Tag Archives: Treasury

The Rescue of Fannie and Freddie

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Federal Reserve researchers, W. Scott Frame, Andreas Fuster, Joseph Tracy and James Vickery, have posted a staff report, The Rescue of Fannie Mae and Freddie Mac. The abstract reads,

We describe and evaluate the measures taken by the U.S. government to rescue Fannie Mae and Freddie Mac in September 2008. We begin by outlining the business model of these two firms and their role in the U.S. housing finance system. Our focus then turns to the sources of financial distress that the firms experienced and the events that ultimately led the government to take action in an effort to stabilize housing and financial markets. We describe the various resolution options available to policymakers at the time and evaluate the success of the choice of conservatorship, and other actions taken, in terms of five objectives that we argue an optimal intervention would have fulfilled. We conclude that the decision to take the firms into conservatorship and invest public funds achieved its short-run goals of stabilizing mortgage markets and promoting financial stability during a period of extreme stress. However, conservatorship led to tensions between maximizing the firms’ value and achieving broader macroeconomic objectives, and, most importantly, it has so far failed to produce reform of the U.S. housing finance system.

 This staff report provides a nice overview of the two companies since the financial crisis. I was particularly interested by a couple of sections. First, I found the discussion of receivership versus conservatorship helpful. Second, I liked how it outlined the five objectives for an optimal intervention:

(i) Fannie Mae and Freddie Mac would be enabled to continue their core securitization and guarantee functions as going concerns, thereby maintaining conforming mortgage credit supply.

(ii) The two firms would continue to honor their agency debt and mortgage-backed securities obligations, given the amount and widely held nature of these securities, especially in leveraged financial institutions, and the potential for financial instability in case of default on these obligations.

(iii) The value of the common and preferred equity in the two firms would be extinguished, reflecting their insolvent financial position.

(iv) The two firms would be managed in a way that would provide flexibility to take into account macroeconomic objectives, rather than just maximizing the private value of their assets.

(v) The structure of the rescue would prompt long-term reform and set in motion the transition to a better system within a reasonable period of time. (14-15)

You’ll have to read the paper to see how they evaluate the five objectives in greater detail.

Another Fannie/Freddie Bailout?

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The Federal Housing Finance Agency Office of the Inspector General has issued a White Paper Report, The Continued Profitability of Fannie Mae and Freddie Mac Is Not Assured. The Executive Summary opens,

Fannie Mae and Freddie Mac (collectively, the Enterprises) returned to profitability in 2012 after successive years of losses. Their improved financial performance is encouraging; however, their continued profitability is not assured. The mortgage industry is complex, cyclical, and sensitive to changes in economic conditions, mortgage rates, house prices, and other factors. The Enterprises have acknowledged in their public disclosures that adverse market and other changes could lead to additional losses and that their financial results are subject to significant variability from period to period.

Notwithstanding the Enterprises’ recent positive financial results, they face many challenges. For example:

  The Enterprises must reduce the size of their retained investment portfolios over the next few years pursuant to the terms of agreements with the U.S. Department of Treasury (Treasury) and additional limits from FHFA. Declines in the size of these portfolios will reduce portfolio earnings over the long term. These portfolios have been the Enterprises’ largest source of earnings in the past.

  Core earnings from the Enterprises’ business segments—single-family guarantee, multifamily, and investments—comprised only 40% of net income in 2013. Sixty percent of the Enterprises’ net income came from non-recurring tax-related items and large settlements of legal actions and business disputes, which are not sustainable sources of revenue. Core earnings comprised 55% of net income in 2014.

  The Enterprises are unable to accumulate a financial cushion to absorb future losses. Pursuant to the terms of agreements with Treasury, the Enterprises are required to pay Treasury each quarter a dividend equal to the excess of their net worth over an applicable capital reserve amount. The applicable capital reserve amount decreases to zero by January 1, 2018.

  Stress test results released by the Federal Housing Finance Agency (FHFA) in April 2014 indicate that the Enterprises, under the worst scenario—a scenario generally akin to the recent financial crisis— would require additional Treasury draws of either $84.4 billion or $190 billion, depending on the treatment of deferred tax assets, through the end of the stress test period, which is the fourth quarter of 2015.

  Absent Congressional action, or a change in FHFA’s current strategy, the conservatorships will go on indefinitely. The Enterprises’ future status is beyond their control. At present, it appears that Congressional action will be needed to define what role, if any, the Enterprises play in the housing finance system. (1-2)

While I am overall sympathetic to the underlying message of this white paper — Reform Fannie and Freddie Now! — I think it is somewhat misleading. Fannie and Freddie have been sending billions of dollars to the Treasury that exceed the amount of support that they received during the financial crisis. Before we could talk about a second taxpayer bailout, I think we would have to credit them with those excess payments.

