a risk that the company might see a capital shortfall in 2009 or later, the company was most likely to maintain its $29 billion in core capital.

_____________________

In other words, if negative trends continued, Freddie Mac may need to issue more equity to offset a statutory shortfall. BlackRock rejected Paulson's belief that the companies were on the brink of insolvency. There is no way to reconcile Paulson's story with the BlackRock work product.

Paulson rejected the statutory definition of GSE capital so that he could declare a multibillion shortfall in the GSEs’ “true economic capital,” to justify conservatorship. (He also argued that the GSEs should have written down the guarantees of private mortgage insurers because they were downgraded from double-A to single-A.)

Contrary to common myth, the GSEs were not placed in conservatorship because of insufficient capital. A capital shortfall would not allow FHFA to immediately take control of the companies. Rather, the statute, 12 U.S.C. 4617(a)(3)(J), gave a GSE another 45 days to come up with a plan to restore its capital base.

The written record seems to suggest that conservatorship was justified under 12 U.S.C. 4617(a)(3)(C) which authorizes a government takeover in case the GSE is in, "An unsafe or unsound condition to transact business." Lockhart was unwilling to wait until the GSEs reached an unsafe and unsound condition. He cited vague and unspecified "safety and soundness concerns" instead. In fact, the two companies had robust liquidity and unfettered access to the unsecured debt markets as of September 3, 2008, when Reuters reported, "Fannie, Freddie debt funding smooth."

However, I have heard from knowledgable sources that the justification of conservatorship came from a different subsection, 12 U.S.C. 4617(a)(3)(I), which says:

The regulated entity, by resolution of its board of directors or its shareholders or members, consents to the appointment.

The reality, according to a highly reliable source, was that the GSE board members of were threatened by Treasury, which acted in lockstep with FHFA, the Fed, the OCC. If they went along and agreed to let the government take over the GSEs, individual board members and officers would be exempt from any legal liability.

But if they did not accede to the demands of those government agencies, high ranking officials would abuse their power to destroy these individuals' reputations, the same way that OFHEO and the SEC abused their powers to fabricate the fact-free Fannie Mae "accounting scandal." That media narrative was used to destroy the reputations of Franklin Raines, J. Timothy Howard, and Leanne Spenser, who were senior executives at the company.

The threatening nature of the government's offer was evident from the interim reviews of both companies, which were packed with lies and distortions.

Of course, the GSEs did recognize massive losses subsequent to conservatorship, up through 2011. Though most of those losses were reversed in fiscal years 2012 and 2013. Even today, the GSEs recognize substantial credit income, instead of credit expense, because of the overblown loss provisions imposed on mortgages prior to 2012.

More nonsense embedded within Perry v. Mnuchin, the "new capital paradigm"

Mon, 20 Mar 2017 00:39:00 +0000

In my takedown of Perry v. Mnuchin, I mentioned that the D.C. Circuit gave short shrift to the statutory requirement to maintain adequate capital at the GSEs. That issue is fleshed out in further detail below.

The D.C. Circuit Court judges who wrote the majority (2-1) decision in Perry v. Mnuchin focused on the distinction between the words "may" and "shall." The statute, 12 U.S.C. § 4617(b)(2)(D), says the conservator may take steps to restore the soundness and solvency of Fannie and Freddie. But no statute expressly dictates that the conservator shall restore the companies' soundness and solvency. Which, according to the judges, must mean that the conservator may do any number of other things, such as draining the companies of all equity in perpetuity.

The court basically ignored the limitations that are set by the regulator, which in this instance is also the conservator. Under 12 U.S. Code § 4513(a), "The principal duties of the Director [of the regulator, FHFA] shall be--(A) to oversee the prudential operations of each regulated entity; and (B) to ensure that [] each regulated entity operates in a safe and sound manner including maintenance of adequate capital and internal controls..." So, one would presume, the conservator shall not do anything disallowed by the duties of the regulator.

And consider the statutes on minimum capital. According to 12 U.S. Code § 4612(a), the minimum capital requirement for the GSEs is 2.5% of balance sheet assets, and 0.5% for guarantee obligations. But 12 U.S. Code § 4612(b) says that, notwithstanding those minimums, "the Director may, by regulations issued under section 4526 of this title, establish a minimum capital level for the enterprises... that is higher than the level specified in subsection (a) for the enterprises."

So we know the FHFA Director may increase the minimum capital ratios. Does it follow that the Director may also reduce the minimum capital amounts? Why, yes, argued FHFA's outside counsel Howard Cayne before the D.C. Circuit judges. On October 9, 2008, when both companies were adequately capitalized, FHFA declared that, "the existing statutory and FHFA-directed regulatory capital requirements will not be binding during the conservatorship." Nothing in the law says FHFA may suspend statutory requirements during conservatorship. But then again, nothing in the law said the regulator shall not suspend statutory requirements. So FHFA decided that it may suspend statutory requirements whenever it deemed appropriate.

