No lame ducks at FHFA

| November 13, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

Fannie Mae and Freddie Mac should know before the end of the year the capital rules they need to play by if they hope to emerge from conservatorship, and they may also see important amendments to the agreement that keeps them in conservatorship. Agency MBS and CMBS and the markets in credit risk transfers could all have different reactions to these likely announcement—if markets think these changes will stick.

One step in, two steps out

The finalization of GSE capital standards, long in the works and expected to come this year, could modestly contribute to tighter spreads since increasing required capital—even if the Federal Housing Finance Agency dials back some of the larger buffers—helps investors by reducing risk. The announcement and publication of the final rule in the Federal Register will likely come the week of Thanksgiving, since regulators prefer to do this stuff when its quiet, though it could be earlier.

If the capital standards remain as proposed, which severely penalized credit risk transfer done through securitization, then both single-family and multifamily CRT securities programs—CAS, STACR, MCAS and FREMF mezzanine debt—are all going to require a rethink. Freddie Mac suspended their multifamily CRT program when the FHFA first proposed the new rule in May, and they seem unlikely to reenter the market if the rule is finalized as originally written. Freddie Mac has continued to issue STACRs and could continue to do so, or it could use finalization to suspend issuance. Fannie Mae suspended issuance of CAS, and finalization would likely leave them out of the market. Assuming the heavy capital requirements remain in the final rule, spreads of existing CRT securities could ultimately tighten due to scarcity issues. However, in the short-term program cessation and an eventual drop in liquidity could lead to wider spreads.

Finalization of the capital standards has to occur before the Senior Preferred Stock Purchase Agreement, which governs the relationship between Fannie Mae, Freddie Mac and the US Treasury, can be amended. That could come in the middle of December, possibly right after Congress goes into recess. In theory that could, and probably will, widen spreads on the announcement. It should be modest depending on what the actual amendment language is, but it plants a flag that the recapitalization and initial public offering plan is going forward. Once the PSPAs are amended by Treasury and FHFA it cannot be undone except by a new amendment. President-elect Biden will almost certainly appoint a Treasury Secretary that would prefer to keep the GSEs in conservatorship. But as long as Calabria is at the helm of the FHFA, he can carry on with the exit. Of course, the market will have it’s own view of Calabria’s ability to navigate the significant political obstacles to making the GSE private again.

The higher capital requirements should actually serve to lower the amount of capital the GSEs need to raise, because shareholders should require a lower return on equity from safer, more stringently capitalized institutions. That was at least the theory of the Congressional Budget Office when it modeled several potential scenarios where the GSEs would sell new common stock to replace the Treasury’s ownership stake. The CBO report, Effects of Recapitalizing Fannie Mae and Freddie Mac Through Administrative Actions, determines that an IPO could raise the required amount of capital, depending on how the Treasury values its stake, how high the GSEs capital requirements are, and the required return demanded by investors. An IPO could also fail to raise the required amount of capital if investors demand too high of a projected return, the capital requirements are too prohibitive, or the Treasury does not sufficiently write down the value of senior preferred shares it redeems.

How the recapitalization and release plan evolved

  • FHFA Director Mark Calabria and his deputies at FHFA, with the support of Treasury Secretary Steve Mnuchin and the administration, have been working since Calabria’s appointment as Director in 2019 to recapitalize and release Fannie Mae and Freddie Mac from conservatorship.
  • The plan for release from conservatorship is contingent upon the GSEs accumulating capital through retained earnings and raising capital from private shareholders via an IPO. Investment bank Houlihan Lokey Capital was hired by the FHFA in February 2020 as a financial advisor to help develop a roadmap and evaluate capital-raising options, including a share offering that could be as high as $200 billion.
  • The FHFA proposed new capital requirements for the GSEs in May 2020 that would increase their previous capital requirements by 80%. Critics of the plan claim that the amount of capital required would so limit the business model and earnings potential of the GSEs that it would discourage private investors from participating in the IPO.
  • Calabria’s term as Director expires in 2024, but a case pending before the Supreme Court could potentially allow President-elect Biden to replace him at will if the Court finds the structure of the FHFA Directorship unconstitutional. This would be consistent with the Supreme Court’s decision in Seila Law vs. the Consumer Financial Protection Bureau regarding the structure of the CFPB, whose Director can now be replaced at will. The FHFA case has some different nuances since the GSEs were intended under current law to be shareholder owned, government sponsored agencies which – based on my limited understanding – means the FHFA as regulator is possibly more independent than the fully government accountable CFPB. However that shakes out, the case won’t be heard until early next year and the decision will likely not be announced until June 2021.

Post-election developments

  • A November 5 story in Housing Wire, With Biden win likely, FHFA doubles down on ending GSE conservatorship quotes an unnamed FHFA spokesperson as stating that the FHFA will continue its mission to release the GSEs from conservatorship under a Biden presidency. Additional background on the Seila Law case is also included in this article.
  • An excerpt from the Housing Wire article,

Previously, at a housing policy conference in Washington, Calabria said he expected the FHFA will have a rule dictating capital requirements in place before Fannie and Freddie can go to market. One option the FHFA was considering is a period where the GSEs technically exit conservatorship but aren’t completely free of government oversight.

