Update on Fannie/Freddie
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Update on Fannie/Freddie
It’s been a while since I’ve opined on the GSE’s (see Kaoboy Musings 4 - 9/30/19), so here is a quick update. Here is quick summary of recent events:
10/4/19: FHFA announces intention to hire external financial/restructuring advisors to come up with a plan for recapitalization.
10/10/19: Calabria gives interview at “Meet the Policymakers Forum” at George Mason University
10/22/19: Mnuchin/Calabria/Carson testify before the House Financial Services Committee on the future of the GSE’s
Summary of House Financial Services Committee testimony on 10/22/19
Yesterday, the House Financial Services Committee held a hearing entitled, “The End of Affordable Housing? A Review of the Trump Administration’s Plans to Change Housing Finance in America.” I listened to all 3.5 hours of committee members grilling Mnuchin, Carson and Calabria, and once again, I’m not surprised that it was 95% partisan, grandstanding “noise,” especially given the title of the hearing. In short, it was a tough crowd.
Calabria reiterated in his opening remarks that Fannie and Freddie, in their current form, would not survive another financial crisis given the lack of capital cushion. He noted that in his first 6 months as FHFA Director, he’s halved the GSEs’ leverage ratio from 1000:1 to 500:1 by allowing the combined capital cushion to expand from the razor-thin $6 bn to $45 bn (see Kaoboy Musings 4). That said, he reiterated that the entities require a lot more capital to get them capitalized similarly to banks which have 10:1 leverage ratios. Both Mnuchin and Calabria testified that the GSEs would need to (and be able to) raise significant external financing.
While both Mnuchin and Calabria testified that their first priorities were to “shore up” these entities financially, they both treaded very carefully to not appear overtly shareholder-friendly. If anything, they went the other way to assuage committee members who were hostile to the “recap and release” plan potentially enriching shareholders and hedge funds -- by repeatedly saying that no decisions have yet been made regarding the method of resolution, i.e. recap and release out of conservatorship or exit via receivership.
I believe this mention of “receivership,” however alarming it sounds, is nothing more than a red herring. The comment that the alarmist financial press latched onto was Calabria’s statement that “if circumstances present [themselves] where we have to wipe out shareholders, we will.” Yet what all of the media/sell-side analysts seem to have already forgotten is that one of the primary plaintiff assertions that the 5th Circuit recently upheld was that the FHFA can be either conservator or receiver and that it already chose the path of conservator in 2008 even though it has proceeded with actions more consistent with receivership (i.e. Net Worth Sweep).
Here are some key passages from the 5th Circuit decision:
Page 7:
FHFA is not just a regulator. Under 12 U.S.C. § 4617 it may serve as conservator or receiver for the GSEs. FHFA has discretion to appoint itself conservator or receiver in some cases, and receivership is mandatory in other critical insolvency situations.25 Conservatorship and receivership are mutually exclusive: Appointing FHFA as receiver “shall immediately terminate any conservatorship established for the regulated entity under this chapter.”
Page 9:
Section 4617 grants some powers to FHFA as conservator only:
Powers as conservator
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.33
It grants other powers to FHFA as receiver only:
Additional powers as receiver
In any case in which the Agency is acting as receiver, the Agency shall place the regulated entity in liquidation and proceed to realize upon the assets of the regulated entity in such manner as the Agency deems appropriate . . . .34
Page 11:
In September 2008, FHFA appointed itself a conservator for the GSEs. The next day, Treasury and the GSEs entered Preferred Stock Purchase Agreements.
Pages 12-13:
The Third Amendment replaced the quarterly 10% dividend with variable dividends equal to the GSEs’ entire net worth except a capital reserve. The Shareholders call this arrangement the “net worth sweep.” The capital reserve buffer started at $3 billion. It decreased annually until it reached zero in 2018. This arrangement was a double-edged sword. The GSEs no longer struggled to make dividend payments, but they would also no longer accrue capital. Treasury also suspended the periodic commitment fees. Treasury announced that the Third Amendment would “expedite the wind down of Fannie Mae and Freddie Mac” and ensure 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.” A federal official commented privately that the Third Amendment was designed to prevent Fannie and Freddie from recapitalizing.
Near the end of the hearing, AOC probed Mnuchin on whether he had anything to gain financially from a recap and release, to which Mnuchin replied an emphatic “no,” stating that he had divested all public holdings as a precondition to accepting his role. Calabria ended by stating that his role as FHFA Director legal requires him to free the GSE’s from conservatorship, even though “Wall Street” doesn’t like the prospect of increased competition.
Having watched more of these hearings over the last 11 years than I care to admit, I think the Mnuchin/Calabria/Carson triumvirate did exactly what I expected them to do: 1) reiterate their mandate to protect the taxpayer as well as the affordable housing mandate, 2) distance themselves from enriching shareholders and hedge funds (especially with an election year coming up), and 3) remain non-committal on next steps. In fact, I believe FHFA’s announcement earlier this month that it is seeking to hire an external financial/restructuring advisor is exactly such an insulating move.
At the end of the day, I believe that both Mnuchin and Calabria understand that receivership would 1) endanger the capital markets and economy, 2) almost definitely invite new Constitutional “takings” claims, and 3) likely face an uphill legal challenge at the SCOTUS given that HERA itself mandates the FHFA to be either conservator or receiver but not both and that the FHFA already chose the path of conservatorship (at least in name) 10 years ago. So when Calabria stated that he would “wipe out shareholders if the circumstances present themselves” and that he’d wished for receivership in 2008, I think he’s telling the truth but carefully omitting the fact that those “circumstances” under which receivership might have been a viable option have long since expired.