With artful flourishes of doublespeak, Cayne argued that the 2008 announcement created a whole new "capital paradigm." Though there seems to be no contemporaneous document expressly stating so, Cayne said that FHFA decided to use Treasury's unused commitment to support the GSEs as a substitute for GSE capital. Cayne's performance--he used close to 2,000 words to make his point--was a tour de force, a symphony of sophistry. Here are some brief excerpts:

So, what we have here at the outset in 2008 at the time the institutions were put into conservatorship, a new capital paradigm was established, and that capital paradigm said as long, by the Director of the Agency as regulator, and that capital paradigm said as long as these institutions are not forced into mandatory receivership they may operate.

And the new paradigm was rather than requiring them to maintain eight percent, five percent, six percent capital, whatever the standard was as a normal banking institution, it was determined that as long as the Treasury commitment was out there ready to come in to cure any insolvency, which as the Court knows if the institutions were insolvent for more than 60 days the Agency would have been forced to place them into mandatory receivership, so the new paradigm was we'll have the 100, 200, eventually Treasury committed to 467 billion, nearly a half a trillion dollars to support these enterprises, and the regulator made the regulatory decision that we will, the Agency will allow that to satisfy capital standards.

...what the statute says is that this action by the Agency as regulator to establish a new capital paradigm for the duration of the conservatorships may not be affected by injunction or otherwise in any manner...

Again, there is no statute that says FHFA as regulator may establish "a new capital paradigm" during conservatorship.

Judge Douglas Ginsberg wanted to be sure he heard right. He said:

There seems to be in the statute [referencing 12 U.S.C. Sec. 4614] a whole typology of classifications, adequately recapitalized, and then under-capitalized, and within that significantly under-capitalized, critically under-capitalized, okay?

Cayne’s response:

Your Honor, that entire system by virtue of the Director's action was set aside, there is an issuance by the Director that says this system doesn't apply.

Proving, once again, that clever people can rationalize away anything.

So, let's recap the government's position. The conservator may, in the absence of any prohibition stating otherwise, drain the GSEs of all equity, and the regulator may, in the absence of prohibition stating otherwise, suspend a statutory requirement for minimum capital. And, because of anti-derivative statutes--which limit shareholders' ability to bring suits alleging wrongs inflicted on the company, as opposed to wrongs directed specifically against the shareholders--FHFA's decision to drain the companies of all equity in perpetuity shall not be challenged on grounds tied to any fiduciary duty owed to the corporation.

However the Court did allow shareholders to litigate their direct claim. The idea behind that claim is that, because Treasury is taking cash dividend distributions today, it is reducing the availability of assets that may be allocated at the time of corporate liquidation. And, by taking away assets available for distribution at liquidation, the government is impairing the value of the junior preferred shares today. Which is why the claim is ripe.

This idea leads to several anomalies. If you add back the cash dividends distributed, in excess the the pre-existing 10% coupon, the GSEs would then be adequately capitalized, or at worst, undercapitalized under the classifications set by 12 U.S.C. Sec. 4614. In which case FHFA would have no statutory grounds, under 12 U.S.C. § 4617(a)(3), to place the the companies in receivership. (The GSE would need to be critically undercapitalized for FHFA to impose receivership.) If FHFA declares a GSE to be undercapitalized, the company has 45 days to come back with a plan to recapitalize before any further action may be taken.

(The original stated grounds for conservatorship used in 2008, "operating in an unsafe and unsound condition," per 12 U.S. Code § 4617(a)(3)(C), can no longer apply. Even in September 2008, FHFA had perverted the meaning of "an unsafe and unsound condition," in order to justify taking immediate control of the companies.)

As for shareholder rights under any liquidation preference, the GSEs situation seems to be an anomaly. It is almost unheard of to liquidate a company when it has substantial positive equity, and has prospects for continuing positive earnings. Moreover, a number of former officials involved in executing the Third Amendment sweep--former acting FHFA director, Edward DeMarco, former Obama White House advisors Gene Sperling and James Parrott--advocate a course of action that is very different from liquidation.

All of the housing finance reform proposals currently touted by James Parrott at the Urban Institute are remarkably similar. They all seem to eschew the concept of liquidation. Instead, they advocate abolishing the GSEs, while appropriating the GSEs' operations and infrastructure to be used in a new government-owned mortgage insurance company. These proposals look, sound and smell like nationalization. Of course, the same might be said about a plan to drain the companies of all equity in perpetuity. "Conservation is not a synonym for nationalization," wrote Judge Janice Rogers Brown in her dissent.

More nonsense embedded within Perry v. Mnuchin, the DTAs

Thu, 16 Mar 2017 17:14:00 +0000

A friend suggested that I expand upon some of the issues mentioned in passing in my takedown of the majority opinion in Perry v. Minuchin, which, by the way, was not intended to be comprehensive.

As I noted, the government's justification for the net worth sweep--to avoid a "dividend driven debt spiral"--was absurd on its face. It was also debunked by evidence obtained through discovery in a lawsuit brought in the Court of Claims.

This evidence was made public and submitted to the D.C Circuit Court while it considered an appeal of the lower court's dismissal of the Perry case. The government's supposed concern about a "downward spiral," is at odds with the sworn testimony of Fannie's CFO at the time, Susan McFarland. She said:

I had a meeting with Treasury [on August 9, 2012] whereby we reviewed our forecasts. I had expressed a view that I believed we were now in a sustainable profitability, that we would be able to deliver sustainable profits over time. I even mentioned the possibility that it could get to a point in the not-so-distant future where the factors might exist whereby the allowance on the deferred tax asset would be released. We were not there yet, but, you know, you could see positive things occurring.

