Fannie Mae, Freddie Mac delaying write-offs of delinquent mortgages, Los Angeles Times
"A government report raises questions on how Fannie and Freddie account for future losses. Mandated changes, once in effect, could eat into their profits as the housing market recovers."
Earlier this month, President Obama renewed his call to replace Fannie Mae and Freddie Mac with private sector solutions, so that taxpayers would never again be forced to bailout the mismanagement of these gargantuan quasi-government entities.
A bipartisan proposal from the Senate has been served up to gradually build private sector financing markets that would somehow keep the federal government in the equation as the ultimate-worst-case-scenario backstop if needed. A more aggressive proposal from the House would simply phase out government involvement altogether and create a new secondary market space for private investment competition.
Our leadership is proposing the creation of a brave new uncharted mortgage finance world to be pioneered by the folks that brought us to the brink of financial Armageddon in 2007. Financial scholars like these ideas, citing increased competition and innovation resulting in new and improved product offerings. These proposals assume that replacing the draconian and dominant 30-year fixed rate mortgage with financing alternatives that better fit the needs of individual borrowers will create a more stable lending environment.
I do not have the credentials of a financial scholar and I am not an elected leader, but apparently I have a better memory. Profit driven competition and innovation in the mortgage industry, and the proliferation of financing alternatives to better fit individual borrowers, gave us the no employment, no income, no asset, no down payment, weak credit history mortgage financing collapse that we are still recovering from. How can anyone propose that we frame a landscape that leaves open a door to the kind of runaway risk that crippled Fannie Mae and Freddie Mac the last time we tried it?
Fannie and Freddie are popularly portrayed as the villains that perpetrated the mortgage meltdown, when in fact they were simply the playing field. With investment banks in the skilled positions, lenders on the line and our political leaders coaching from the sidelines, private sector competition and innovation in the mortgage industry is the villain that led to the collapse. Remember, Fannie and Freddie purchase and securitize mortgage loans from banks and mortgage lenders, essentially creating the secondary market space for Mortgage Backed Securities (MBS). As the sellers of these loans, the banks and mortgage lenders are responsible for the quality of the loans they are selling. It was the sub-standard quality of the loans originated and underwritten by the banks and mortgage lenders that resulted in widespread defaults and caused the catastrophic losses at Fannie Mae and Freddie Mac.
Our political leadership is proposing that we abolish Fannie and Freddie for the sins of the banks and the mortgage lenders, and then hand over the keys to these same architects of the mortgage disaster that brought us to the brink of financial collapse. We are still healing and these are serious people proposing that we again legislate our way to mortgage prosperity, using no more common sense than that which got us into this mess. What could go wrong?
Mortgage underwriting guidelines, limits, parameters, do’s and don’ts, time frames, fouls, requirements, all rules promulgated to create a uniform baseline for constructing quality loan files are vetted and published in Fannie Mae and Freddie Mac Selling Guides. These are the mortgage bibles from which all mortgage lending originates, private lending sources refer to these Selling Guides when constructing their own private lending guidelines, tweaking as their individual markets dictate. Eliminating Fannie and Freddie will erase the home base source from which mortgage rules come from, leaving market forces to determine what is necessary and what is not.
The sheer size of these two government sponsored institutions validates the statistical populations from which mortgage underwriting guidelines are created. Delegating this function to individual private lending institutions, however big they may be, creates a fertile breeding ground for evolutionary risk/return mortgage lending that is absent boundaries but with a government bailout safety net.
The existence of Fannie Mae and Freddie Mac provides accountability and recourse for policing lenders that cut corners and sell low quality default risk loans. Today, post-mortgage meltdown, a lender can be forced to buy back a loan that is below guideline or document credit quality even if it is not in default. Without Fannie and Freddie, lenders will be guided by the Consumer Financial Protection Bureau (CFPB) and the feeble Ability-to-Repay Rule (seeThe Great And Powerful New Ability-To-Repay Rule), or better yet, be left to police themselves.
