GSE Shareholders Floored, Again

The United States Court of Appeals for the Eighth Circuit issued an opinion in Saxton v. FHFA (No. 17-1727, Aug. 23, 2018). The Eighth Circuit joins the Fifth, Sixth, Seventh and D.C. Circuits in rejecting the arguments of Fannie and Freddie shareholders that the Federal Housing Finance Agency exceeded its authority as conservator of Fannie Mae and Freddie Mac and acted arbitrarily and capriciously. The Court provides the following overview:

     The financial crisis of 2008 prompted Congress to take several actions to fend off economic disaster. One of those measures propped up Fannie Mae and Freddie Mac. Fannie and Freddie, which were founded by Congress back in 1938 and 1970, buy home mortgages from lenders, thereby freeing lenders to make more loans. See generally 12 U.S.C. § 4501. Although established by Congress, Fannie and Freddie operate like private companies: they have shareholders, boards of directors, and executives appointed by those boards. But Fannie and Freddie also have something most private businesses do not: the backing of the United States Treasury. 

     In 2008, with the mortgage meltdown at full tilt, Congress enacted the Housing and Economic Recovery Act (HERA or the Act). HERA created the Federal Housing Finance Agency (FHFA), and gave it the power to appoint itself either conservator or receiver of Fannie or Freddie should either company become critically undercapitalized. 12 U.S.C. § 4617(a)(2), (4). The Act includes a provision limiting judicial review: “Except as  provided in this section or at the request of the Director, no court may take any action to restrain or affect the exercise of powers or functions of the [FHFA] as a conservator or a receiver.” Id. § 4617(f). 

     Shortly after the Act’s passage, FHFA determined that both Fannie and Freddie were critically undercapitalized and appointed itself conservator. FHFA then entered an agreement with the U.S. Department of the Treasury whereby Treasury would acquire specially-created preferred stock and, in exchange, would make hundreds of billions of dollars in capital available to Fannie and Freddie. The idea was that Fannie and Freddie would exit conservatorship when they reimbursed the Treasury.

     But Fannie and Freddie remain under FHFA’s conservatorship today. Since the conservatorship began, FHFA and Treasury have amended their agreement several times. In the most recent amendment, FHFA agreed that, each quarter, Fannie and Freddie would pay to Treasury their entire net worth, minus a small buffer. This so-called “net worth sweep” is the basis of this litigation. 

     Three owners of Fannie and Freddie common stock sued FHFA and Treasury, claiming they had exceeded their powers under HERA and acted arbitrarily and capriciously by agreeing to the net worth sweep. The shareholders sought only an injunction setting aside the net worth sweep; they dismissed a claim seeking money damages. Relying on the D.C. Circuit’s opinion in Perry Capital LLC v. Mnuchin, 864 F.3d 591 (D.C. Cir. 2017), the district court dismissed the suit.

What amazes me as a longtime watcher of the GSE litigation is how supposedly dispassionate investors lose their heads when it comes to the GSE lawsuits. They cannot seem to fathom that judges will come to a different conclusion regarding HERA’s limitation on judicial review.

While I do not rule out that the Supreme Court could find otherwise, particularly if Judge Kavanaugh is confirmed, it seems like this unbroken string of losses should provide some sort of wake up call for GSE shareholders. But somehow, I doubt that it will.

The FHFA’s Take on Housing Finance Reform

FHFA Director Watt

Federal Housing Finance Agency Director Watt sent Federal Housing Finance Agency Perspectives on Housing Finance Reform to Senate Banking Chair Michael Crapo (R-ID) and Senator Sherrod Brown of Ohio, the top Democrat on that committee. There are no real surprises in it, but it does set forth a series of housing finance objectives that the FHFA supports:

• Preserve the 30-year fixed-rate, prepayable mortgage;

• End taxpayer bailouts for failing firms;

• Maintain liquidity in the housing finance market;