“If all goes well, 2021, 2022 we will see very large public offerings from these companies,” Calabria said. “The consent decree will be able to give that window where they can go to market, do an offering and still operate under a way where we’ve got some prudential safeguards.”

Fannie and Freddie could be looking at exiting government control by 2022 or 2023, according to Calabria.

And Calabria told members of the Credit Union National Association earlier this year that he expects the offering of stock in Fannie and Freddie to take place in 2021. The IPO is projected to be the largest public share offering in U.S. history. Analysts have valued the offering between $150 billion and $200 billion.

  • On November 9 the FHFA announced that they had named 27-year FDIC veteran Jason Cave the new Head of Division Resolutions, formerly the Division of Conservatorship. An article covering the announcement from Inside Mortgage Finance is here.
  • Perhaps not coincidentally, Sheila Bair, former head of the FDIC during the financial crisis was made a director on Fannie Mae’s board in 2019. Next week she will be elevated to chairman of Fannie Mae’s board based on a unanimous election of her fellow directors. The current board chairman Jonathan Plutzik will remain on the board.
  • On November 9, American Banker published an article What Sheila Bair brings to the table as chair of Fannie Mae.
  • However, under conservatorship Fannie’s Board of Directors has no independent power or duty to direct or oversee Fannie Mae’s business and affairs. An excerpt from Fannie Mae’s Corporate Governance Guidelines:

1. The Roles and Responsibilities of the Board and Management

On September 6, 2008, the Director of FHFA appointed FHFA as Fannie Mae’s conservator in accordance with the GSE Act. As conservator, FHFA succeeded to all rights, titles, powers and privileges of Fannie Mae, and of any shareholder, officer or director of Fannie Mae with respect

to Fannie Mae and its assets. As a result, Fannie Mae’s Board of Directors (Board or Board members) no longer had the power or duty to manage, direct or oversee Fannie Mae’s business and affairs.

As conservator, FHFA reconstituted the Board and provided the Board with specified authorities. Board members serve on behalf of the conservator and exercise their authority as directed by and with the approval, where required, of the conservator. Board members have no fiduciary duties to any person or entity except to the conservator. Accordingly, Board members are not obligated to consider the interests of the company, the holders of Fannie Mae’s equity or debt securities, or the holders of Fannie Mae MBS unless specifically directed to do so by the conservator.

The Board exercises specified authorities provided to it pursuant to an order from FHFA, as Fannie Mae’s conservator. The conservator also provided instructions regarding matters for which conservator decision or notification is required. The conservator retains the authority to amend or withdraw its order and instructions at any time.

FHFA’s instructions require that we obtain the conservator’s decision before taking action on matters that require the consent of or consultation with Treasury under the senior preferred stock purchase agreement.

Background on conservatorship

  • On September 6, 2008, Fannie Mae and Freddie Mac were placed into conservatorship by the FHFA due to their rapidly deteriorating financial condition. The recently passed Housing and Economic Recovery Act (HERA) temporarily gave the Treasury unlimited investment authority in the two firms. The Treasury and FHFA, as conservator, entered into senior preferred stock purchase agreements with each GSE to prevent them from becoming insolvent.
  • Mark Calabria was a staff member on the Senate Banking Committee in 2008 and helped write HERA.
  • The Treasury injected capital into the GSEs through the purchase of $189 billion of senior preferred stock between November 2008 and March 2012. The capital covered their losses and allowed their businesses to continue operating, stabilizing the housing market and secondary mortgage market. The Treasury also received warrants that give it the right (but not the obligation) to buy common stock in each of the GSEs equal to 79.9% of total outstanding shares for a nominal amount. Those warrants expire on September 7, 2028.
  • To date, Treasury has provided $119.8 billion to Fannie Mae and $71.7 billion to Freddie Mac for a total of $191.5 billion of injected capital.
  • The preferred stock purchase agreements, including various amendments to them over the years, required the GSEs to pay dividends to the Treasury. To date, Fannie Mae has made $181.4 billion of cumulative dividend payments to Treasury and Freddie Mac has made $119.7 billion, for a total of $301.1 billion. The two GSEs have together returned $109.6 billion more in capital to the Treasury and the taxpayers than was injected.
  • Conservatorship was intended to be temporary, until the GSEs returned to a safe and sound financial condition. To understand why it has now dragged on for over a decade, analysis and commentary is available here or here.

A notable white paper, The Conservatorships of Fannie Mae and Freddie Mac: Actions Violate HERA and Established Insolvency Principles by Michael Kimminger and Mark Calabria was published by Cato Institute in February 2015.

john.killian@santander.us 1 (646) 776-7714

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