The automakers, Wall Street investment banks, gargantuan global insurance companies, all received government bailout money and nobody on either side of the aisle is proposing that any of these entities be dissolved. The proposed replacing of Fannie Mae and Freddie Mac with private sector participants is political theater and does not address the fixing that is really needed to reshape the mortgage lending landscape. Best and brightest management people paid in Wall Street dollars are needed to right Fannie and Freddie. Save the feigned outrage, get the right people on the bus and let them navigate Fannie and Freddie to the center of the mortgage universe.
Erasing Fannie Mae and Freddie Mac from the mortgage landscape will leave a void that market forces will fill quickly with a too-big-to-fail risk/return model with a federal government safety net. Smart financial and political people will argue to the contrary but the institutional structure of our interdependent financial markets will force this outcome or risk collapse, it is how our engine runs. We will replace what we have with a trust evoking new name, a fluid risk aversion mission statement and overwhelming lobby forces muting consumer needs. There will be no baseline underwriting standard to stray from, private sector players will create their own, beginning with a maximum return/ minimum risk code that will evolve as the mortgage markets absorb paper.
There will be new legislation to manage the new financial labyrinth of lending guidelines and product offerings. Pricing will be market driven and absent any incentive to manage consumer access to mortgage financing. Consumers will be priced or underwritten out of the opportunity to buy a house. The playing field will tilt away from the striving and remain open for only the sure thing, it is that way now, it will become more so.
Replacing Fannie Mae and Freddie Mac as a constructive consequence to the mortgage meltdown is akin to pulling over when the check engine light comes on and changing a tire, the fix has nothing to do with the problem. Life after Fannie Mae and Freddie Mac will be pretty much what it is now, except more deregulated, more expensive and further behind the velvet ropes, other than that . . . we’re good.
(Reuters) - U.S. government housing finance authorities are pressing JPMorgan Chase & Co for at least $6 billion to settle lawsuits over bonds backed by subprime mortgages, according to a person familiar with the matter.
The company is arguing that it should pay less to settle the claims by the U.S. Federal Housing Finance Agency, according to the source, who was not authorized to speak for attribution.
The FHFA litigation is among a raft of legal issues JPMorgan is trying to work through in addition to investigations over its $6.2 billion "London Whale" derivatives loss of last year.
An FHFA spokeswoman declined to comment.
The FHFA, which oversees Fannie Mae and Freddie Mac, sued JPMorgan over some $33 billion of securities two years ago and also sued at least 16 other financial institutions.
The lawsuits alleged that the banks misrepresented how well they had checked the underlying mortgages and charged that they did not meet investors' criteria. As borrowers fell behind in payments, the value of the securities fell, causing losses.
The securities at issue in the talks with JPMorgan include bonds that were sold by Washington Mutual and Bear Stearns, two troubled institutions that JPMorgan took over with government encouragement during the financial crisis.
Some banks have already settled mortgage litigation with government officials who are trying to make the banks bear more of the cost of the housing crisis. Switzerland-based UBS settled with the FHFA for $885 million in July. Citigroup Inc and General Electric Co have also reached settlements.
Fannie Mae and Freddie Mac, entities sponsored by the U.S. government, were seized by the government in 2008 and received $187.5 billion to stay afloat.
The Financial Times reported the amount being sought from JPMorgan over the mortgage securities on its website earlier on Tuesday.
JPMorgan has spent about $5 billion for legal costs in each of the past two years. The company raised its estimate of possible losses in excess of its reserves to $6.8 billion at the end of June from $6 billion three months earlier.
(Reporting by David Henry in New York and Margaret Chadbourn in Washington; editing by Gary Hill and Matthew Lewis)
By Jonathan Stempel
NEW YORK (Reuters) - A U.S. government lawsuit accusing Bank of America Corp of fraud in the sale of billions of dollars of toxic mortgage loans to Fannie Mae and Freddie Mac is on track to go to trial next month after a judge rejected the bank's bid to dismiss the case.
In an order made public on Tuesday, U.S. District Judge Jed Rakoff in Manhattan said there were "genuine factual disputes" that justify letting the case continue against the second-largest U.S. bank.