That being said, the Obama Administration and Congress have left Fannie and Freddie to linger for far too long in conservatorship limbo. I have no doubt that this state of affairs will contribute to some kind of crisis for the two companies, so we should support some kind of exit strategy that gets implemented sooner rather than later. Inaction is the greatest threat to Fannie and Freddie, and to the housing finance system itself.

Friday Government Report Roundup

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Treasury Gives RMBS a Workout

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The Treasury has undertaken a Credit Rating Agency Exercise. According to Michael Stegman, Treasury

recognized that the PLS market has been dormant since the financial crisis partly because of a “chicken-and-egg” phenomenon between rating agencies and originator-aggregators. Rating agencies will not rate mortgage pools without loan-level data, yet originator-aggregators will not originate pools of mortgage bonds without an idea of what it would take for the bond to receive a AAA rating.

Using our convening authority, Treasury invited six credit rating agencies to participate in an exercise over the last several months intended to provide market participants with greater transparency into their credit rating methodologies for residential mortgage loans.

By increasing clarity around loss expectations and required subordination levels for more diverse pools of collateral, the credit rating agencies can stimulate a constructive market dialogue around post-crisis underwriting and securitization practices and foster greater confidence in the credit rating process for private label mortgage-backed securities (MBS). The information obtained through this exercise may also give mortgage originators and aggregators greater insight into the potential economics of financing mortgage loans in the private label channel and the consequent implications for borrowing costs.

While this exercise is very technical, it contains some interesting nuggets for a broad range of readers. For instance,

The housing market, regulatory environment, and loan performance have evolved significantly from pre-crisis to present day. Credit rating agency models appear to account for these changes in varying ways. All credit rating agency models incorporate the performance of loans originated prior to, during, and after the crisis to the degree they believe best informs the nature of credit and prepayment risk reflected in the market. Credit rating agency model stress scenarios may be influenced by loans originated at the peak of the housing market, given the macroeconomic stress and home price declines they experienced. The credit rating agencies differ, however, in how their models adjust for the post-crisis regime of improved underwriting practices and operational controls. Some credit rating agencies capture these changes directly in their models, while other credit rating agencies rely on qualitative adjustments outside of their models. (10)

It is important for non-specialists to realize how much subjectivity can be built into rating agency models. Every model will make inferences based on past performance. The exercise highlights how different rating agencies address post-crisis loan performance in significantly different ways. Time will tell which ones got it right.

Reiss on $191B for Fannie & Freddie

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GlobeSt.com quoted me in About that $191B Profit from the GSEs. It opens,

Last week when the White House released its budget for fiscal year

2016, it included one eyebrow-raising line item: it assumed that Fannie Mae and Freddie Mac could return $191.2 billion in profits to the US Treasury over the next decade if they continue operating under federal conservatorship.

The item gave the commercial real estate industry pause for a few reasons. This number 1) assumes the GSEs will remain under federal conservatorship 2) it assumes that the lawsuits filed by GSE shareholders disgruntled by the government’s decision to sweep all profits from the GSEs back to the US Treasury will go nowhere 3) it assumes the GSEs will continue to bring in record profits.

Of all of these, the latter supposition is the least controversial.

The two GSEs have paid back more than what their received in federal aid; Fannie Mae has sent back the government $134.5 billion in payments compared to $116.1 billion it received, while Freddie Mac has sent $91 billion compared to $72.3 billion it received in rescue funds.

This cash flow is one reason why some in the industry quietly speculate that the government has little intention of cutting the GSEs loose to be privatized—despite the stated intention of the Obama Administration to do so.

Also, consider that the government can basically set the GSEs’ profit levels, David Reiss, professor of Law and research director for the Center for Urban Business Entrepreneurship at Brooklyn Law School, tells GlobeSt.com.

“Their regulator, the Federal Housing Finance Agency, sets the amount of their guarantee fee. If the FHFA raises it, it tends to raise profits for the two companies,” he notes.

The FHFA also sets, within limits, the types of mortgages the GSEs can buy, thereby increasing the size of the total market and the market share of the two entities, Reiss continues. “For instance, the FHFA recently lowered the down payment requirements for Fannie/Freddie loans. This action will increase the total number of loans made and will also increase Fannie and Freddie’s market share because they can now operate in a part of the market that had been off limits.”

The GSE Litigation Footnote Everyone Is Talking About

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Judge Pratt (S.D.Iowa) ruled against the plaintiffs in the GSE shareholderr litigation, Continental Western Insurance Company v. The FHFA et al. (4:14-cv-00042, Feb. 3, 2015). The Judge’s order is mostly an analysis of why this case should be dismissed because of the doctrine of issue preclusion, which bars “‘successive litigation of an issue of fact or law actually litigated and resolved in a valid court determination essential to the prior judgment . . .'” (6, quoting Supreme Court precedent). The relevant prior judgment was Judge Lamberth’s (D.D.C.) opinion in a similar case that was decided last October.

