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On November 30, 2016, President-elect Donald Trumpâs choice for Treasury Secretary, Steven Mnuchin, said, âIt makes no sense that [Fannie Mae and Freddie Mac] are owned by the government and have been controlled by the government for as long as theyâŚ
HOWARD ON MORTGAGE FINANCE Release 2.0
By jtimothyhoward on December 9, 2024
On November 30, 2016, President-elect Donald Trumpâs choice for Treasury Secretary, Steven Mnuchin, said, âIt makes no sense that [Fannie Mae and Freddie Mac] are owned by the government and have been controlled by the government for as long as they have,â adding, âwe gotta get them out of government controlâŚ.and in our administration itâs right up there in the list of the top ten things weâre going to get done, and weâll get it done reasonably fast.â
The first Trump administration, of course, never did. Mnuchin has not addressed this issue publicly, but former FHFA Director Mark Calabria does discuss it in his book, Shelter from the Storm, albeit briefly and vaguely, and essentially blaming Mnuchin. He states, âSecretary Mnuchin generally felt that any option had to maintain Treasuryâs priority in the capital structure. Treasury could be heavily diluted, and almost certainly would have to be, but it did not want to see that accomplished by losing its standing.â Later Calabria says, âWe were ready to conduct a restructuring by late summer 2020â (without specifying how they were planning to deal with Treasuryâs senior preferred stock or its liquidation preference in the companies,) and goes on to ask, â[since] we had well-developed restructuring plans by late summer 2020, why did none of them happen? First, I believed both the Treasury and the White House wanted to push the issue until after the election. Since any change had the potential to create short-run volatility in the mortgage market, I believe the administration did not want to run that riskâŚ.[Then], once the election was behind us, Mnuchinâs attention clearly turned to his post-Treasury plans. Any restructuring, to be successful, would have offended somebody. We did not get it done because Mnuchin did not want to upset anyone on his way out the door, including incoming Treasury secretary Janet Yellen.â
This is just Calabriaâs side of the story. The more complete version is that he and Mnuchin had different objectives for the restructuring of Fannie and Freddie that they were unable or unwilling to reconcile. More problematically, both of their objectives were based on fictions about the companies, not facts, and the institutional investors whose participation was essential for the recapitalization of Fannie and Freddie knew this. Mnuchin seemingly wanted Treasury to be repaid twice for 2008 ârescuesâ the companies did not request and did not need, while Calabria was insisting on âhardwiringâ the entirely arbitrary 80 percent increase in required capital he had imposed on Fannie and Freddie in December of 2020, creating a severe handicap for their business. The investment community was being asked to bear the cost of both of these non-economic objectives, which was unreasonable to expect it to be willing to do.
During the Biden administration, Treasury Secretary Yellen and FHFA Director Thompson showed no interest in addressing Fannie and Freddieâs conservatorships. Yellen simply was silent on the matter, while Thompson repeatedly said she would defer to Congress to solve the problem through some unspecified type of legislative âreform.â But the companies have been reformed. They no longer are allowed to hold mortgages in portfolioâwhich had been the main objection to them prior to the conservatorshipsâand along with primary lenders are subject to the âability to repayâ provision of the 2010 Dodd-Frank Act that prohibits the toxic loan types and lending practices that triggered the 2008 financial crisis. Moreover, Fannie and Freddieâs entity-based business modelâin which revenues on good loans from all years, regions and loan types are available to cover losses on any loans that go badâis already far superior to the senior-subordinated model used in private-label securitizations (PLS). In the PLS model, each pool must stand on its own, and the inability to reach beyond it for revenues, or add capital post-securitization, requires substantial initial subordination, which translates into much higher credit guaranty costs and still leaves the holders of the senior tranches exposed to any losses that exceed the fixed loss-absorbing capacity of the subordinated tranches. Fannie and Freddieâs credit guaranty model is the gold standard.
So now, the second Trump administration is inheriting two companies that together finance 48 percent of the $14.1 trillion of single-family mortgages in America, have been extremely profitable for the last dozen years and need no further reform, yet because of policy choices made during previous administrations remain mired in conservatorships that would take them almost 15 years to emerge from on their own, during which their current degree of overcapitalization would continue to prevent them from providing affordable mortgage financing to the low- moderate- and middle-income families they were chartered to serve.
