Tag Archives: government-sponsored enterprise

The Second Frannie Bailout: Who Could’ve Known?

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There is a good chance that five or so years from now, Fannie and Freddie will be in the midst of another bailout. This next crisis will be directly caused by the Executive and Legislative branches of the federal government. But members of those branches will say, “Nobody could have known that this crisis was going to happen, nobody is at fault.” That won’t be true, but nobody will be punished in any case. That’s because the crisis will result from inaction, that most fearsome of government flaws.

Who is the Cassandra, warning us of this impending crisis? None other than Donald Layton, the CEO of Freddie. You may think that he is speaking merely from self-interest and you would probably be right. But his self-interest happens to align with the truth in this matter.

In a letter to FHFA Director Watt, Layton writes:

the ability of Freddie Mac to continue to support the mortgage markets and the U.S. economy duling an unprecedentedly lengthy transition period should be one of the most important objectives of a housing finance reform proposal, such as the Johnson-Crapo Bill. The existing Bill draft does not focus on this issue and so, in my personal but experienced opinion, leaves the risk of a failure in Freddie Mac’ss Core Policy Function unacceptably high. With certain specific changes, none of which alter the fundamental nature of the future state envisioned or even the key aspects of the transition, l believe this risk can be reduced, although it would still remain high. (7)

Layton highlights the extraordinary complexity of Freddie’s activities in an appendix to the letter. The highlights include the fact that Freddie Mac guarantees  “about  17% of all U.S. mortgage debt outstanding;” 1,400 Servicers and 2,000 Sellers work with Freddie; and Freddie manages 44,600 REO properties. (8)

Layton states that “It goes without saying that Freddie Mac cannot deliver upon its Core Policy Function, its support of the transition to a future state, or its support of Conservatorship initiatives without experienced and knowledgeable people in place at the executive level, at the Subject matter expert level and at the “been-here-a-long-time-to-know-how-everything-works level.” (3) He believes that departures are likely to cripple the company as experienced staff move on to other, more stable opportunities, leaving behind the quagmire that life in a GSE has become.

The Executive and Legislative branches are not really moving toward some kind of resolution of the Fannie and Freddie conservatorships, although we are now five years past the initial crisis. There is a good chance that the federal government will not move us to the next phase of housing finance in the next couple of years. Operations at the two GSEs will thus continue to suffer and will likely build up to a new crisis. And it will be a totally predictable crisis.

I am the kind of person who likes to say, “I told you so.” But the stakes here are so humungous and so important for the health of the economy, that I could take no pleasure in saying I told you in 2014 that our entire housing finance edifice was going to crumble a second time in a decade. But it will, if nothing is done to prevent it today.

Stressing out on Fannie and Freddie

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The Federal Housing Finance Agency issued Projections of the Enterprises’ Financial Performance (Stress Tests) (Apr. 30, 2014). This is a pretty technical, but important, document. The Background section provides some needed context:

This report provides updated information on possible ranges of future financial results of Fannie Mae and Freddie Mac (the “Enterprises”) under specified scenarios, using consistent economic conditions for both Enterprises.

*     *     *

. . . the Dodd-Frank Act requires certain financial companies with total consolidated assets of more than $10 billion, and which are regulated by a primary Federal financial regulatory agency, to conduct annual stress tests to determine whether the companies have the capital necessary to absorb losses as a result of adverse economic conditions. This year is the initial implementation of the Dodd-Frank Act Stress Tests.

In addition to stress tests required per the Dodd-Frank Act, this year as in previous years, FHFA worked with the Enterprises to develop forward-looking financial projections across three possible house price paths (the “FHFA scenarios”). The Enterprises were required to conduct the FHFA scenarios as they have in the past, in conjunction with the initial implementation of the Dodd-Frank Act Stress Tests.

*     *     *

The projections reported here are not expected outcomes. They are modeled projections in response to “what if” exercises based on assumptions about Enterprise operations, loan performance, macroeconomic and financial market conditions, and house prices. The projections do not define the full range of possible outcomes. Actual outcomes may be very different. (4, emphasis in the original)

 The stress test results are as follows:

Dodd-Frank Act Stress Tests Severely Adverse Scenario

  • As of September 30, 2013, the Enterprises have drawn $187.5 billion from the U.S. Treasury under the terms of the Senior Preferred Stock Purchase Agreements (the “PSPAs”).
  • The combined remaining funding commitment under the PSPAs as of September 30, 2013 was $258.1 billion.
  • In the Severely Adverse scenario, incremental Treasury Draws range between $84.4 billion and $190.0 billion depending on the treatment of deferred tax assets.
  • The remaining funding commitment under the PSPAs ranges between $173.7 billion and $68.0 billion. (3)

FHFA Scenarios

  • In the FHFA scenarios, cumulative, combined Treasury draws at the end of 2015 remain unchanged at $187.5 billion as neither Enterprise requires additional Treasury draws in any of the three scenarios.
  • The combined remaining commitment under the PSPAs is unchanged at $258.1 billion.
  • In the three scenarios the Enterprises pay additional senior preferred dividends to the US Treasury ranging between $54.0 billion to $36.3 billion. (3)

There are a number of important points to keep in mind when reviewing this report. First, it addresses just four scenarios out of the the multitude of possible ones. But hopefully the Severely Adverse Scenario gives us a sense of the outer limits of what a crisis could do to the Enterprises and the taxpayers who backstop them.