And later:

I mean, in general, I [had] put [the deferred tax asset release] on people's radar screens that it's something that could happen in the not-so-distant future. I will say that I believe Mary Miller asked me in this meeting about how large would it be and did I have any idea of when. And I believe my response was around 50 billion, but that could be larger or smaller depending upon when... but I said probably in the $50 billion range and probably sometime mid-2013...

Eight days later, on August 17, 2012, the Third Amendment sweep was publicly announced. McFarland testified:

So when the amendment went into place, part of my reaction was they did that in response to my communication of our forecasts and the implication of those forecasts, that it was probably a desire not to allow capital to build up within the enterprises and not to allow the enterprises to recapitalize themselves.

The Third Amendment sweep was set to commence in fiscal year 2013, in line with what McFarland told Miller. But then Fannie's earnings began to rise more rapidly. In McFarland's judgement, it became necessary to release the $59 billion DTA allowance in the fourth quarter of fiscal 2012. In early 2013, before the company reported any year-end numbers, McFarland went to the SEC to seek permission to release the DTA allowance. Her presentation laid out detailed justifications for release in fiscal year 2012. From the presentation:

In assessing the valuation allowance as of December 31, 2012, we concluded that the positive evidence of sustainable future taxable income, based upon improvements in our financial results, positive trends in the housing market and the credit quality and expected profitability of our book of business outweigh the negative evidence of future projected charge offs related to current and future delinquent loans and a three year cumulative pre-tax book loss...
Based on our income forecasts and our sensitivity analysis, we expect future taxable income to achieve realization of all of our DTAs, including the tax attributes prior to their expiration. Therefore, we have concluded that the valuation allowance should be released as of December 31, 2012.

The government refused to release the DTAs in fiscal year 2012, when the Income would have been retained and not swept up to Treasury. As it happened, McFarland announced her retirement from Fannie on February 5, 2013, before the Fannie's 2012 financials were published. She had been with the company less than 20 months. The timing, as the cliche goes, raises serious questions.

When she joined Fannie in July 2011, the CFO position had been vacant for six months after her predecessor, David Johnson, left at the end of 2010. He joined the company in November 2008, two months after the government demanded the resignations of the entire senior management teams of Fannie and Freddie Mac when they were placed in conservatorship. Frequent turnover at the top of a large institution is generally considered a red flag, a sign that something is amiss.

Perry v. Mnuchin: A case study in disingenuity

Fri, 10 Mar 2017 16:00:00 +0000

Clever people can rationalize anything. They might take one or two factoids out of context, misrepresent the broader written record, and ignore the contravening evidence, so that they can arrive at an otherwise unsupportable conclusion. Exhibit A: The absurd outcome the D.C. Circuit case, Perry v. Mnuchin, which validates the government's net income sweep designed to drain all earnings and equity out of Fannie Mae and Freddie Mac. Judges Douglas Ginsberg and Patricia Millett (they don't specify who wrote the 2-1 majority decision) turn a blind eye to:

the broader regulatory framework,
tenets of accounting and finance,
government documents in the public domain, and
common sense.

Let's walk through what the judges chose to ignore.

The regulatory framework

The judges base much of their analysis on the keen distinction between the words, "may" and "shall." "May” is permissive but not obligatory, whereas "'shall" is mandatory. "May" refers to rights and powers; "shall" refers to duties and obligations. The judges focus on how Congress used "may" and "shall" in different places in the text of the Housing Economic Recovery Act of 2008. One statute, 12 U.S.C. § 4617, "Authority over critically undercapitalized regulated entities," includes a subsection 12 U.S.C. § 4617(b), "Powers and duties of the Agency as conservator or receiver." More specifically, 12 U.S.C. § 4617(b)(2)(D), titled "Powers as conservator," says:

The Agency may, as conservator, take such action as may be—(i) necessary to put the regulated entity in a sound and solvent condition; and(ii) appropriate to carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.

So we know what the conservator may do pursuant its statutory powers. What else--aside from restoring the government sponsored enterprises' soundness and solvency, and preserving and conserving their assets--may a conservator do? What other powers are enumerated? The judges point to U.S.C. § 4617(b)(2)(J), "Incidental powers,"

The Agency may , as conservator or receiver—(i) exercise all powers and authorities specifically granted to conservators or receivers, respectively, under this section, and such incidental powers as shall be necessary to carry out such powers; and(ii) take any action authorized by this section, which the Agency determines is in the best interests of the regulated entity or the Agency.

The judges write:

In short the most natural reading of the [Housing Economic Recovery Act of 2008] is that it permits FHFA, but does not compel it in any judicially enforceable sense, to preserve and conserve Fannie’s and Freddie’s assets and to return the Companies to private operation. ... Entirely absent from the Recovery Act’s text is any mandate, command, or directive to build up capital for the financial benefit of the Companies’ stockholders. That is noteworthy because, when Congress wanted to compel FHFA to take specific measures as conservator or receiver, it switched to language of command, employing “shall” rather than “may.”