Are there any reasons to believe that the new Secretary-designate of the Treasury, Scott Bessent, might have better luck in âgetting them out of government controlâ than Steven Mnuchin did? In fact, there are, because of all of the changes in Fannie and Freddieâs circumstances and condition that have occurred over the past eight years.
Perhaps most significantly, at the end of 2016 Treasury still was institutionally committed to âwinding down and replacingâ Fannie and Freddie legislatively, as it had been since before Secretary Paulson put them into conservatorship. This goal was driving Treasuryâs policies toward the companies, as memorialized in a December 12, 2011 Draft Internal Memorandum for Treasury Secretary Geithner, containing âa plan with FHFA to transition the GSEs from their current business model of direct guarantor to a model more aligned with our longer-term vision of housing finance.â Components of this plan included guaranty fee increases that would continue âuntil pricing reaches levels that are consistent with those charged by private financial institutions with Basel III capital standardsâ (irrespective of risk), a single securitization platform for Fannie and Freddie (which could be used by their successors or competitors), securitized sharing of credit risk (which the memo said âwould likely reduce the earnings capacity of the GSEsâ), and âfaster retained portfolio wind down.â All of these were done. This same memo also contained a proposal to âRestructure the calculation of Treasuryâs dividend payments from a fixed 10 percent annual rate to a variable payment based on available net worth (i.e., establish an income sweep).â That, of course, was done as well, eight months later, and it became known as the net worth sweep.
But after the November 2018 midterms, which moved the House of Representatives under Democratic control, virtually the entire financial community, along with Treasury, gave up on the idea of trying to replace Fannie and Freddie. Numerous effortsâincluding the first Corker-Warner bill in 2013, Johnson-Crapo in 2014, and what was called âCorker-Warner 2.0â early in 2018âall had flaws that prevented them from generating any momentum, and a divided Congress was the final blow to the aspirational notion that it might be possible to create a viable alternative to Fannie and Freddie legislatively. Removal of the companies from conservatorship would need to be done by administrative action. And here is where the problem arose. As I wrote in a January 2020 post titled How We Got to Where We Are, âthe fictions about Fannie and Freddie that were essential elements of the attempt to replace the companies in a legislative process become impediments when the goal is to successfully recapitalize and release them in an administrative process.â
In his book, On the Brink, Secretary Paulson falsely says,âFannie and Freddie were the most egregious example of flawed policies that inflated the housing bubble and set off the financial crisis.â Throughout the first ten years of the companiesâ conservatorships, that was the version of them repeated by the financial mediaâand Treasuryâand the $187 billion in Treasury senior preferred stock Fannie and Freddie had drawn between 2008 and 2011 was universally viewed as the cost to taxpayers of their profligacy. Very few knew the true story, until more than two dozen shareholder suits were filed against the net worth sweep, beginning with Perry Capital v. Treasury and FHFA in July of 2013.
The amicus curiae brief I submitted for Perry Capital in July of 2015 summarized the facts that were coming to light in these cases. I noted that both Fannie and Freddie had been in compliance with their capital requirements when Paulson asked their boards to acquiesce to his conservatorship request, and that more than all of their $187 billion in senior preferred stock (which Treasury had made repayable only with its permission) was the result of over $300 billion in noncash expenses booked by FHFA as conservator that either were temporary, advanced from future periods, or based on estimates. And I pointed out that Treasury and FHFA had imposed the net worth sweep just before the majority of those noncash expenses reversed and came back into income ($158 billion in 18 months), so that the resulting revenues went to Treasury, rather than enabling Fannie and Freddie to rebuild their capital. (For those interested in the full set of facts about the conservatorships and the net worth sweep, I recommend my Supreme Court amicus written for Collins v. Yellen.) Â
In July 2017, the judge in another case against the net worth sweep, Fairholme Funds v. The United States, in the Court of Federal Claims, released 33 documents produced in discovery that made clear that Treasury was not being truthful in its public explanation for the sweep, which was that it was done to save the companies from a âdeath spiralâ of borrowing to pay the dividends on their senior preferred. Not only did these documents reveal that Treasury and FHFA were fully aware that Fannie and Freddie were about to enter âgolden years of earningsâ just as the sweep was being imposed, there also were memos among Treasury staff making blatant admissions such as, âBy taking all of their profits going forward, we are making clear that the GSEs will not ever be allowed to return to profitable entities at the center of our housing finance systemâ [emphasis in original]. Finally, and more recently, in August 2023, a jury hearing a remand of Perry Capital (now Fairholme Funds v. FHFA) in the U. S. District Court for the District of Columbia found that FHFA âwrongly amendedâ the Senior Preferred Stock Purchase Agreements when it agreed with Treasury to impose the net worth sweep, and awarded plaintiffs damages plus interest totaling $831 million to date (to be paid by the companies, which have accrued their respective portions).