The order clears the way for the case to proceed toward a scheduled September 23 jury trial. Only a few prominent cases tied to the financial crisis have ever gone to trial.
Rakoff also said he expects to decide before trial which theories he will allow the government to pursue. He said he would explain his reasons for Tuesday's order "in due course."
The U.S. Department of Justice sued Bank of America last October, joining a whistleblower lawsuit originally brought by former Countrywide Financial Corp executive Edward O'Donnell.
It alleged that Countrywide, acquired by Bank of America in July 2008, caused more than $1 billion of taxpayer losses by selling defective home loans to Fannie Mae and Freddie Mac, the mortgage financiers seized by the government in September 2008.
The government said the loans went through a program called the "High Speed Swim Lane" - also known as "HSSL" and "Hustle" - that Countrywide devised in 2007 to speed up loan processing, even if it meant ignoring safeguards to help ensure that loans were sound and not tainted by fraud.
Bank of America, in court papers, countered that HSSL was a "legitimate and good-faith effort" to develop systems for making prime loans after the collapse of the subprime market.
A Bank of America spokesman, Lawrence Grayson, said after Rakoff issued his order, "This program ended before our purchase of Countrywide, as the government acknowledges. We believe there was no fraud."
At an August 13 hearing, Rakoff signaled that the government could take its case against Bank of America and former Countrywide executive Rebecca Mairone to a jury.
"The government's theory in part has always been that the defendants, through their own internal processes, covered up how defective the loans were and made them appear - even for the purposes of their ultimate internal figures, let alone what they represented to others - less defective than they were," Rakoff said. "That may be right, that may be wrong."
CHALLENGE FOR CEO MOYNIHAN
While Bank of America Chief Executive Brian Moynihan has made major strides in resolving litigation tied to the financial crisis, with the bank having already agreed to pay more than $45 billion, the lawsuit makes clear his work is far from done.
Indeed, the Charlotte, North Carolina-based lender was hit just three weeks ago with lawsuits by the Justice Department and the Securities and Exchange Commission alleging fraud in an $850 million mortgage debt sale in early 2008.
In the case before Rakoff, Bank of America was sued under the federal False Claims Act and the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), a 1989 federal law passed in the wake of that decade's savings-and-loan crisis.
FIRREA has a lower burden of proof and longer statute of limitations than other laws often used in financial fraud cases.
Earlier this month, Rakoff endorsed a broad interpretation of FIRREA. He has also taken a tough line in SEC cases against banks, initially rejecting a Bank of America settlement over Merrill, and rejecting a separate accord with Citigroup Inc (C.N) because that bank did not admit wrongdoing.
"Admitting it did something wrong could have preclusive effects in subsequent private civil litigation or parallel litigation involving the government, so the bank needs to tread carefully," David Freeman Engstrom, an associate professor at Stanford Law School, said in an interview about Bank of America. "Rolling the dice and going to trial may be more attractive."
The case is U.S. ex rel. O'Donnell v. Bank of America Corp et al, U.S. District Court, Southern District of New York, No. 12-01422.
(Reporting by Jonathan Stempel in New York; Additional reporting by Nate Raymond; Editing by Tim Dobbyn and John Wallace)
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:
"A 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." http://en.wikipedia.org/wiki/Derivative_suit
If Steve Linick, Inspector General of the Federal Housing Finance Agency, set out to bamboozle the press and the public, he succeeded beautifully.
With the notable exception of Nick Timiraos at The Wall Street Journal, just about every other major news outlet was tricked into believing that Fannie Mae and Freddie Mac were less than scrupulous about posting credit losses on their books. Check out these headlines:
Fannie Mae, Freddie Mac delaying write-offs of delinquent mortgages, Los Angeles Times
None of those claims is true. The issue under discussion would have a de minimis impact on the GSEs' reported earnings, probably something close to zero. But, given the false and misleading insinuations set forth in the IG's report, it's easy to see how reporters, always burdened by tight deadlines, were tricked.
