Fannie Mae, Freddie Mac, and Administrative Law

Source: NYU LAW

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Fannie Mae Survival on Table as Congress Drafts Plan (Correct)

source: Bloomberg News

(Corrects Senator Johnson’s state in 13th paragraph.)

The consensus in Washington that Fannie Mae and Freddie Mac should be dismantled is weakening amid opposition from hedge funds, regional banks and others who could benefit if the companies survive in some form.

President Barack Obama and lawmakers from both parties have called for the two mortgage-finance companies to be replaced by a new U.S. housing system. While the official position hasn’t changed, a bipartisan group of U.S. senators writing legislation is grappling with how to ensure that changes to Fannie Mae and Freddie Mac don’t disrupt the recovering housing market.

Some Democrats said they are leery of engineering a switch that would depend on private entities to risk their own capital on home loans.

“I’m not sure that eliminating the GSEs totally makes sense, as some have suggested, and so I have an open mind on it,” Robert Menendez of New Jersey, a Democratic member of the Senate Banking Committee, said in an interview last week. His comments came after Senate Majority Leader Harry Reid, a Nevada Democrat, said in August that the companies shouldn’t be dismantled.

Since they nearly collapsed during the 2008 credit crisis, the two government-sponsored enterprises, or GSEs, have drawn $187.5 billion from taxpayers and have been considered too politically toxic to be preserved. While the U.S. holds controlling stakes, the outcome will affect private investors including hedge funds Perry Capital and Paulson and Co., which have accumulated preferred shares and have spent months lobbying for Fannie Mae and Freddie Mac to be recapitalized.


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The Future of Fannie and Freddie: Conservatorship and the Takings Clause

source: NYU LAW

Mario Rizzo, associate professor of economics and co-director of the Classical Liberal Institute, with Professor Richard Epstein, the institute's director

Mario Rizzo, associate professor of economics and co-director of the Classical Liberal Institute, with Professor Richard Epstein, the institute's director

On September 20, the daylong conference “The Future of Fannie and Freddie,” co-sponsored by the Classical Liberal Institute and the NYU Journal of Law & Business, featured experts on law, finance, and economics examining the challenges to investment in the government-sponsored entities Fannie Mae and Freddie Mac. Four separate panels focused on the reorganization of Fannie and Freddie, recent litigation surrounding the Treasury Department’s decision to “wind down” the two entities and the legal issues involved, and economic policy and future prospects for Fannie and Freddie in light of proposed House and Senate legislation.

The event also served as the launch of NYU Law’s Classical Liberal Institute (CLI), a new center studying core conceptions of limited government and private property in a wide range of modern contexts including political and corporate governance, taxation, takings, intellectual property, and different forms of regulation. The CLI will host the Hayek Lecture in October as well as an ongoing series of student lunches with Law School faculty discussing their work in the CLI’s areas of academic focus. Future CLI conferences are planned, including one in February 2014 on The Classical Liberal Constitution, an upcoming book by Richard Epstein, Laurence A. Tisch Professor of Law and the director of the new institute, who gave opening remarks at the “Future of Fannie and Freddie” conference along with Dean Trevor Morrison.

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Fannie and Freddie Aim for Mortgages with 'Zero Defects'


"As rates go up, the credit box will try to be expanded, corners will be cut and that's when we will be on the front lines," said Christopher Mock, Freddie's vice president of quality control.

Fannie Mae and Freddie Mac are about to get tougher on banks and other lenders that cut corners when originating mortgages and try to sell them to the government-sponsored enterprises.

For the first time ever, the GSEs are creating formal programs to flag defective loans and assess risks in lenders' mortgage processes. Lenders will be graded and receive feedback on areas such as underwriting, quality control and governance and, if loans are defective, the GSEs will require lenders to immediately repurchase them. In the past, it might have taken years for the GSEs to spot defects and force a lender to repurchase a loan.

"Our expectation is zero defects," Steve Spies, a vice president of loan quality and lender assessment at Fannie Mae, told a group of risk managers at an industry conference last week.

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Why Former Investors Despair of Returning to Mortgages


Investors are likely to say "fool me once…" which may explain why the volume for newly issued private label residential mortgage securitizations is a fraction of what it was a few years ago. Through bitter experience, bond purchasers learned about the moral hazard embedded in private RMBS and their grossly inadequate legal protections.

"The private RMBS market was at the heart of the financial panic and the Great Recession that followed," writes Mark Zandi of Moody's Analytics. Indeed. At year-end 2007, private RMBS totaled $2.2 trillion. According to Zandi's tally, those bonds realized losses, during the 2006-2012 period, of $449 billion.  That amount exceeded the total losses on $9 trillion of mortgage debt financed by everyone else, all depository institutions and all government-backed lenders, including Fannie Mae and Freddie Mac. Also, Zandi excludes synthetic subprime collateralized debt obligations, which financed nothing tangible and which lost more money than Fannie and Freddie combined.