• Attract significant amounts of private capital to the center of the housing finance system through both robust equity capital requirements and credit risk transfer (CRT) participation;

• Provide for a single government-guaranteed mortgage-backed security that will improve the liquidity of the to-be-announced (TBA) market and promote a fair and competitive funding market for Secondary Market Entities (SMEs);

• Ensure access to affordable mortgages for creditworthy borrowers, sustainable rental options for families across income levels, and a focus on serving rural and other underserved markets;

• Provide a level playing field for institutions of all sizes to access the secondary market;

• Include tools for the regulator to anticipate and mitigate downturns in the housing market, including setting appropriate capital and liquidity requirements for SMEs, having prompt, corrective action authority for SMEs that are weak or troubled, and having authority to adjust CRT requirements as needed; and

• Provide a stable transition path that protects the housing finance market and the broader economy from potential disruptions and ensures that the new housing finance system operates as intended. (1)

The FHFA’s take on housing finance reform seems to be somewhat different from what various members of Congress are reportedly promoting. It is not clear though that the views of the FHFA are all that relevant to the Congressional leaders who are shaping the next housing finance reform bill. Nor do I expect that Director Watt’s views are particularly valued by the Trump Administration, given that he is a former Democratic member of Congress. That being said, Director Watt has always made it clear that it is Congress and not the FHFA that should be charting the path forward for housing finance reform.

While his views on the matter differ from those of some members of Congress, all of the relevant stakeholders seem to agree on the broad contours of what the 21st century’s housing finance infrastructure should look like. There should be an explicit guarantee to support the housing market during liquidity crises.  And the main elements of the current market, such as the thirty year fixed-rate mortgage, should be maintained. Here’s hoping that a bipartisan push can get this done this year.

Fannie and Freddie Visit the Supreme Court

Justice Gorsuch

Fannie and Fredddie investors have filed their petition for a writ of certiorari in Perry Capital v. Mnuchin. The question presented is

Whether 12 U.S.C. § 4617(f), which prohibits courts from issuing injunctions that “restrain or affect the exercise of powers or functions of” the Federal Housing Finance Agency (“FHFA”) “as a conservator,” bars judicial review of an action by FHFA and the Department of Treasury to seize for Treasury the net worth of Fannie Mae and Freddie Mac in perpetuity. (i)

What I find interesting about the brief is that relies so heavily on the narrative contained in Judge Brown’s dissent in the Court of Appeals decision. As I had noted previously, I do not find that narrative compelling, but I believe that some members of the court would, particularly Justice Gorsuch. The petition’s statement reads in part,

In August 2012—nearly four years after the Federal Housing Finance Agency (“FHFA”) placed Fannie Mae and Freddie Mac1 in conservatorship during the 2008 financial crisis—FHFA, acting as conservator to the Companies, agreed to surrender each Company’s net worth to the Treasury Department every quarter. This arrangement, referred to as the “Net Worth Sweep,” replaced a fixed-rate dividend to Treasury that was tied to Treasury’s purchase of senior preferred stock in the Companies during the financial crisis. FHFA and Treasury have provided justifications for the Net Worth Sweep that, as the Petition filed by Fairholme Funds, Inc. demonstrates, were pretextual. The Net Worth Sweep has enabled a massive confiscation by the government, allowing Treasury thus far to seize $130 billion more than it was entitled to receive under the pre-2012 financial arrangement—a fact that neither Treasury nor FHFA denies. As was intended, these massive capital outflows have brought the Companies to the edge of insolvency, and all but guaranteed that they will never exit FHFA’s conservatorship.

Petitioners here, investors that own preferred stock in the Companies, challenged the Net Worth Sweep as exceeding both FHFA’s and Treasury’s respective statutory powers. But the court of appeals held that the Net Worth Sweep was within FHFA’s statutory authority, and that keeping Treasury within the boundaries of its statutory mandate would impermissibly intrude on FHFA’s authority as conservator.