If I weren't familiar with banking and accounting terminology, and with Fannie and Freddie's financials, I might have fallen for the IG's obfuscatory rhetoric as well. Here's a key passage of the IG report, which, for the most part, is BS. An explanation and translation into plain English follows:
FHFA examination staff identified no later than January 2012 a significant risk management issues relating to loan loss reserves, with potentially significant consequences for Fannie Mae and Freddie Mac, concerning the treatment of loans delinquent for more than 180 days.
Appropriately classifying assets according to risk characteristics is a key safety and soundness practice that could have an impact on loan loss reserves. The loan loss reserve is a critical/significant accounting estimate for both Fannie Mae and Freddie Mac.
FHFA recognized the issue's significance when it issued the advisory bulletin in April 2012, directing the enterprises to classify loans delinquent for more than 180 days as a "Loss." The bulletin notes that it is consistent with the system for loan classification followed by federal banking regulators.
The bulletin states that it "embodies a basic principle in GAAP that losses should be recognized on loans that are deemed uncollectible and that there should be no delay in loss recognition of probable incurred losses." (Emphasis added). Yet, it will not be fully implemented until January 2015, three years after the issue was first raised.
How Credit Losses Are Booked
First of all, here's how Fannie and Freddie recognize credit losses, in really simple terms. They look at their delinquent loans and then estimate a default rate (based on recent default rates) and a loss per property (based on the expected sale proceeds and mortgage insurance proceeds versus the loan balance). That estimated credit loss is expensed on the income statement for the current period. On the balance sheet, the loan amounts are not reduced, but the new loan loss reserve reduces total assets by the amount of the loss expense on the income statement.
Later, when foreclosure proceedings are actually initiated, a GSE will write down the face amount of the loan by the amount of the loss reserve, which is then extinguished. All of this is fully compliant with GAAP, and, if you parse the IG report carefully, no one is saying--as opposed to suggesting and insinuating--that the GSEs' financial accounting is not entirely proper.
A Simple Example: Here's a very simple example, which assumes that a GSE has only one loan on the books:
In the 1st quarter, a GSE estimates a 20% loss on a $100 loan. So current income is reduced by $20, and a $20 loan loss reserve is netted against the loan on the balance sheet, so that total loan assets, which were previously $100, now equal $80.
Then, in the 4th quarter, foreclosure proceedings are initiated, at which point the loan, which was previously $100, is now valued at $80, but the offsetting entry is the elimination of the $20 reserve. Total loans on the balance sheet, which were $80 before, are still $80.
Again, the initial loss provision in the 1st quarter affects income and net worth; the loan write-off in the 4th quarter is a wash, because assets are simply shifted from one account to another.
So WTF is the Inspector General talking about? Nothing subtstantive.
All along, the GSEs maintained their own systems of risk classification for loans in various stages of delinquency. And, consistent with accounting standards, they booked credit losses as soon as they saw signs of trouble. Over the past seven years, the GSEs methods for booking credit losses have proved to be excessively conservative, because actual proceeds from foreclosure liquidations were higher than the GSEs estimates of recovery.
In April 2012, the FHFA announced that the GSEs should change over to the risk classification systems used by bank regulators. Every banker knows those risk categories, which also represent successive stages of deterioration: Pass, Special Mention, Substandard, Doubtful, and Loss.
Generally speaking, a bank assigns a loss provision to any loan that has deteriorated to the Substandard category. The loss provision may increase as the loan deteriorates to Doubtful. When a loan is classified as Loss, the loan is written down, so, as in the GSE example above, the $100 loan and the $20 loss reserve will be converted into an $80 loan with no reserve. But the actual losses hit the income statement much earlier.
In terms of substance, what is the difference between the GSEs and the banks? The GSEs write down their loans as soon as the loan servicer initiates foreclosure proceedings, whereas, under bank regulations, the loan must be written down once it becomes 180 days delinquent. But again, writing down the loan should not impact the income statement. It's a timing difference that should wash out over time.
Yet the IG insinuates things that are not true:
- It insinuates that the GSEs were not maintaing proper risk classifications for their loans.