It's hard to overstate the disingenuity of this analysis, which mimics that of the lower court decision by District Court Judge Royce Lamberth. Look again, the words,"the regulated entity," should be a big tipoff. Contrary to what the judges insinuate, HERA does not exist in a vacuum. The bill merely supplements the broader regulatory framework originally set forth in the Federal Housing Enterprises FinancialSafety and Soundness Act of 1992. GSE regulation did not stop on September 6, 2008, when Fannie and Freddie were formally placed in conservatorship. The conservator has no power whatsoever to exceed the strictures set forth in other statutes. (Surely, if Congress ever contemplated otherwise, it would have said, so.)

Consider, for instance 12 U.S. Code § 4513, "Duties and authorities of Director [of FHFA]":

a) Duties(1) Principal duties. The principal duties of the Director shall be—(A) to oversee the prudential operations of each regulated entity; and(B) to ensure that—(i) each regulated entity operates in a safe and sound manner including maintenance of adequate capital and internal controls;(ii) the operations and activities of each regulated entity foster liquid, efficient, competitive, and resilient national housing finance markets (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities);...

So the director of FHFA, who is also the conservator of Fannie and Freddie, shall, as in must, oversee the companies to ensure that they operate in a safe and sound manner. In this context, safety and soundness is not some vague platitude subject to varying interpretations. It is a highly developed concept linked to the Uniform Financial Institutions Rating System (UFIRS), used by all federal regulators of financial institutions. This system is more commonly known by the acronym CAMELS, which stands for:

C: the quality and adequacy of capital;

A: the quality of assets:

M: the capability of the board of directors and management;

E: the quantity, sustainability, and trend of the bank’s earnings;

L: the adequacy of the bank’s liquidity position; and

S: its sensitivity to market risk.

So nothing in HERA obviates FHFA's principal duty to ensure the adequacy of Fannie or Freddie's capital. Moreover, maintenance of capital adequacy is a core function of FHFA, as detailed 12 U.S. Code Subchapter II - REQUIRED CAPITAL LEVELS FOR REGULATED ENTITIES, SPECIAL ENFORCEMENT POWERS, AND REVIEWS OF ASSETS AND LIABILITIES. These include

12 U.S. Code § 4611 - Risk-based capital levels for regulated entities12 U.S. Code § 4612 - Minimum capital levels12 U.S. Code § 4613 - Critical capital levels12 U.S. Code § 4614 - Capital classifications12 U.S. Code § 4615 - Supervisory actions applicable to undercapitalized regulated entities12 U.S. Code § 4616 - Supervisory actions applicable to significantly undercapitalized regulated entities12 U.S. Code § 4617 - Authority over critically undercapitalized regulated entities

Again, the concepts of conservatorship and receivership are set forth within 12 U.S. Code § 4617 -"Authority over critically undercapitalized regulated entities."

Circling back to the distinction between "may" and "shall," the conservator's actions are limited to what the regulator shall allow under its statutory mandate. The regulator has a specific duty to ensure that the GSEs maintain adequate capital. Authorizing cash dividends, any cash dividends, while undercapitalized is antithetical to that legal duty, something that Judges Ginsberg and Millett choose to ignore.

An additional wrinkle. On October 9, 2008 FHFA announced: "The Director has determined that it is prudent and in the best interests of the market to suspend capital classifications of Fannie Mae and Freddie Mac during the conservatorship...FHFA will continue to closely monitor capital levels, but the existing statutory and FHFA-directed regulatory capital requirements will not be binding during the conservatorship."

FHFA had no legal authority and no rational basis for suspending capital classifications. Moreover, on October 9, 2008 the GSEs were adequately capitalized. Not many people paid attention at the time; they were distracted by the broader financial meltdown. In later years, FHFA would cite this spurious suspension of its duties as a justification to ignore its duty to rebuild GSE capital.

Tenets of accounting and finance

When faced with a challenge to the Third Amendment sweep in court, the government offered up a story that fails the laugh test. As litigation proceeded, the government's story was debunked. In response, the government pivoted, and claimed that its motivations were irrelevant, given that Congress had extended the conservator virtually unlimited discretion, which was exempt from judicial review.

Yet Judges Ginsberg and Millett accept the government's story and in so doing come across as financial illiterates. They write:

Fannie’s and Freddie’s frequent inability to make those dividend payments, however, meant that they often borrowed more cash from Treasury just to pay the dividends, which in turn increased the dividends that Fannie and Freddie were obligated to pay in future quarters....In simple terms, the Third Amendment requires Fannie and Freddie to pay quarterly to Treasury a dividend equal to their net worth—however much or little that might be. Through that new dividend formula, Fannie and Freddie would never again incur more debt just to make their quarterly dividend payments, thereby precluding any dividend-driven downward debt spiral.

False. This "dividend-driven downward debt spiral," is divorced from reality, a conceit in which the judges conflate the definitions of equity, debt and cash. Prior to 2012, the GSEs had insufficient equity or earnings to pay senior preferred cash dividends. So, to finance $36 billion in cash dividends, FHFA drew down "bailout" funds wherein Treasury purchased additional senior preferred equity. That way, the GSEs could then turn around and then send funds back to Treasury. The net result would be that the GSEs’ total cash and equity position would be unchanged and Treasury’s cash position would be unchanged. Contrary to the judges' claims, the companies never incurred more debt to pay out cash dividends.