The decision of the court of appeals adopts an erroneous view of conservatorship unknown to our legal system. Conservators operate as fiduciaries to care for the interests of the entities or individuals under their supervision. Yet in the decision below, the D.C. Circuit held that FHFA acts within its conservatorship authority so long as it is not actually liquidating the Companies. In dissent, Judge Brown aptly described that holding as “dangerously far-reaching,” Pet.App. 88a, empowering a conservator even “to loot the Companies,” Pet.App. 104a.

The D.C. Circuit’s test for policing the bounds of FHFA’s statutory authority as conservator—if one can call it a test at all—breaks sharply from those of the Eleventh and Ninth Circuits, which have held that FHFA cannot evade judicial review merely by disguising its actions in the cloak of a conservator. And it likewise patently violates centuries of common-law understandings of the meaning of a conservatorship, including views held by the Federal Deposit Insurance Corporation (“FDIC”), whose conservatorship authority under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (“FIRREA”), served as the template for FHFA’s own conservatorship authority. Judge Brown correctly noted that the decision below thus “establish[es] a dangerous precedent” for FDIC-regulated financial institutions with trillions of dollars in assets. Pet.App. 109a. If the decision below is correct, then the FDIC as conservator could seize depositor funds from one bank and give them away—to another institution as equity, or to Treasury, or even to itself—as long as it is not actually liquidating the bank. The notion that the law permits a regulator appointed as conservator to act in a way so manifestly contrary to the interests of its conservatee is deeply destabilizing to our financial regulatory system. (1-2)

We shall see if this narrative of government overreach finds a sympathetic ear at the Court.

FHFA’s Strategic Plan for Fannie and Freddie

The Federal Housing Finance Agency released its Strategic Plan for fiscal years 2018-2022 for public input. As discussed in yesterday’s post, Director Watt is very focused on maintaining the health of Fannie Mae and Freddie Mac. The Strategic Plan reiterates that focus:

As conservator of the Enterprises, FHFA will also promote stability by working to preserve and conserve the Enterprises’ assets and business operations. Additionally, FHFA will encourage the Enterprises and the housing industry to adopt standards and practices that promote market and stakeholder confidence. (8)

The Plan goes into depth to describe the FHFA’s role as conservator:

The Enterprises were placed into conservatorships in September 2008 in the midst of a severe financial crisis. Their ongoing participation in the housing finance market has been an important factor in maintaining market liquidity and stability. Conservatorship permitted the U.S. Government to take greater control over management of the Enterprises and gave investors in the Enterprises’ debt and MBS confidence that the Enterprises would have the capacity to honor their financial obligations. As conservator, FHFA establishes restrictions and expectations for the Enterprises’ boards and for their managements while authorizing them to conduct the Enterprises’ day-to-day operations.

As detailed earlier, FHFA’s authority as both regulator and conservator of the Enterprises is based upon statutory mandates. FHFA, acting as regulator and conservator, must follow the mandates assigned to it by statute and the missions assigned to the Enterprises by their charters. Congress may choose to revise the statutory mandates governing the Enterprises at any time.

*      *     *

The Enterprises are also parties to PSPAs with the Treasury Department. Under the PSPAs, the Enterprises are provided U.S. taxpayer backing with explicit dollar limits. The PSPA commitment still available to Fannie Mae is $117.6 billion and the commitment still available to Freddie Mac is $140.5 billion. Additional draws would reduce these commitments, and dividend payments do not replenish or increase the commitments under the terms of the PSPAs. Starting in 2013, the PSPAs provided each Enterprise with a capital buffer of $3 billion to protect each Enterprise against making additional draws of taxpayer support in the event of an operating loss in any quarter, and the PSPAs provide mandated declines of $600 million each year to these capital buffers. On January 1, 2017, each Enterprise’s capital buffer declined to $600 million and the capital buffer is scheduled to decline to zero on January 1, 2018.