- It insinuates that the date when a loan is written down is the same as the date when the credit loss is recognized on the income statement.
- It insinuates that the GSEs failure to follow bank regulators' terminology, which designates retail mortgage loans in the "Loss" category once a loan is 180 days delinquent, is the same thing as failing the recognize a loan loss provision on the income statement.
First we start with Page 96 in the notes to the consolidated financial statements. As ofJune 30, 2013, FNM had about $140 billion in total delinquent loans on its balance sheet, including about $80 billion in the "seriously delinquent" category. Good guess for loss given default on this subset of bad paper is well north of the high 20% rates that FNM is reporting on current disposals and the 40% loss severity rates we hear discussed in polite society. One particular RMBS veteran thinks the severity on the 04-08 vintage is more like 60-70% because so much of the underlying collateral remains under water. The remaining delinquent loans total about $60 billion. FNM has about $50 billion in reserves set aside to cover losses on these bad loans and other assets.
So if FNM was to immediately implement the new accounting rules put in place in 2012, the question is what losses would be applied to the $140 billion? Looking at the loss severities for FNM loans bandied about by analysts, a haircut of about 40% would seem like a good point of departure. But let's instead go back to the figures as the top of this piece. If we put a 60-70% loss severity on that $80 billion in seriously delinquent loans, we are talking ~ $50 billion right there. Take half that rate -- 30-35% loss given default -- on the remaining delinquent loans and we get another ~ $20 billion or $70 billion or so in total charge offs against reserves.
Why the divergence from current FNM loss severities in the estimates? Because, as is axiomatic, the better loans and REO assets with lower losses tend to get sold first. To be conservative, in keeping with the FHFA guidance, a more severe haircut is appropriate. If the loss severities turn out to be lower, then the enterprise can book a recovery to loss reserves, which will positively affect income.
So if we were to implement the guidance from FHFA today, it is pretty clear that the profits of the GSEs would have been largely offset by the allocations needed to replenish the reserves. If we use the income figures from the FNM 10-Q, all of the "profits" from 2012 and the first half of 2013 would disappear, and then some. Reserves of $54 billion would be consumed and another $10-20 billion would need to be immediately allocated from income to cover the balance. Treasury would need to replace this deficit to avoid seeing FNM operating insolvent. Just for giggles, compare this adjustment to the $1.6 billion in charge-offs taken by FNM in Q2 2013 under the current rules.
FNM would then need to retain income to replenish reserves for future losses, but fortunately loss rates on new production are far lower than during the awful 2004-2008 period. Arguably a reserve buffer of $25-30 billion or half of current reserves would be a reasonable starting point for the "new," post crisis FNM. Some may differ with my view on loss severities, but for an investor in FNM, a $60-70 billion unrealized loan loss certainly seems material to me.
Whalen frames his analysis on the premise that Fannie is lying, because it has always lied:
After years, no, really decades of obfuscation and outright mendacity, are the folks at Fannie Mae and Freddie Mac really telling us the truth now about their financial condition? Washington is a city of lies, let us remember, with a good part of the population paid to disseminate falsities as part of their job description. But the biggest lie of all was allowing the GSEs to avoid marking their impaired assets down to fair value as commercial banks are required to do. Had this been done, the losses reported by the enterprises would have been far larger.
Speaking of which, we are still waiting to see how Whalen's other prediction, about Fannie and Freddie concealing $100 billion in losses, plays out.
As for the years of obfuscation and mendacity, check out:
It appears that Washington is finally getting around to grappling with the largest unresolved question left over from America's housing meltdown: What's to become of the government-backed mortgage giants, Fannie Mae and Freddie Mac? Their fate has been in limbo since the federal government bailed them out and put them in conservatorship in 2008.
Now, however, the two government-sponsored enterprises (GSEs) are reaping enormous profits as housing markets rebound. This has gotten lawmakers' attention. House Republicans have introduced a typically radical bill that would eliminate Fannie and Freddie altogether. A bipartisan Senate proposal would wind down Fannie and Freddie over five years and replace them with a similar functioning institution that charges a fee to insure loans in the event of catastrophic losses. And President Obama weighed in recently as well, saying it's time to end Fannie and Freddie “as we know them.” Though widely misinterpreted as a call to eliminate the GSEs, this artfully ambiguous formulation actually left the president a lot of wiggle room.