It is true that some companies with robust equity have limited cash, so they incur additional debt to fund cash dividends. Also, there are companies like the GSEs, with nominal equity but abundant cash. But the "dividend-driven downward debt spiral," is an absurdity. Because the round-tripping phenomenon that bothered the judges--Treasury sends cash to the GSEs, which immediately return cash to Treasury--had nothing to do with debt whatsoever. (None of the bailout funds were ever used for traditional bailout purposes. The taxpayer draws were never used to cover cash shortfalls or operating expenses.)

Indeed, the round-tripping described above reveals something that should be obvious to everyone. These cash dividends served no legitimate purpose. They served no business purpose for the benefit of the GSEs; nor did they improve the government's cash or income position, and they imposed additional burdens on taxpayers while further reducing the size of the government's commitment to support the GSEs. Though the cash dividends did have a markedly negative impact on the GSEs' ability to rebuild capital and thereby improve the safety and soundness of their operations.

The judges seem to conflate debt with equity and thereby confuse the reader into thinking that cash dividends are some kind of fixed obligation imposed on the GSEs. There is no such thing as a legal obligation to pay dividends within any timeframe. Any investment with a fixed obligation to pay cash within a deadline fits the definition of debt, not equity. The senior preferred dividends could always be paid in kind. True, payments in kind bumped up the dividend coupon from 10% to 12%, but cash dividends reduce equity, whereas dividends in kind leave corporate equity unchanged.

What really happened

The only way to grasp the full story of the GSE conservatorships is to follow the money, which in this context means cash, or the f!ow of funds. For a large financial institution, the chasm—between cash versus earnings, or between liquidity and solvency—may seem wider than the Grand Canyon. Every financial institution's earnings and equity are driven by non-cash provisions, timing differences under Generally Accepted Accounting Principles, which are always subject to dramatic revision. These companies need to build up capital as a cushion to withstand any future downward revision.

The facts are beyond dispute. On September 5, 2008, the day the government announced its plans to put both government sponsored enterprises in conservatorship, the companies generated positive cash flow, maintained adequate regulatory capital, robust liquidity, and unfettered access to the unsecured debt markets. (Many people state that the GSEs suffered liquidity problems prior to their takeover. These people are either misinformed or dishonest.)

Under HERA, the Department of Treasury had recently been given special temporary powers to invest in the GSEs, on terms accepted by GSE directors, in order to bolster the companies' liquidity and capital. These special powers were given by Congress for the purpose of forestalling the possibility that the GSEs might be placed in conservatorship. Indeed, one of the purposes of these special powers was to protect the taxpayer, which was defined to mean, among other things, preserving the GSEs as private shareholder companies.

Of the many possible grounds that enabled FHFA to impose immediate conservatorship on the GSEs, set forth in 12 U.S.C. § 4617(a)(3), only one had anything close to a veneer of plausibility. It was:

Again, this phrase has a very specific meaning within the CAMELS methodology; it means that an institution has received a CAMELS rating of 5 or possibly 4, and it also indicates that the institution is approaching a state of collapse. FHFA director James Lockhart distorted that meaning of the statute to justify his agenda to apprehend the GSEs sooner rather than later. He declared that the government takeover was necessary in order to address, "safety and soundness concerns," which were also characterized as, "safety and soundness issues." If the distinction isn't apparent to you, think of it this way: just because a person has health concerns or health issues, it does not necessarily follow that he is currently ill. (As I've written elsewhere, the FHFA document used to justify conservatorship is packed with lies and distortions.)

Nothing about conservatorship compels FHFA to force out the management and the directors. Though FHFA, in collusion with Treasury, demanded that top management and directors leave immediately. That way, Treasury could negotiate the terms of its equity investments in the GSEs by dealing with FHFA instead of GSE management. The Senior Preferred Stock Purchase Agreement (PSPA) negotiated by Treasury was designed to subvert federal statutes, which were drafted to assure the FHFA's independence as a regulator. The PSPA disallows FHFA from taking any significant action with regard to the GSEs without first securing Treasury's approval.

FHFA's actions prior to execution of the Third Amendment sweep fit a pattern. its distortion of statutory wording as a pretext for placing the GSEs in conservatorship, its removal of GSE directors so that FHFA itself would negotiate the terms of the PSPAs, its agreement to give Treasury veto power over its regulatory prerogatives, its suspension of capital classifications, its payouts of cash dividends that serve no legitimate purpose, all fit a pattern. They all demonstrate a concerted effort by FHFA to subvert the legislative intent of HERA. The Third Amendment sweep to the PSPA is consistent with that pattern.

After being placed in conservatorship, the companies continued to operate as before, generating positive cash flow, and of course, maintaining their robust liquidity and unfettered access to capital markets, with the further enhancement of government support.

Subsequent to the announced conservatorship, the companies changed their methodology for calculating loan loss reserves; and in short order the companies' non-cash provisions skyrocketed. For fiscal years 2008-2011, the two companies recognized non-cash losses that wiped out all equity, and which necessitated a federal bailout of $151.5 billion. In addition, the companies drew down $36 billion in taxpayer funds to cover the unnecessary and imprudent cash dividend payments of 10% coupon on the U.S. Treasury's senior preferred stock. The grand total of taxpayer draws equaled $187.5 billion.