FHFA continues to encourage Congress to complete the important work of housing finance reform. FHFA has reiterated the urgency of reform and that it is up to Congress to determine what future, if any, the Enterprises will have in the future housing finance system. (16-17)

Reading between the lines, I see the FHFA under Watt doing whatever it has to in order to maintain stability and liquidity in the mortgage markets. If Congress does not act, if the Treasury does not act, I think that Director Watt will go it alone and do what it takes to maintain Fannie and Freddie’s reputation with mortgage lenders and MBS investors.

Watt’s Happening with Fannie and Freddie?

FHFA Director Watt

Federal Housing Finance Agency Director Watt testified before the House Committee on Financial Services today and gave a good overview of the decade-long conservatorship of Fannie and Freddie.  He also gave some sense of the urgency of coming up with at least a stopgap measure before the two companies’ capital buffer drops to zero at the end of the year pursuant to the terms of the Senior Preferred Stock Purchase Agreements (PSPAs) that govern the two companies’ relationship with the Treasury. He stated that it would

be a serious misconception for members of this Committee, or for anyone else, to consider any actions FHFA may take as conservator to avoid additional draws of taxpayer support either as interference with the prerogatives of Congress, as an effort to influence the outcome of housing finance reform, or as a step toward recap and release. FHFA’s actions would be taken solely to avoid a draw during conservatorship.

This signifies to me that he is planning on doing something other than reducing the capital buffer to $0.  As far as I can tell, Watt is playing a game of chicken with Congress — if you do not act, I will.

It is not clear to me clear how much authority Watt has or thinks he has to change the rules relating to the capital buffer. Does he think that he could act inconsistent with the PSPAa and withhold capital?  I have not seen a legal argument that says he could.  Is he willing to do it and be sued by Treasury?  These are speculative questions, but I do think that he has laid the groundwork for taking action if Congress and Treasury do not.

It does not seem to me that he was much wiggle room according to the terms of the PSPAs themselves, except perhaps to delay making the net worth sweep at the end of this year by converting it to an annual sweep or by some other mechanism.  That will be a short-term fix.

Given his strong language — “FHFA’s actions would be taken solely to avoid a draw during conservatorship” — I think he might be prepared to take an action that is inconsistent with the plain language of the PSPAs in order to act in a way that he thinks is consistent with his duty as the conservator.  This is less risky than it sounds because the only party that would seem to have standing to sue would be the Treasury, the counter-party to the PSPAs.  One could imagine that the Treasury would prefer to negotiate a response with the FHFA or await Watt’s departure rather than to have a judge decide the issue.  One could also imagine that Treasury would go along with the FHFA without explicitly condoning its actions, particularly if its actions soothed a turbulent market for Fannie and Freddie mortgage-backed securities.

Watt has consistently signaled that he will act if no other responsible party does and he emphasized that again today.

This Is What GSE Reform Looks Like

Scene from Young Frankenstein

The Federal Housing Finance Agency’s Division of Conservatorship release an Update on Implementation of the Single Security and the Common Securitization Platform. As I had discussed last week, housing finance reform is proceeding apace from within the FHFA notwithstanding assertions by members of Congress that they will take the lead on this. The Update provides some background for the uninitiated:

The Federal Housing Finance Agency’s (FHFA) 2014 Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac includes the strategic goal of developing a new securitization infrastructure for Fannie Mae and Freddie Mac (the Enterprises) for mortgage loans backed by 1- to 4-unit (single-family) properties. To achieve that strategic goal, the Enterprises, under FHFA’s direction and guidance, have formed a joint venture, Common Securitization Solutions (CSS). CSS’s mandate is to develop and operate a Common Securitization Platform (CSP or platform) that will support the Enterprises’ single-family mortgage securitization activities, including the issuance by both Enterprises of a common single mortgage-backed security (to be called the Uniform Mortgage-Backed Security or UMBS). These securities will finance the same types of fixed-rate mortgages that currently back Enterprise-guaranteed securities eligible for delivery into the “To-Be-Announced” (TBA) market. CSS is also mandated to develop the platform in a way that will allow for the integration of additional market participants in the future.