So Democrats and Republicans are laying out their opening positions in a crucial negotiation over the shape of America's future housing finance system. It's about time.
Clearly, we can't simply revert to the status quo before the housing crisis, when the GSEs (and their politically wired and lavishly paid executives) profited handsomely from the government's implicit guarantee of their securitized mortgage portfolios. Their structure enabled private investors to reap all the upside gains while exposing taxpayers to catastrophic downside losses.
So GSE reform is essential, but it shouldn't mean a death sentence. Without some kind of modified government guarantee, home buyers of modest means can kiss goodbye that sturdy prop of middle class home ownership: the 30-year, fixed-rate mortgage.
Shuttering the GSEs completely, as both bills call for, makes little sense. The idea that you can completely dismantle a housing finance infrastructure that is the foundation of an $11 trillion market is a fantasy the likes of which is only found in Washington. The likely outcome would be chaos, as banks and investors try to reconfigure trillions of dollars in mortgages they have sold into secondary markets with the help of Fannie and Freddie. Replacing the GSEs with some kind of similar institution would likely cost billions of dollars – making it one of the most expensive rebranding exercises in history.
Instead, a realistic debate would focus on how to reform the GSEs, while protecting taxpayers from future bailouts, preserving the 30-year fixed rate loan and reasonable down payments for the middle class. For that, reform should center on preserving the government guarantee. This is a nuanced but important difference to investors who buy GSE securities. Guarantees are absolute, while insurance has conditions that need to be met and can ultimately be rejected.
Here's another important reason why we shouldn't cavalierly junk Fannie and Freddie. They have spent the last 70 years acquiring vast experience in housing markets and boast a cadre of highly skilled specialists in housing finance. All this human capital and market intelligence institutionalized in the GSEs have become necessary to market efficiency and order. How exactly do we replicate that in five years while beginning from scratch? Aren't all the people we will need to staff the new institution the Senate bill envisions already working at Fannie and Freddie?
Nearly everyone agrees on the need to reduce the government's oversized footprint in housing finance and bring private capital back into the market. Right now the GSE's account for more than 90 percent of new lending. But if you took a poll of actual mortgage investors, as opposed to free market ideologues, you'd find few who actually want to drive government out of housing markets altogether. They just want a chance to go back to work making loans and not have to be priced out of the market by Uncle Sam.
OK, so let's shrink the amount of loans by the GSEs by increasing the fee for guaranteeing the mortgage (g-fees) and slowly decreasing guaranteed loan amounts. All the while we can use those two simple levers as a countercyclical measure if more liquidity is needed.
Similarly, there's little clamor on Main Street for doing away with Fannie and Freddie. Last time I checked, middle class homeowners still prefer fixed-rate mortgages, low rates and affordable down payments to tight credit and ARMs. No doubt, the GSE bailouts were expensive, requiring an initial taxpayer infusion of $187 billion. But Fannie and Freddie have been reaping so much cash – more than $15 billion in profits from the twins last quarter-as homeowners refinance and people purchase new homes – that taxpayers will get all their money back and then some by 2014. What's more, the loans they are making are pristine, high-quality, plain vanilla loans. No systemic risk here and no angry mobs on the lawns of Fannie and Freddie.
The conservative's claim that Fannie and Freddie somehow caused the housing bubble is pure fiction. To be sure, it's not easy to serve two masters – private shareholders and the government – and the GSEs never charged properly for the explicit government guarantee they provided to banks. That problem has been fixed. The GSE's most stable business line through the crisis was multi-family lending, which never experienced heightened losses. Those departments are still going strong. And this is the most crucial point: The GSEs went awry by acquiring portfolios of risky loans in pursuit of ever escalating market returns. Thanks to new loan standards issued as part of the Dodd-Frank regulatory reforms, the GSEs will never be able to operate that model again.