More pointedly, the heart of the financial panic and the Great Recession that followed was an epidemic of fraud and sloppy recordkeeping facilitated by the originate-to-distribute model for private RMBS.  Parties complicit in fraud – borrowers, mortgage brokers, originators, rating agencies, investment banks and servicers – calculated that the odds of being held fully accountable were close to nil. That assessment has stood the test of time.

How bad was the fraud?

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David Fiderer has previously worked in energy banking for more than 20 years. He is currently working on a book about the rating agencies.

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Fannie Mae: Supporting the Multifamily Market

Fannie Mae and our DUS lenders play a critical role in the multifamily market, making safe, decent, affordable housing possible for working families across the country.

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Dylan Ratigan on Frank-Dodd Resolution Authority

Dylan Ratigan coined the phrase "Corporate Communism." The video below is a couple of years old, but it truly delivers the reality of our situation.

"The savings of America was the piggy-bank that this type of product was being sold to; that the savings of America, whether it's the New York State pension managers, or any of the -- I would have to list all of the various pensions -- are the ones that got stuck with a lot of this paper; not to mention Fannie, Freddie, and now the Federal Reserve." --- Dylan Ratigan

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New Shipmon Derivative Lawsuit Filed

Lockhart's announcement envisioned that the Company would eventually be returned to profitability, and the conservatorship would be lifted. He made clear that the conservatorship would be run with an eye toward attracting additional private investment to the Company, noting that "some of the key regulations will be minimum capital standards, prudential safety and soundness standards and portfolio limits." According to Lockhart, the purpose of the new regulations was "so that any new investor will understand the investment proposition."

Bear in mind, that the parties are not suing Fannie Mae’s board or management, but are defending the company against its conservator, the FHFA.  Thus, the defendant is the Federal government. Here is a definition of a derivative lawsuit from Wikipedia:

"shareholder derivative suit is a lawsuit brought by a shareholder on behalf of a corporation against a third party. Often, the third party is an insider of the corporation, such as an executive officer or director. Shareholder derivative suits are unique because under traditional corporate law, management is responsible for bringing and defending the corporation against suit. Shareholder derivative suits permit a shareholder to initiate a suit when management has failed to do so."

View the Full Complaint >>

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Hensarling Bill to Wind-down GSEs Gets Wind-down of Its Own

According to multiple sources, including Inside Mortgage Finance, Hensarling's bill, which called for the wind-down of the GSEs, is no longer on the agenda for the foreseeable future. This is great news for taxpaying shareholders and brings us one step closer to a practical, sustainable, and safe solution. This also means that the nation is one step closer to protecting American taxpayers, as well as the National Housing Trust Fund, since the key stakeholders involved in GSE reform are now being heard. Hensarling's bill would also have other, negative, sweeping impacts on American families, businesses, and homeowners, such as eliminating the 30-year fixed rate mortgage, increasing interest rates, and providing full control to big banks, which might later lobby for the ability to lend customer's deposits to other customers with much higher interest rates. In addition, the bill would increase risk to taxpayers by placing the primary responsibility of lending, securitizing, and backstopping mortgages in the hands of the too-big-to-fail (TBTF) banks.

Senate majority leader, Harry Reid, has hinted at prospects for a bill that would maintain Fannie and Freddie's role in America's future housing finance system in an interview with Nevada Public Radio last month. As Corker/Warner loses traction in the Senate, and new bills present more pragmatic solutions to a safe, stable, housing finance system, we should begin to see a slow but healthy entrance of private capital to work alongside Fannie and Freddie -- as many, such as Bank of America, have stated is the most desirable structure. As Fannie and Freddie quickly approach zero debt owed to taxpayers -- it does appear likely that a transition from conservatorship back to a pre-crisis, pre-subprime, #GSEReform is approaching. This is what Barack Obama alluded to in his talk with Zillow's CEO last month, which appears to align nicely with all of the key stakeholders. Stay tuned for some statistics as we approach net-zero (zero debt owed by Fannie and Freddie to the US Treasury).

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A Model for the Future of Mortgage Securitization

source: Freddie Mac

Multifamily SVP David Brickman
When it comes to mortgage credit risk, many policymakers today are searching for ways to shield the federal government from all risks short of a major economic catastrophe. They want to build a future system where private capital bears the risk of most residential mortgages, and have a federal backstop only in cases of emergency.

One set of experiences that can be informative to this discussion is the way Freddie Mac Multifamily securitizes mortgages for apartment loans, the vast majority of which support affordable rental housing.