Summary of George Mason University Interview on 10/19/19
I also went back and listened to the George Mason University interview on 10/10/19, and I thought that the stance was far less curated to mollify hostile congresspeople, i.e. there was far more “signal” and less “noise” in this forum.
Calabria emphasized that his legal mandate as FHFA Director was to get the GSE’s out of conservatorship, and that the prerequisite for the exit was “9-18 months” of retaining earnings. He reiterated that, given his belief that we are potentially “late in the [housing] cycle” albeit with a strong equity market, he felt that now is a perfect time (over the next 1-3 years) for the GSE’s to tap the external markets for capital.
When queried on how to incentivize new private capital given sub-par returns the businesses currently generate while in conservatorship, Calabria said:
“We are spending a fair amount of time internally looking at a whole menu of options to raise Fannie and Freddie’s ROE’s going forward…I do recognize that to build capital, they have to be attractive…We have made changes that we think have already boosted the ROE relative to conservator capital…Just keep an eye on the business, and you’ll see margins that change.”
Interestingly, he also gave some historical context on why the HERA language (which he had a part in developing) closely resembles the verbiage governing the FDIC’s bank resolution powers – they were very wary of putting in new receivership language that would invite “takings” claims, hence they defaulted to precedent.
Finally, he hinted that the negotiations with the Treasury around the PSPA should be done by “middle of next year,” and that they’re driven less by time-line than by “getting the sequencing right.” He said that he expected the hiring of an external restructuring advisor to be done by November.
Here is a distillation of my thesis on the GSE preferreds over the last 11 years:
How did we get here?
Fannie and Freddie are systemically important, with a guarantee book of $5.6 trillion.
Due to their TBTF (Too Big To Fail) status, the Paulson Treasury of 2008 put them into conservatorship to supposedly forestall a crisis of confidence by essentially making the previously “implicit” guarantee “explicit.”
Ironically, as a result of conservatorship, Fannie and Freddie had to take massive write-downs of deferred tax assets, which generated massive amounts of accounting losses, which then “required” the “taxpayer bailout” of $190 bn of senior preferred being inserted into the capital structure carrying a 10% dividend. This is an angle that no reporter has covered.
Curiously, just as Fannie and Freddie were about to turn the corner on profitability, net of the 10% dividend to the senior preferred, the Geithner Treasury of 2012 replaced the 10% dividend with the Net Worth Sweep (NWS), which sweeps all profits to Treasury ad infinitum except for a razor-thin $6 bn combined capital margin.
Now that we are 11 years post-conservatorship and almost 8 years post-NWS, Treasury has swept $310 bn into its coffers without deeming one penny of the $190 bn of senior preferred liquidation preference as repaid.
What is prompting a change now?
Eleven years into this expansion, there is a growing concern that this particular housing cycle is near a peak.
With liabilities of nearly $6 trillion and a capital base of $6 billion, Fannie/Freddie are 100x more levered than banks. With the relaxation of the NWS last month, Fannie/Freddie will now be allowed up to $45 billion of capital.
While this is an improvement, I think the GSE’s will require $250-$500 bn of capital to place them truly in sound financial condition on par with the banks.
The only way for Fannie/Freddie to raise another $200-$450 bn of non-taxpayer capital while still preserving the 30-year mortgage and not disrupt the housing market is to recapitalize these entities by enticing new private capital.
What will incentivize new private capital to step in?
A demonstration and commitment that private capital cannot be taken without compensation – which is what the conservatorship/NWS have done.
Reassurance that contingent liabilities (i.e. all the shareholder lawsuits) have been cleaned up.
A clear path to profitability and return on equity.
What are the likely steps (in my humble opinion) required to get from A to B?
End the NWS – this has been done only partially thus far, due to the $45 bn cap.
Deem the senior preferred liquidation preference repaid, even if it first has to be adjusted up for the retroactive, explicit cost of an explicit government guarantee. Could this number be $200 bn? $250 bn? $300 bn? I get the distasteful political optics of paying shareholders back (even though it is the shareholders who have been wronged), but without the elimination of this liquidation preference and the consequent settling of myriad lawsuits, I do not see how or why any new private capital would want to step in.
Crystallize the business plan going forward such that shareholders know the cost of the explicit guarantee as well as their ability to raise their guarantee fees to a level that gives an adequate return on equity.
Only after all of these conditions are met, can the entities go on the road and pitch a new offering.
At the end of the day, I believe the “signal-to-noise” ratio has always been very low in these Congressional hearings due to political pandering. The George Mason University testimony provided far more informational content on FHFA’s true intentions, in my opinion.
My thesis is unchanged.
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Kaoboy Musings is a private distribution list/blog that I created to encourage dialogue regarding the economy & markets, geopolitics, investment ideas, and life in general. I have a passion for the markets and investing, and even though I no longer accept investor capital, I try to keep current on global events and opportunities and remain active in the markets. I’ve always found that writing my ideas down, sharing them with smart people, and encouraging two-way discourse and devil’s advocacy is often the best way to validate or invalidate a thesis and stay mentally flexible.
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