So, if government still has to play a role in housing markets please explain again why Fannie and Freddie must be shut down or replaced by something that performs functions indistinguishable from theirs? It's time for all sides to acknowledge that government has an indispensable role to play in expanding middle class home ownership. That's why GSEs need to be fixed, not thrown out with the bathwater.
Jason R. Gold is director of the Progressive Policy Institute's "Rebuilding Middle Class Wealth Project" and senior fellow for financial services policy. Keep up with his work at PPI here and follow him on Twitter at @PPI_JGold.
- Read Gregg Laskoski: Fracking Our Way to Higher Incomes
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“He (President Obama) says he wants to get rid of [Fannie and Freddie]. We’ve got to be very, very careful doing that. I have no problem looking at them, revamping. But I think getting rid of them is not the right thing to do.”
Senate Majority Leader Harry Reid
By Paul Muolo
August 12, 2013
Senate Majority Lender Harry Reid may support the president on many issues – but not when it comes to winding down Fannie Mae and Freddie Mac. “We have to make sure we protect home ownership and we have to make sure we do that and the reason we have Fannie and Freddie is because during the Great Depression people couldn’t buy homes and that’s why they (Fannie and Freddie) were developed,” he said late last week. Reid noted that he will consider what the White House has to say on the GSEs, but is offering no guarantees on what he will support. Some mortgage trade group officials are pointing to Reid’s comments as a sign that perhaps, finally, the GSE issue is being correctly understood in Washington. One lobbyist predicted that when it comes to an actual bill, it may be a matter of replacing what he calls the “entrance and foyer” of the GSEs, without gutting the “plumbing”…
Meanwhile, the federal government is on track to record a significant drop in the budget deficit this year with stronger growth helping to boost tax revenues. The Congressional Budget Office, in a new forecast, estimates that the deficit for the first 10 months of the fiscal year will be $606 billion, compared to $974 billion in the same period a year earlier. One reason for the improvement? Answer: the GSEs earning $15 billion a quarter in real profits. Annualized, that’s $60 billion…
The following text was taken from a white paper, Privatizing Fannie Mae and Freddie Mac, authored in 2004 by a group of Koch family funded lobbyists, masquerading as academics and analysts. We've posted extensively about Peter Wallison's misinformation campaign, and his connection to the unsuccessful effort to place blame for the subprime crisis on Fannie and Freddie's low-income housing initiatives (represented by Ed Pinto's untruths). The paper reads like an instruction manual for efforts to justify the conservatorship and then privatize Fannie and Freddie. Ironically, many of the concerns in the "risks" section were called out by Fannie Mae executives throughout 2000 with calls to increase guarantee fees and increase the risk-capital requirements, but were denied by the Bush appointed, government overseers of Fannie and Freddie (see details). This created a self fulfilling prophecy, in an attempt to generate one big free lunch for the government's subprime crisis bailout plans. I encourage you to get a cup of coffee before you begin reading the excerpt from the paper below. After reading the paper, it does not take long to realize that many of the items in this paper are playing out like greek poetry, which began on the first day that Fannie and Freddie were placed into conservatorship by the Bush administration.
The events leading up to the crisis, including the overstated losses of roughly $100B, were calculated maneuvers, which instantiated a planned effort to shift the entire secondary mortgage market to private banks. However, the turmoil, or disruptions to the mortgage market that erupted as a side-effect, as Wallison puts it, and the rampant fraud by big banks leading up to the conservatorship, were some of the "risk" factors that Wallison posited that his plan would avoid in leading up to the subprime crisis; these can be found in the sections preceding page 25 in Privatizing Fannie Mae and Freddie Mac. In other words, as you read the excerpts below from the document, including the insights into the outcome for Fannie and Freddie shareholders, realize that this paper was written in 2004, and then contrast Wallison's detailed plans with the current Corker-Warner GSE reform bill; they're almost entirely the same plan. As events often happen and history tells us, the impacts on the global economy and the magnitude of losses were never considered in AEI's plans for GSE reform. As the old poem states, and Ben Bernanke quoted in his speech to Princeton's graduating students, " . . . the best laid schemes of mice and men go often awry." Still doubt that the keys to the kingdom were handed over to big banks? Then why is the recently appointed CEO of Fannie Mae (appointed by the good friend of Mercatus, Ed DeMarco) a former top executive at Bank of America during the financial crisis?