As a hedge fund manager, Treasury Secretary-designate Bessent should be aware of the plaintiffsâ (correct) version of the Fannie and Freddie story, and if he is not there will be people with whom he is close who can tell him. Knowing the facts should make Bessent more likely to concede that Treasuryâs $193.4 billion in senior preferred stock in the companies is fully repaid (as it has been), and to agree that it should be cancelled, along with Treasuryâs liquidation preference ($341.0 billion at December 31, 2024, and growing each quarter). Yet should he insist that payments made to Treasury under the net worth sweep are not repayments of the senior preferredâand that the companies should pay Treasury again by having its senior preferred converted to common stockâhe at least will be cognizant that this stance will make the recapitalization of Fannie and Freddie much more challenging, because their investors will know that they are not being treated fairly.
Deeming Fannie and Freddieâs senior preferred to have been repaid, and cancelling it and the liquidation preference, will put the companies firmly on the path towards release. But to get to that release point more quicklyâand to deliver on the Trump campaignâs pledge to reduce the cost of homeownership for ordinary AmericansâTreasury and FHFA also must undo the damage to Fannie and Freddieâs credit guaranty business caused by the punitive and unjustified Enterprise Regulatory Capital Framework (ERCF) imposed by former FHFA Director Calabria. New information about Fannie and Freddieâs risk, and the âCalabria capital standard,â also has become available over the past eight years, which should make tackling and resolving this issue easier for Bessent than it proved to have been for Mnuchin.
Most important is Fannie and Freddieâs continued improvement in their annual Dodd-Frank stress tests. In the last test made available before Mnuchin was appointed Secretary, Fannie required initial capital of 79 basis points to survive a stylized 25 percent decline in home prices, while Freddie required 156 basis points. For the test run in 2020, when Calabria put out his ERCF for comment, Fannie required no capital to survive a 28 percent drop in home prices, while Freddie required 31 basis points. Since then, neither company has required any initial capital to survive their Dodd-Frank stress tests in 2021, 2022, or 2023, and the 2023 test subjected them to a 38 percent decline in home prices. (Curiously, FHFA delayed releasing the results of the 2024 stress tests beyond its August 15 deadline, âso that the Enterprises may provide additional supporting information and analysis of the scenarios, that the Director of FHFA may deem necessary,â but since the 36 percent home price drop in the 2024 test was slightly less than in 2023, itâs safe to assume the companies required no initial capital to pass the 2024 test either.) In sharp contrast, the average risk-based capital requirement for Fannie and Freddie of the Calabria standardâpurportedly calibrated to a lesser degree of stress than the Dodd-Frank testâwas 4.27 percent at September 30, 2024.
Why is the Calabria capital requirement so much higher? Because itâs purely arbitrary, and not based on risk at all. Rather than create a true risk-based capital requirement for Fannie and Freddie and then set a minimum capital requirement that was lower, Calabria did the opposite. He began by setting a âbank-likeâ minimum capital requirement of 4.0 percent for the companies (despite the fact that they have no business in common with banks), then used three contrivancesânot considering guaranty fees in the risk-based capital stress test as absorbing credit losses, artificially increasing capital on all loans though add-ons, buffers and cushions, and subjecting low-risk loans to a minimum risk weightâto engineer a result for the required amount of Fannie and Freddieâs ârisk-basedâ capital that was greater than his arbitrary minimum of 4.0 percent. (A much more comprehensive discussion of this topic can be found in the September 2021 post Capital Fact and Fiction.)