Second, the report is another corrective to arguments that the federal government’s bailout of the Enterprises can be measured by the amount of money that they actually advanced to the two companies, as opposed to a measure that also accounts for the additional amount that the federal government is committed to provide them if their financial situation takes a turn for the worse.

Finally, as I have noted before, there is an important political battle for control of the narrative of the bailout of the Enterprises. The only narrative during the crisis itself was that the federal government bailed out the two companies because they were insolvent. Revisionist histories, put forward in the main by private shareholders of the two Enterprises, challenge that narrative. The shareholders put forth another version of history: the federal government effectively stole  solvent, viable Fannie and Freddie from them. It will be important for objective third parties to document the truth about this in accordance with Generally Accepted Accounting Principles. From my understanding of the facts, however, it is clear that the two companies were as good as dead when the federal government put them into conservatorship in 2008 and started advancing them tens of billions of dollars year after year until their fortunes turned around in 2012.

Inside Johnson-Crapo

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Enterprise Community Partners, Inc. has posted Inside Johnson-Crapo: What the Senate Housing Finance Reform Bill Could Mean for Low- and Moderate-income Communities. Parsing the various Congressional proposals for housing finance reform is hard enough for an expert, let alone for an interested observer. This policy brief provides a helpful overview of the proposal that is setting the terms for the debate today, with a focus on low- and moderate-income homeownership. Its key findings include:

  • The bill, called the Housing Finance Reform and Taxpayer Protection Act of 2014 or S. 1217, lays a clear and thoughtful path forward for the nation’s housing finance system, including the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac.
  • A new federal agency, modeled after the Federal Deposit Insurance Corporation, would oversee the entire secondary mortgage market and establish a new system of government-insured mortgage-backed securities (MBS). In exchange for a fee, the agency would provide limited insurance against catastrophic losses on qualifying securities issued by private companies. Investors in the private companies would need to incur significant losses before the insurance pays out to holders of the MBS. The bill also winds down Fannie Mae and Freddie Mac, the mortgage companies that were placed under government conservatorship in 2008.
  • The bill includes several provisions to ensure that the new system adequately serves low- and moderate-income communities. First, it requires any issuer of government-insured securities to serve all eligible single-family and multifamily mortgages. Second, it preserves the GSEs’ current businesses for financing rental housing, while ensuring that those businesses continue to support apartments that are affordable to low-income families. Third, it requires issuers to contribute funding to programs that support the creation and preservation of affordable housing. Finally, it creates new market-based incentives to serve traditionally underserved segments of the housing market.
  • Enterprise strongly supports the direction laid out in this bill and appreciates the inclusion of important multifamily provisions. At the same time, we suggest several proposals to further strengthen the bill. Among other things, we recommend that lawmakers promote a level playing field among eligible risk-sharing models; authorize the federal regulator to enforce the bill’s “equitable access” rule; expand the scope of the affordable housing fee; simplify the incentives for supporting underserved market segments; and establish separate insurance funds for single-family and multifamily securities. (1)

The left has criticized Johnson-Crapo for not doing enough for low- and moderate-income homeownership. The right has criticized it for leaving too much risk with the taxpayer. But it seems that a broad center finds that the outline provided by the bill provides a way forward from the zombie-state housing finance finds itself in, with a Fannie and Freddie neither fully alive nor fully dead. Nobody seems to think that a bill will pass this year. But hopefully Congress will keep attending to this issue and we can soon see a resurrected housing finance system, one that can take us through much of the 21st Century just as Fannie and Freddie got us through the 20th.

 

Fannie and Freddie’s Debt to Treasury

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Larry Wall of the Federal Reserve Bank of Atlanta has posted one of his Notes from the Vault, Have the Government-Sponsored Enterprises Fully Repaid the Treasury? It opens,

Have U.S. taxpayers been fully compensated for their bailout of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac? The Treasury is reported to have argued that “the value of Treasury’s commitment to the GSEs was “incalculably large,'” with the implication that it could never be repaid. Richard Epstein, the Peter and Kirsten Bedford Senior Fellow at the Hoover Institution [and who discloses that he consults “with several hedge funds with positions in Fannie and Freddie”], responded that “the level of the Treasury commitment was not ‘incalculably large’: it was $188 billion, all of which will shortly be repaid.” The significance of Epstein’s argument is that if Treasury has been fully compensated for its bailout of Fannie and Freddie, a case can be made that the future profits of the two GSEs should go to their private shareholders.