Those non-cash loss provisions were eventually reconciled with cash outcomes, as distressed loans were liquidated off the books. Beginning in 2012, GSE earnings began to skyrocket as overly conservative loss provisions were reversed. Fannie's annual income for 2012 was $17 billion, more than twice its previous annual record. In 2013 Fannie earned $84 billion, which set an all-time record for the highest annual income reported by any Fortune 500 company ever. (The $84 billion amount is almost twice the amount that Fannie earned over the entire decade preceding the 2008 government takeover. Total earnings during 1998 -2007 were $43 billion.)

On August 17, 2012, nine days after Fannie reported a record $7.8 billion in six-month earnings, FHFA and Treasury announced the Third Amendment to the Senior Preferred Stock Purchase Agreement. Going forward, the cash dividend coupon would be upsized, from 10% of the initial investment, to 100% of all corporate earnings generated in perpetuity. By early 2014, both GSEs had repaid the entire $187 billion drawn down from Treasury's coffers.

With 20/20 hindsight, we know that the GSEs never needed the massive bailouts they received, because the non-cash loss provisions, booked during 2009-2011, proved to be wildly over-inflated. If FHFA and the GSEs' auditors were clairvoyant, so that loss provisions predicted cash losses with great precision, the GSEs' need for government bailout funds would have been close to zero.

But, according to the government, FHFA began to fear a GSE "death spiral" right at the point when evidence suggested the companies would experience a robust recovery. Out of "fear" that the companies would not be able to fund cash dividends in the future, FHFA and Treasury agreed that, going forward, cash dividends on senior preferred stock would be no more than 100% of quarterly earnings, irrespective of whether that amount was higher or lower than 10% of the initial $187.5 billion "bailout" amount.

Rudiments of financial literacy

Then there are the reasons why the government's story fails the laugh test. First, the cash dividends paid prior to 2012 served no legitimate business function. They did not improve the GSEs' equity or cash positions; nor did they provide the government with additional cash or reduce the likelihood of future bailout drawdown .

So, at the risk of belaboring the obvious, let's recap those distinctions. No company is legally required to pay cash dividends by a specified date, ever. If there's a firm obligation to make a cash payment by a date certain, that obligation is debt, not equity. A company always has the option to pay preferred dividends in kind, which is an accounting accrual for later payment. Unlike cash dividends, dividends in kind do not reduce shareholder equity.

The judges seem to have forgotten some principles of contract law, specifically, enforceable contracts require consideration, which can be one party's forsaking of his legal rights. But Treasury never had a right to receive cash dividends. Which is why it extended no consideration to the GSEs in exchange for a permanent upsizing of cash dividend payouts. The prior purchases of senior preferred stock don't count, because past consideration is no consideration.

Government documents in the public domain

Treasury was perfectly obvious about its agenda, which was never about protecting anyone from an imaginary death spiral. The August 17, 2012 press release to announce the third amendment sweep was titled, “Treasury Department Announces Further Steps to Expedite Wind Down of Fannie Mae and Freddie Mac.” Though the press release was dishonest—it insinuated that Treasury and FHFA held a nonexistent right to wind down the GSEs—it accurately reflected Treasury’s intent, which was to put the GSEs out of business by draining them of all equity. More specifically, Treasury misrepresented an earlier document—its Report to Congress released on February 11, 2011, which offered recommendations to Congress—as something that gave it some imaginary authority to wind down the two companies. The press release says Treasury was, “[a]cting upon the commitment made in the Administration’s 2011 White Paper that the GSEs will be wound down and will not be allowed to retain profits, rebuild capital, and return to the market in their prior form."

To spread the word, White House advisor James Parrott alerted two leaders iof a multi-year disinformation campaign against the GSEs, Peter Wallison and Edward Pinto. Since late 2008, Wallison and Pinto kept spreading the false meme that GSE underwriting standards, specifically those set forth under affordable housing goals, had poisoned the well of housing finance. It was nonsense, for the simple reason that GSE loan performance was always exponentially superior to every other player in the market. The Wallison/Pinto thesis was based class bigotry, some cherrypicked factoids, and an adamant refusal to ever talk about comparative loan performance.

The Financial Crisis Inquiry Commission reviewed Pinto's "research" in the context of comparative loan performance and found that his risk categorizations were all but meaningless. Neither Pinto nor Wallison could offer any response, so Wallison, a Republican member of the FCIC, defamed the Commission when he lied and said that the Commission refused to review Pinto's work. The Wallison/Pinto meme, which is still promoted to this day, is frequently characterized as The Big Lie about the financial crisis. And yet a wide assortment of observers treat these dissemblers as bona fide experts in housing finance. Indeed, Parrott considered them his "fellow travelers," and offered to walk them through the mechanics of the Third Amendment sweep to show them how they were designed to drain the the companies of all equity. This email correspondence was made public many months before the Circuit Court handed down its decision.