The impact of this gross overcapitalization has been severe. Fannie has been most affected by it, because the ERCF imposes a graduated capital surcharge for financing more than 5 percent of outstanding single-family mortgages (a âstability capital bufferâ), and Fannie is larger. Since the ERCF took effect in the first quarter of 2022, its stability capital buffer has averaged 30 basis points more than Freddieâs (at September 30, 2024 it was 111 basis points of Fannieâs total assets).
A comparison of selected financial data for Fannie between the five years before the ERCF took effect (2017-2021) and after is telling. In the five years prior to the ERCF, Fannieâs guaranty fee on new single-family business averaged 46.5 basis points (not including the 10 basis points it has to charge and remit to Treasury); because of the ERCF that average fee has steadily risen to 54.1 basis points in the third quarter of 2024. We saw in the mid-2010s that when Fannieâs average guaranty fee on new business exceeded 50 basis points, the growth in its single-family business stalled out. The same is happening now. After growing by 3.0 percent in 2022, Fannieâs single-family book shrunk slightly (by 0.1 percent) in 2023, and it has continued to shrink in the first three quarters of this year. As a consequence, while Fannie financed 27.8 percent of outstanding single-family mortgages at December 31, 2021, it financed just 26.1 percent as of June 30 this year (the latest date for which totals on outstanding single-family mortgages are available).
The impact of Fannieâs pricing also is evident in securitization shares. During 2017-2021, Fannie issued an average 39 percent of all new single-family MBS; Freddie and Ginnie Mae each issued 29 percent, and the other 3 percent were issues of PLS. But in the third quarter of 2024 Ginnie Mae was the leading issuer of single-family MBS, at 37 percent; Freddie was second at 28 percent, Fannie third at 27 percent, and the PLS share had risen to 8 percent.
Less evident, but more dramatic, has been the sharp drop in Fannieâs credit guarantees to borrowers with less-than-perfect credit (who typically have lower incomes). Here the relevant base of comparison is pre-conservatorship, and the last five years when Fannie had a ânormalâ profile of new business acquisitionsâbefore underwriting standards were distorted by originations destined for private-label securitizationâwhich was 2000-2004 (also my last five years as Fannieâs CFO). During that period, the average credit score of all single-family loans Fannie purchased or guaranteed was 715, and 36 percent of its business had a credit score under 700. By comparison, during the first nine months of 2024 Fannieâs average credit score on new business was 759, and a mere 10 percent of that business had a credit score under 700. That is a plunge of over 70 percent in what are predominately affordable housing loans. This, too, is the result of pricing, particularly the feature of the ERCF that does not consider guaranty fees to absorb losses. Because of that, the credit ârisk weightâ of a loan with a 90 percent loan-to value ratio and a credit score of 660 results in required capital of 945 basis points. And when you add in the additional percentages for management and operations risk, and the stress and stability capital buffers, Fannieâs total required capital on a 90 LTV, 660 credit score loan is 11.50 percent, requiring the company to charge a guaranty fee of 125 basis points to earn a return on capital comparable to what it's earned on its average credit guaranty portfolio so far in 2024. Thatâs preposterous.
None of these trends are going to improve as long as the ERCF remains in effect. And what has been happening with Fannie also is reflected in national housing trends. Earlier this month the Washington Post published an article that reported, âBetween July 2023 and June 2024 the share of first-time home buyers in the market was only 24 percent â a historic low.â It also said, âThe share of home buyers paying all cash reached 33 percent through August this year, according to data from Redfin â one of the highest rates since the years following the Great Recession,â and added, âAs cash purchases have become more common, the median age of home buyersâŚnow stands at 56 years old,â compared with 39 years old in 2008 (when Fannie and Freddie were put into conservatorship). The high all-cash share of homebuyers, and their increased average age, are flip sides of mortgage costs that are unaffordable to younger potential homebuyers with decent but not great credit. This is a real problem, and getting Fannie and Freddie out of conservatorship with capital requirements based on economics rather than ideology would be a real solution, which the second Trump administration could take credit for.