The development of and transition to the new UMBS constitute the Single Security Initiative. FHFA has two principal objectives in undertaking this initiative. The first objective is to establish a single, liquid market for the mortgage-backed securities issued by both Enterprises that are backed by fixed-rate loans. The second objective is to maintain the liquidity of this market over time. Achievement of these objectives would further FHFA’s statutory obligation and the Enterprises’ charter obligations to ensure the liquidity of the nation’s housing finance markets. The Single Security Initiative should also reduce the cost to Freddie Mac and taxpayers that has resulted from the historical difference in the liquidity of Fannie Mae’s Mortgage-Backed Securities (MBS) and Freddie Mac’s Participation Certificates (PCs). (1, footnote omitted)

This administratively-led reform of Fannie and Freddie is not necessarily a bad thing, particularly because the executive and legislative branches have not taken up reform in any serious way since the two companies entered conservatorship in 2008. While Congress could certainly step up to the plate now, it is worth understanding just how far along the FHFA is in its transformation of the two companies:

Upon the implementation of Release 2, CSS will be responsible for bond administration of approximately 900,000 securities, which are backed by almost 26 million home loans having a principal balance of over $4 trillion. CSS’S responsibilities related to security issuance, security settlement, bond administration and disclosures were described in the September 2015 Update on the Common Securitization Platform. The Enterprises and investors, along with home owners and taxpayers, will rely on the operational integrity and resiliency of the CSP to ensure the smooth functioning of the U.S. housing mortgage market. (8)

That is, upon the implementation of Release 2, the merger of Fannie and Freddie into Frannie will be complete.

Fannie + Freddie = Frannie

The Federal Housing Finance Agency released its 2016 Scorecard Progress Report. It contains some interesting information about the FHFA’s ongoing efforts to reshape Fannie and Freddie notwithstanding the inaction of Congress. These efforts are not broadcast very clearly, but they are documented nonetheless:

Maintaining a high degree of uniformity in the prepayment speeds of the Enterprises’ mortgage-backed securities is important to the success of the Single Security Initiative. Accordingly, the 2016 Scorecard called for the Enterprises to assess new or revised Enterprise programs, policies, and practices for their effect on the cash flows of mortgage-backed securities eligible for financing through TBA market.

In July 2016, FHFA published An Update on Implementation of the Single Security and the Common Securitization Platform (July 2016 Update), which included a description of specific steps FHFA would take and steps FHFA would require the Enterprises to take to ensure the continued convergence of prepayment speeds across the Enterprises’ mortgage-backed securities. The July 2016 Update indicated that each Enterprise would be required to submit for FHFA review any proposed changes the Enterprise believed could have a measureable effect on the prepayment rates and performance of TBA-eligible securities, including its analysis of any effects on prepayment speeds and/or removals of delinquent mortgage loans from securities under a range of scenarios. In addition, FHFA monitors Enterprise programs, policies, and practices that are initially determined to have no significant effect on prepayment rates or security performance and works with the Enterprises to address any unexpected effects as they arise. (25)

While this is all very technical stuff, it boils down to the effort of the FHFA to make Fannie and Freddie’s securities indistinguishable from each other so they can be treated as a Single Security. Once this process is completed, we will enter a new phase for the GSEs. The two companies wont really be competitors, they will be like identical twins.

Senators Corker and Warner are trying to resuscitate a housing finance reform bill, but this administrative reform is proceeding apace through ten years of Congressional inaction. The FHFA’s actions will likely limit the choices that Congress will have in very real ways, assuming Congress can ever get itself to act.

This is not necessarily a bad thing, it is just good to name it for what it is: housing finance reform implemented by an independent agency, not by a democratically elected Congress.