The acting FHFA director who negotiated and signed the Third Amendment sweep, Edward DeMarco, has made no secret of his stalwart opposition to the GSEs accumulating additional capital. "The GSEs are failures." seems to be his mantra. "Restoring Fannie Mae and Freddie Mac is not the solution," he said after leaving office. "They failed and their business model failed. Going backwards to an obviously failed model cannot be dressed up with some promise of higher capital or explicit rather than implicit guarantees." He drives home his points by pandering to those unfamiliar with timing differences under GAAP by saying, "There should be no doubt that this set of events [leading to conservatorship of the government-sponsored enterprises] and the billions of dollars in subsequent losses meant that Fannie Mae and Freddie Mac had failed...[indeed] there was broad consensus at that time that not only had Fannie Mae and Freddie Mac failed, but the GSE model had failed."

And of course, in mid-2012 GSE management and FHFA were fully aware that the companies were likely to see a huge spike in earnings once the companies overly-inflated loss provisions were reversed. Testimony by key witnesses and contemporaneous documents, still mostly under seal, described in plaintiffs' motions, prove that FHFA never believed in any kind of specious "death spiral."

Judges Ginsberg and Millett turn a blind eye to all of this. Which brings us to the final category.

Common sense

There is one, and only one, reason why Fannie and Freddie do not maintain $250 billion in capital. FHFA engineered it that way. The economic substance of FHFA's actions, taken in its role as conservator, speak for themselves. The $250 billion cash dividend distributions, justified by non-cash reversals of non-cash provisions, speak for themselves.

Kroll Rating Agency Frames GSE Reform Around Urban Myths

Fri, 27 Jan 2017 18:00:00 +0000

Every credit analysis must grapple with two eternal questions: How do the past and present inform us about the future? And, what is the breakeven?

Kroll Bond Rating Agency all but ignored the first question in its report, “Housing Reform 2017: Can the GSEs be Privatized?" It simply failed to consider how Fannie Mae and Freddie Mac had been self-supporting for more than 35 years, right up until the day they were apprehended by the government. "KBRA reminds all concerned with the issue of housing finance reform that the GSEs failed because of a loss of confidence and market liquidity, not inadequate capital,” it says.

Really? If the metric for GSE failure is a loss of market liquidity, then the tangible evidence against the GSEs seems to be non-existent.

The GSEs access the short and medium-term debt markets once a week, on Wednesdays. “Fannie and Freddie Debt Funding Smooth,” was the Reuters headline on the morning of September 3, 2008, the last Wednesday before the government took them over. Later that day, Reuters reported that, "the two government-sponsored enterprises continue to have relatively unhindered access to debt funding." That same day, the Associated Press reported, "The companies' ability to sell debt has diminished expectations that a government rescue is imminent. Investors are demanding a smaller premium for Freddie Mac's debt than last month."

One reason why Fannie and Freddie maintained unfettered access to the unsecured debt markets was their highly liquid balance sheets. The GSEs reminded investors in every quarterly financial report that they were required to maintain 90-days liquidity at all times. Fannie's July 2008 Monthly Summary Report, released in mid-August 2008, showed the company held $103 billion in liquid investments.

Investors could also access Fannie’s 2008 Funding Summary Reports, which disclosed how the company funded itself each month. Fannie issued more short-term debt than it repaid in every month, except for the three months, which had four, instead of five, Wednesdays.

Market confidence also came from Treasury Secretary Hank Paulson's testimony before the Senate Banking Committee on July 15, 2008. “Fannie Mae and Freddie Mac play a central role in our housing finance system and must continue to do so in their current form as shareholder-owned companies,” he testified. Paulson sought legislation, the Housing Economic Recovery Act of 2008, which gave the Treasury Department temporary emergency powers to invest in GSE securities at terms accepted by the GSEs. Any Treasury investment would be done for the purpose of, among other things, “The need to maintain the corporation’s status as a private shareholder-owned company.”

Kroll Ratings is right about GSEs' regulatory capital, which was more than adequate on the date of the government takeover. Fannie had bolstered its capital by issuing $7.4 billion in new common and preferred shares in May and June 2008.

Given that the companies had adequate liquidity and adequate capital, plus Treasury’s vote of confidence, investors were dumbfounded to learn that the government intended to wipe out the value of shares issued four months before the September 2008 takeover.

"The Treasury Department's decision to wipe out shareholders of two of the largest financial institutions on the planet shocked markets, making it apparent that no institution was safe," writes Mark Zandi of Moody's Analytics in his book, Paying the Price.

British economist Anatole Kaletsky agrees. In Capitalism 4.0 he writes. “Paulson’s decision to wipe out the Fannie and Freddie shareholders just a few weeks after their official regulator had issued a public declaration of their solvency, and at a time when they were still enjoying positive cash flows, sent a terrifying but unmistakable signal to shareholders in all other U.S. banks and financial institutions: They, too, could be wiped out by a U.S. government fiat at a moment’s notice, even if the banks they owned were generating positive cash flows, had raised new capital, and had received regulatory approvals as recently as a few weeks before.”

“The government's takeover of Fannie and Freddie arguably ignited the global financial panic," writes Zandi. That panic triggered liquidity crises at Lehman Brothers, AIG, Morgan Stanley and other firms, which held large risk exposures to deeply subordinated tranches of private label residential mortgage-backed securitizations. (By way of contrast, the GSEs held only the most senior triple-A tranches of RMBS deals.)