What prevented Treasury Secretary Mnuchin and FHFA Director Calabria from delivering on Mnuchinâs November 2016 pledge to get Fannie and Freddie out of government control was the inability of the former to get comfortable with ending (not just suspending) the net worth sweep and eliminating Treasuryâs senior preferred stock and liquidation preference in the companies, and the intransigence of the latter in making the release process much more difficult by insisting on nearly doubling their capital requirements at the same time as their credit risks were falling and their revenues soaring (as reflected in the results of their Dodd-Frank stress tests). The lessons from this failure, plus a fresh face at Treasury, should ensure that these mistakes arenât repeated in âRelease 2.0.â
Something else that wonât happen with Bessent as Treasury Secretary is âprivatizationâ as defined by the Heritage Foundation in Project 2025. For most people, privatization means the return of Fannie and Freddie to shareholder ownership. But the Heritage Foundationâs definition of privatization is stripping Fannie and Freddie of all of the federal attributes in their charters, while leaving their business restrictions intact. The companies would not survive in that state, as the Heritage Foundation implicitly admits with its recommendation that, âFannie Mae and Freddie Mac (both GSEs) must be wound down in an orderly manner [and] the Common Securitization Platform should be privatized and broadly available.â In other words, run off $7.3 trillion in Fannie and Freddieâs single- and multifamily mortgages and hope they can be re-issued as private-label securities. That is a disastrous prescription by academic theoreticians with no market experience, and Bessent will treat it as such.
More likely, in my view, would be for Bessent to arrive at a strategy for the release of Fannie and Freddie through an analytical process similar to what I outlined in my September 2023 post, An Easy Way Out:
âAs Treasury evaluates ending the net worth sweep and allowing Fannie and Freddie to exit conservatorship, it will need to determine which of its claims on them [its senior preferred, liquidation preference, and warrants] have the most value. And that will not be hard. To get value out of its $120.8 billion of senior preferred stock in Fannie and $72.6 billion of senior preferred in Freddie, Treasury will have to convert them into each companyâs common stock. Yet the very act of doing so will reinforce investorsâ strong views of unfair treatment. They know Fannie and Freddie have repaid their senior preferred, with dividends; itâs just that Treasury has used its non-repayment provision as a reason not to count net worth sweep remittances as repayments. Treasuryâs insisting that its senior preferred be converted to common would be requiring the companies to repay their senior preferred twice. If it does, how many investors would choose to buy Fannie or Freddie common stock againâincluding the stock Treasury would need to sell to get value from converting its senior preferredâand how much would they be willing to pay for it?
Now consider the alternative: making Treasuryâs warrants for 79.9 percent of Fannie and Freddieâs existing common stock more valuable by making the companies more valuable. Here, Treasury would work with FHFA and the administrationâs senior economic team to negotiate a recapitalization and release agreement that includes retroactive cancellation of the non-repayment provision of the senior preferred and a recasting of the companiesâ remittances under the net worth sweep as repayments of the senior preferred stock (which would pay all of it off for both). Fannie and Freddie, in return, would agree to accept utility-like return targets on their credit guaranty business, benefitting homebuyers. Then, for its part, the administration would acknowledge the criticisms made by commenters on FHFAâs request for input on Fannie and Freddieâs capital and pricing, and strongly encourage (or require) FHFA to remove the excess and unwarranted conservatism in the ERCF, to have it more closely reflect the true risks of Fannie and Freddieâs business.â
An Easy Way Out also suggests a âquick fixâ to the ERCF that would not require re-issuance of the rule, at least not immediately: âto drop the âprescribed leverage bufferâ Calabria added to the 2.5 percent minimum capital requirement FHFA set for the companies in its 2018 capital standard, and then remove enough of the non-risk-based minimums and buffers in the ERCFâs risk-based component to reduce it to below the 2.5 percent minimum, which would become the companiesâ binding capital requirement for the foreseeable future.â In conjunction with that, of course, Treasury and FHFA would cancel or replace the January 14, 2021 letter agreement between Mnuchin and Calabria setting 3.0 percent CET1 capital as the threshold for ending the companiesâ conservatorships.
Deeming Fannie and Freddieâs senior preferred to have been repaid and canceling the net worth sweep and the liquidation preference, and giving the companies a true risk-based capital standard and a reasonable minimum capital percentage, would be a âwinâ for all parties. The biggest winners would be millions of low- and moderate-income Americans, who once again would have a large-scale source of low-cost mortgage credit to help them achieve their dream of homeownership. But not far behind would be Treasury, whose stakes in Fannie and Freddie would become a great deal more valuable were the companies to be treated fairly, returned to private management, and structured to succeed.
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