As an accounting matter, one could argue that Epstein is correct; the dividends equal the amount of Treasury funds provided to the GSEs. And as a legal matter, the issue may ultimately be resolved by the federal courts. However, as an economic matter, the value of the government’s contribution clearly exceeds $188 billion once the risk borne by taxpayers is taken into account.

In this Notes from the Vault I examine the value of the taxpayers’ contribution to Fannie and Freddie from an economic perspective. My analysis of these contributions is divided into three parts: (1) the GSEs’ profitability prior to the 2008 conservatorship agreement (bailout), (2) the value of the taxpayer promise at the time of the bailout, and (3) support of new investments since they were placed in conservatorship. (1)

The article goes on to explain each of these three parts of the taxpayers’ contribution and concludes,

The claim that the taxpayers and Treasury have been fully repaid for their support of Fannie Mae and Freddie Mac is based on an accounting calculation that does not withstand economic analysis. The claim that Treasury’s commitment has been fully repaid attributes no dividend payments to Treasury starting in 2012, attributes no value to the government guarantee to absorb whatever losses arose in the pre-conservatorship book of business, and arguably reflects Treasury setting too low of a dividend rate on its senior preferred stock. Moreover, the profits that are being used to pay the dividends did not arise from the contributions of private shareholders but rather entirely reflect risks borne by the Treasury and taxpayers. Thus, the Treasury claim that the value of the aid was “incalculable” is an exaggeration; the value surely can be fixed within reasonable bounds. However, the implication of this claim, that the GSEs cannot repay the economic value on behalf of their common shareholders, is nevertheless accurate. (2)

This article offers a useful corrective to the story one hears from those representing Fannie and Freddie’s shareholders. They have constructed a simple narrative of the bailout of the two companies that ignores the way that the two companies’ fortunes have been intrinsically tied to the federal government’s support of them. That simple narrative just nets out the monies that Treasury fronted Fannie and Freddie with the payments that the two companies made back to Treasury.  After netting the two, they say, “Case closed!” Wall has demonstrated that there are a lot more factors at play than just those two.

I would also highlight something that Wall did not: the federal government actually determines the level of profits that Fannie and Freddie can make by setting the fees the two companies charge for guaranteeing mortgages. So, the federal government could wipe away future profits by lowering the guaranty fees. And wiping away those profits would make those outstanding shares worthless.

So the question remains: what is the endgame for the investors who have brought these lawsuits?

Reiss on Fannie and Freddie Conservatorship Litigation

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I have posted An Overview of the Fannie and Freddie Conservatorship Litigation to  SSRN (and to BePress as well). The abstract reads:

The fate of Fannie Mae and Freddie Mac are subject to the vagaries of politics, regulation, public opinion, the economy, and not least of all the numerous cases that have been filed in 2013 against various government entities arising from the placement of the two companies into conservatorship. This short article will provide an overview of the last of these. The litigation surrounding Fannie and Freddie’s conservatorship raises all sorts of issues about the federal government’s involvement in housing finance. These issues are worth setting forth as the proper role of these two companies in the housing finance system is still very much up in the air. The plaintiffs, in the main, argue that the federal government has breached its duties to preferred shareholders, common shareholders, and potential beneficiaries of a housing trust fund authorized by the same statute that authorized their conservatorships. At this early stage, it appears that the plaintiffs have a tough row to hoe.

Federalizing Monoline Mortgage Insurance

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The Federal Insurance Office of the Department of Treasury issued a report required pursuant to Dodd-Frank, How To Modernize And Improve The System Of Insurance Regulation In The United States, which addresses among other things the state of the monoline mortgage insurance industry:

Recommendation: Federal standards and oversight for mortgage insurers should be developed and implemented.

Like financial guarantors, private mortgage insurers are monoline companies that experienced devastating losses during the financial crisis. A business predominantly focused on providing credit enhancement to mortgages guaranteed by the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac, mortgage insurers migrated from the core business of insuring conventional, well-underwritten mortgage loans to providing insurance on pools of Alt-A and subprime mortgages in the years leading up to the financial crisis. The dramatic decline in housing prices and the impact of the change in underwriting practices required mortgage insurers to draw down capital and reserves to pay claims resulting in the failure of three out of the eight mortgage insurers in the United States. Historically high levels of claim denials, including policy rescissions, helped put taxpayers at risk.