Our program is called K-Deals, and it is how we finance almost all our loan purchases. Here is how it works. When we purchase loans, we assemble them into diversified pools, and place them into securities that are comprised of two classes of bonds: guaranteed senior bonds and unguaranteed bonds known as subordinate and mezzanine bonds. Should credit losses materialize, those losses are initially borne by the private investors who have purchased the subordinate bond. That is called a “first-loss position” or a “B-piece” and in our K-Deals it typically represents the first 7.5 percent of the mortgage pool. In the unlikely event that losses were to exceed this level, losses would then be absorbed by yet a second layer, the mezzanine bonds, which represent another five to 10 percent of the mortgage pool.

On average, these unguaranteed bonds represent approximately 15 percent of the mortgage pool, which would likely be sufficient to absorb all the losses in the pool if even half of all the loans were to default.* These two classes of unguaranteed bonds act like a succession of firewalls: only after losses in the total pool (and not loan by loan) exceed the total amount of subordination in each of the unguaranteed classes would Freddie Mac be exposed to a single dollar of credit loss. Given that our current loan delinquency rate is just 0.06 percent and our loss rate is a microscopic 0.01 percent, 15 percent is a very big level of protection. Thus, the senior bonds we guarantee, where the risk is borne by U.S. taxpayers, have so little risk exposure that they, in effect, function more like catastrophic insurance for investors.

Freddie Mac Multifamily is the only government-backed entity that has such a financing structure. And it has worked well. To date, K-Deals have financed $60 billion in apartment loans and the current delinquency rate on these deals is as low as it can possibly be: zero.

Indeed, the delinquency rates on our entire portfolio have been consistently low, going no higher than 0.26 percent during the height of the U.S. financial crisis, compared to more than 11 percent for privately-funded commercial backed mortgage securities (CMBS). And so far this year, we have experienced just $3 million in net credit losses on a $130 billion loan portfolio. [SEE GSE CRITICS IGNORE LOAN PERFORMANCE]

Indeed, the quality of loan underwriting has been a key part of our K-Deal success. Every three weeks or so, we issue a new K-Deal which contains about 80 underlying loans that have been underwritten, structured, and priced by in-house staff. When we do this, there are lots of eyes on us: a subordinate bond investor, multiple mezzanine investors, and a dozen or more investors in senior bonds.

Our investor base is broad. It includes conventional real estate investors who may view our subordinate bonds like other real estate equity investments; life insurance companies and pension fund managers seeking high yield on our mezzanine bonds; and major financial institutions that treat our senior bonds as an alternative to Treasury bonds. Also looking closely at us are rating agencies (typically two firms render independent opinions on each K-Deal), master and special loan servicers, trustees, and Wall Street research analysts.

Together, all these parties probe our credit standards, asset quality, and program changes. Their collective attention and feedback instills within us market discipline and accountability, forcing us to continuously improve our securities program such that we can continue to finance affordable rental housing.

Of course, we were not always in this position. As recently as 2008, we had financed 98 percent of multifamily loan purchases through Freddie Mac’s retained portfolio. When the company entered conservatorship the risk was fully borne by U.S. taxpayers. K-Deals and other forms of securitization supported the remaining two percent. It took just four years to completely reverse these figures, a testament to our ability to innovate, learn from the capital markets, and implement a completely new business model.

But we did not merely replicate a securitization model in which we shouldered most of the credit risk. Instead, we looked for ways to marry two things: a CMBS-like structure where we could lay off significant amounts of risk, and features commonly found in portfolio lending that provided a certain amount of flexibility to borrowers. We also had to transform the infrastructure within our business, from accounting, information systems, legal documentation, and more. Then, in June 2009, we issued our first modern K certificate. More than 50 have followed.

Our efforts during this time have financed more than two million apartment units, shielded taxpayers from most credit risk, and built a durable business model that has contributed about $5 billion in net segment earnings to Freddie Mac. We have worked to avoid relying merely on the special powers and privileges of being a government-sponsored enterprise, and instead establish best practices in mortgage securitization, credit standards, and asset management. To this end, any one K-Deal is more than the sum of its individual loans; instead, it is a Freddie Mac Multifamily deal, with the earned power of its brand behind it.

In 2013, we find our business as one that has shed its past as a “buy and hold” investor that, when Freddie Mac entered conservatorship, placed U.S. taxpayers in a first-loss position. Now we are a true financial intermediary that is less of a risk taker and more of a market maker and liquidity provider in all economic cycles.

In recent years, rental housing has been a growing part of the U.S. economy, for those who rent for economic need and lifestyle choice. At Freddie Mac Multifamily, our K-Deal securities program has proven to be an effective means to finance housing for this ever-growing population while exposing taxpayers to minimal risk. By its program structure, K-Deals offer one proof point that mortgage securitization, if done right, can attract substantial private investment while assuring market support for affordable rental housing.

*Based on the assumption that average loss severity or loss given default is approximately 28.7 percent, which has been Freddie Mac Multifamily’s historical average loss severity over the past 20 years

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