While Judge Pratt did not reach the merits because he dismissed the case, he stated in a footnote

The Court notes that even if it were to reach the merits of Continental Western’s claims, including the allegedly new claims, it would agree with the well-reasoned opinion of the very able Judge Lamberth in Perry Capital that the case must be dismissed. Specifically the Court agrees that: (1) FHFA and Treasury did not act outside the power granted to them by HERA (see Perry Capital, 2014 WL 4829559 at *8–12); (2) HERA bars Continental Western’s claims under the APA (see id. at *7); (3) Continental Western’s claims for monetary damages based on a breach of contract and breach of the implied covenant of good faith and fair dealing against FHFA must be dismissed because they are not ripe and because Continental Western’s shares of the GSEs do not contractually guarantee them a right to dividends (see id. at *15–19); and (4) Continental Western’s claim for breach of fiduciary duty by FHFA is barred by HERA because it is a derivative claim and HERA grants all shareholder rights, including the right to bring a derivative suit, to FHFA (see id. at *13–15). The Court shares in Judge Lamberth’s observation that “[i]t is understandable for the Third Amendment, which sweeps nearly all GSE profits to Treasury, to raise eyebrows, or even engender a feeling of discomfort.” Perry Capital, 2014 WL 4829559 at *24. But it is not the role of this Court to wade into the merits or motives of FHFA and Treasury’s actions—rather the Court is limited to reviewing those actions on their face and determining if they were permissible under the authority granted by HERA. (19, n.6)

As I have noted before, this is not a surprising result. What remains surprising is how so many analysts refuse to see how these cases might be decided this way.

This is not to say that the plaintiffs’ cases are dead in the water. Appeals courts may reach a different result from those of the trial courts. But so many of those writing on this topic refuse to see any result other than a win for plaintiffs. Time for a reality check.

Krimminger and Calabria on Conservatorships

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When the Federal Housing Finance Agency (“FHFA”) was appointed conservator for Fannie Mae and Freddie Mac, it was the first use of the conservatorship authority under the Housing and Economic Recovery Act of 2008 (“HERA”), but it was not without precedent. For decades, the Federal Deposit Insurance Corporation (“FDIC”) has successfully and fairly resolved more than a thousand failing banks and thrifts using the virtually identical sections of the Federal Deposit Insurance Act (“FDIA”).
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The predictability, fairness, and acceptance of this model led Congress to adopt it as the basis for authorizing the FHFA with conservatorship powers over Fannie Mae and Freddie Mac in HERA. Instead of following this precedent, however, FHFA and Treasury have radically departed from HERA and the principles underlying all other U.S. insolvency frameworks and sound international standards through a 2012 re-negotiation of the original conservatorship agreement.
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     This paper will:
  • Describe the historical precedent and resolution practice on which Congress based FHFA’s and Treasury’s statutory responsibilities over Fannie Mae and Freddie Mac;
  • Explain the statutory requirements, as well as the procedural and substantive protections, in place so that all stakeholders are treated fairly during the conservatorship;
  • Detail the important policy reasons that underlie these statutory provisions and the established practice in their application, and the role these policies play in a sound market economy; and
  •  Demonstrate that the conservatorships of Fannie Mae and Freddie Mac ignore that precedent and resolution practice, and do not comply with HERA. Among the Treasury and FHFA departures from HERA and established precedents are the following:
    • continuing the conservatorships for more than 6 years without any effort to comply with HERA’s requirements
      to “preserve and conserve” the assets and property of the Companies and return them to a “sound and solvent” condition or place them into receiverships;
    • rejecting any attempt to rebuild the capital of Fannie Mae or Freddie Mac so that they can return to “sound and solvent” condition by meeting regulatory capital and other requirements, and thereby placing all risk of future losses on taxpayers;
    • stripping all net value from Fannie Mae and Freddie Mac long after Treasury has been repaid when HERA, and precedent, limit this recovery to the funding actually provided;
    • ignoring HERA’s conservatorship requirements and transforming the purpose of the conservatorships from restoring or resolving the Companies into instruments of government housing policy and sources of revenue for
      Treasury;
    • repeatedly restructuring the terms of the initial assistance to further impair the financial interests of stakeholders contrary to HERA, fundamental principles of insolvency, and initial commitments by FHFA; and
    • disregarding HERA’s requirement to “maintain the corporation’s status as a private shareholder-owned company” and FHFA’s commitment to allow private investors to continue to benefit from the financial value of the company’s stock as determined by the market. (1-3, footnotes omitted)

I am intrigued by the recollections of these two former government officials who were involved in the drafting of HERA (much as I was by those contained in a related paper by Calabria). But I am not convinced that their version of events amounts to a legislative history of HERA, let alone one that should be given any kind of deference by decision-makers. The firmness of their opinions about the meaning of HERA is also in tension with the ambiguity of the text of the statute itself. The plaintiffs in the GSE conservatorship litigation will see this paper as a confirmation of their position. I do not think, however, that the judges hearing the cases will pay it much heed.