Securities firms can require enormous amounts of liquidity in order to trade on behalf of their clients and themselves. If clients pull their accounts, or if banks cut their daylight overdraft lines, a firm’s operations can come to a sudden halt. Whereas the GSEs’ largest business segment entailed unfunded guarantees of mortgage securitizations; and it never funded itself with demand deposits or uncommitted lines.

We must be careful not to conflate Wall Street’s liquidity crises with the issues faced by the GSEs. Indeed, there seems to be no hard data showing that the GSEs’s “implicit guarantee” from the federal government, which had been in effect for decades, was not working successfully right up until the date of the government takeovers. Which is why the notion, posited by KBRA and others, that recapitalized GSEs might not continue their operations absent an express federal guarantee, seems to be based on urban myths instead of hard data.

Is the Common Securitization Platform Legal?

Tue, 10 Jan 2017 15:22:00 +0000

As regulator and as conservator, FHFA has one job, to support the financial health of the GSEs, so that they may liquefy the mortgage markets. Period. It has no statutory authority to do anything else. It has no authority to accommodate the Department of Treasury's desire to reform housing finance. It has no authority to use GSE money to build up an infrastructure designed to replace the GSEs, which is what it set about to do in 2012 when it set about building up a common securitization platform.

How did FHFA divine this new authority? It cited a white paper and some legislative proposals mulling around Congress. FHFA explains in its 2012 strategic plan:

One critical point: The steps envisioned in this strategic plan are consistent with each of the housing finance reform frameworks set forth in the white paper produced last year by the U.S. Department of the Treasury and the U.S. Department of Housing and Urban Development as well as with the leading congressional proposals introduced to-date. This plan envisions actions by the Enterprises that will help establish a new secondary mortgage market, while leaving open all options for Congress and the Administration regarding the resolution of the conservatorships and the degree of government involvement in supporting the secondary mortgage market in the future.

FHFA's one critical point is trumped by two much more critical points:

1. Legally, that white paper and the proposals in Congress mean nothing. They confer no rights or privileges to FHFA or anyone else.

2. The while paper prepared by Treasury and HUD is highly misleading. It was drafted pursuant to Section 1074 of Dodd-Frank, which directed Treasury to provide Congress with a study to analyze different options for, “Ending the Conservatorship of Fannie Mae, Freddie Mac, and Reforming the Housing Finance System.” The options specified by statute included winding-down and liquidating the companies, privatizing of the companies, incorporating the GSEs’ functions into a Federal agency, and breaking up Fannie and Freddie into smaller companies. Treasury Secretary Timothy Geithner curtailed the scope of the study to exclude any discussion of an outcome under the law as it is currently written.

Four weeks before the final document's due date, 11 senior Treasury officials signed off on an internal memo, which was to be used as a template for the report to Congress, aka the white paper, which discussed three possible “end state options.” Of those three, only one, privatizing them—which in this context meant recapitalizing the companies and returning them to private control— was authorized by law. The privatization end state was, "essentially the path laid out under HERA [the Housing and Economic Recovery Act of 2008] and the Paulson Treasury when the GSEs were put into conservatorship in September 2008.” The advisable scenario would be as follows:

After becoming adequately capitalized during the Transition, the GSEs would exit conservatorship as private companies. Treasury converting its preferred into common equity [would] be sold to the public over time (under legal review); the GSE's existing common shareholders being substantially diluted. The companies continue to guarantee a large share of mortgages, with PMI [private mortgage insurance] companies and homeowners taking the first loss risk as they have done traditionally.

…[Furthermore], Dodd-Frank strengthens [the recapitalization] option through the ability to designate the GSEs as SIFIs [Systemically Important Financial Institutions], and thereby subject them to more rigorous prudential standards and Fed supervision. GSEs/successor entities would maintain higher capital requirements and investment restrictions as envisioned in Transition. The other two end state options, which involved downsizing or revoking the GSEs’ corporate charters, required new legislation, because the two companies operated under Congressional charters.

Geithner overruled 11 senior officials and excluded from the report, and from every public discussion involving Treasury officials, any mention of an outcome under the law as it is currently written. In so doing, he made it seem less obvious that FHFA's actions exceeded its legal powers.

Shooting Down Dubious Arguments Against GSE Recapitalization

Sat, 07 Jan 2017 15:00:00 +0000

Is there any good reason to oppose rebuilding the balance sheet equity of an undercapitalized financial institution ? I can't think of any. Michael Bright of the Milkin Institute seemed to suggest otherwise in National Mortgage News. In, "GSE 'Recap' Experiment Is Just a Sideshow," he says, "there is a lot of dangerous misinformation," about the push to recapitalize.

In response I wrote, "GSEs Have Been Ill-Served by Balance Sheet Equity Experiment," One excerpt:

[W]e know with absolute certainty why the GSEs' balance sheet capital remains close to zero. The Federal Housing Finance Agency engineered it that way. It chose to reduce Fannie and Freddie's equity by $250 billion in order to fund cash dividends to the Treasury. Irrespective of what Bright or anyone else thinks, the FHFA's decision-making could never be described as normal. It is never normal for an undercapitalized, regulated financial institution to pay cash dividends. It is never normal for a conservator to authorize any cash dividends prior to the company's emergence out of conservatorship.