Regulatory oversight of mortgage insurance varies state by state. Though mortgage insurance coverage is provided nationally, only 16 states impose specific requirements on private mortgage insurers. Of these requirements, two govern the solvency regime and, therefore, are of particular significance: (1) a limit on total liability, net of reinsurance, for all policies of 25 times the sum of capital, surplus, and contingency reserves, (known as a 25:1 risk-to-capital ratio); and (2) a requirement of annual contributions to a contingency reserve equal to 50 percent of the mortgage insurer’s earned premium. In addition to the states, the GSEs (and through conservatorship, the Federal Housing Finance Agency) establish uniform standards and eligibility requirements that in some cases are more stringent than those required by state regulators. As the financial crisis unfolded, mortgage insurers no longer met state or contractual capital requirements. State regulators granted waivers in order to allow mortgage insurers to continue to write new business while the GSEs loosened other standards that were applicable to mortgage insurers.

The private mortgage insurance sector is interconnected with other aspects of the federal housing finance system and, therefore, is an issue of significant national interest. As the United States continues to recover from the financial crisis and works to reform aspects of the housing finance system, private mortgage insurance may be an important component of any reform package as an alternative way to place private capital in front of any government or taxpayer risk. Robust national solvency and business practice standards, with uniform implementation, for mortgage insurers would help foster greater confidence in the solvency and performance of housing finance. To achieve this objective, it is necessary to establish federal oversight of federally developed standards applicable to mortgage insurance. (31-32)

This critique of the monoline insurance industry seems accurate to me. The industry has a tendency to fail when it is needed most — during major financial crises. Having multiple states regulate monoline insurers allows this nationally (and globally) significant industry to engage in regulatory arbitrage — that is, finding the most pliable regulatory environment in which to operate. National regulation would solve that problem. As always, a single federal regulator is more prone to capture by the industry it regulates than a bunch of state regulators. We have, however, tried the alternative and it has not worked so well. I think a federal approach is worth a try.

Reiss on Cases To Watch In 2014

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Law360 quoted me in Real Estate Cases To Watch In 2014. The story reads in part,

The real estate market’s recovery from the financial crisis of the past few years has created a host of new issues — from contract disputes to eminent domain litigation — for government lenders, developers and investors to litigate in 2014.

Real estate finance attorneys are paying close attention to an expected rise in judicial scrutiny of banks’ ownership of loans, while also closely watching the multitude of cases that have been brought against the U.S. government and its handling of profits made by Fannie Mae and Freddie Mac.

At the same time, development attorneys are tuned in to how an increase in construction in gateway cities might soon lead to more litigation over land use and eminent domain.

Here are some of the most important cases and trends real estate attorneys are watching closely:

Challenges to Allocation of Fannie and Freddie Profits

A collection of cases making their way through the Washington, D.C., federal court and the Court of Federal Claims challenge the government’s taking of all of the profits from Fannie Mae and Freddie Mac and directing them toward the U.S. Department of the Treasury.

Two of the most-watched cases were brought by hedge funds Perry Capital LLC and Fairholme Capital Management LLC, the latter of which has since offered to purchase the government-sponsored entities’ insurance businesses.

Perry Capital accused the Treasury in July of illegally speeding up the GSEs’ liquidation, entitling the government to all of their mounting profits and essentially “extinguishing” privately held securities, according to the complaint filed in Washington federal court.

Fairholme made a similar claim in the Court of Federal Claims two days later, alleging that the government had acted unconstitutionally when it altered its bailout deal for the GSEs to keep the companies’ profits for itself.

“The universe of cases impacting the current operation of Fannie and Freddie is very important from a policy perspective, and it’s also an interesting battle between hedge funds and the government,” said David Reiss, a professor at Brooklyn Law School.

There will likely be a flurry of motions to dismiss and requests for summary judgment on all sides in these cases 2014, but from the perspective of a real estate attorney, the policy implications will be more interesting than the precedential value of any decisions, he said.

A hearing on defendants’ dispositive motions and plaintiffs’ cross motions has been set for June 23 in the Washington cases.

Perry Capital is represented by Theodore B. Olson, Janet Weiss, Douglas Cox, Matthew McGill, Nikesh Jindal and Derek Lyons of Gibson Dunn. The case is Perry Capital LLC v. Lew et al., case number 1:13-cv-01025, in the U.S. District Court for the District of Columbia.

Fairholme is represented by Charles J. Cooper, Vincent J. Colatriano, David H. Thompson and Peter A. Patterson of Cooper & Kirk PLLC. That case is Fairholme Funds Inc. v. U.S., case number 1:13-cv-00465, in the U.S. Court of Federal Claims.