Be sure you don't skip the juicy details below about the future of Fannie and Freddie shareholders.
Beginning from page 25 of Privatizing Fannie Mae and Freddie Mac
Mortgages and MBSs Held in Portfolio. Immediately upon enactment of privatization legislation (the act), the plan requires Fannie Mae and Freddie Mac to stop acquiring mortgages and MBSs for their portfolios but permits them to continue their activities as GSEs solely through the securitization of mortgages and the issuance of MBSs. The immediate effect of this step will be to stop the accumulation of interest rate risk by both enterprises and simultaneously begin the process of shrinking both their portfolios and their risks. However, because the process of mortgage securitization will continue, there will be no disruption of the residential mortgage market. Originators of mortgages, if they choose, will continue to sell their mortgages to Fannie and Freddie for subsequent securitization, or establish pools of mortgages against which MBSs guaranteed by Fannie or Freddie will be issued.
Since Fannie and Freddie will be forbidden to acquire any additional mortgages or MBSs for their portfolios as of the date of enactment of the act, their portfolios and their overall size will immediately begin to decline as mortgages are paid off or refinanced. To supplement this normal runoff, the plan requires that Fannie and Freddie sell off mortgages and MBSs according to a previously established five-year schedule. The purpose here is to assure that, at the end of five years from the date of enactment of the act, Fannie and Freddie will have sold off all the mortgages and MBSs they hold and will not delay disposition in the hope that Congress will eventually relieve them of this obligation. The plan contains penalties for failure to meet the required disposition schedule.
The proceeds of the sale of mortgages and MBSs will of course be used to pay down debt as it comes due during the five-year period after enactment. Nevertheless, at the end of that period, Fannie and Freddie are likely still to have outstanding debt contracted while they were GSEs. The plan provides for this debt to be defeased in a transaction in which Treasury securities in an amount sufficient to pay all interest and principal on the outstanding GSE debt will be placed in separate trusts by Fannie and Freddie. As the debt comes due, the proceeds of the sale of the Treasury securities will be used to liquidate it.
After providing for the defeasance of remaining debt, Fannie’s and Freddie’s charters will sunset and their remaining assets and liabilities be transferred to the holding companies they were permitted to establish, as described later. If Fannie and Freddie have taken certain necessary steps, also described later, their holding companies will be permitted to carry on any business, including the businesses of acquiring and securitizing mortgages.
Mortgage Securitization and the Issuance of MBSs. For six months after enactment, Fannie and Freddie will be permitted to continue to securitize mortgages and issue and guarantee MBSs without limit. Thereafter, for the next two and a half years, they will be required gradually to phase down their GSE securitization activities according to a schedule that will result in the complete termination of these activities three years from the date of enactment. At the end of this period, the remaining MBSs in trusts operated by Fannie and Freddie will be transferred to one or more well-capitalized trusts with independent trustees. The following summarizes the sequential privatization steps required under the plan:
INTRODUCTION AND SUMMARY 23
Date of enactment
All purchases of mortgages and MBSs for portfolio cease. Mortgage portfolio begins to run off.
Securitization continues as before.
Six months after date of enactment
Phase-out of GSE securitization activity begins.
10 percent of mortgage and MBSs portfolio on date of enactment (DOE) should have been liquidated.
One year after enactment
GSE securitization activity should be reduced by 20 percent. 20 percent of DOE mortgage and MBS portfolio should have been liquidated.
Two years after enactment
GSE securitization activity reduced by 60 percent.
40 percent of DOE mortgage and MBS portfolio should have been liquidated.
Three years after enactment
GSE securitization terminates.
60 percent of DOE mortgage and MBS portfolio should have been liquidated.
Four years after enactment
80 percent of DOE mortgage and MBS portfolio should have been liquidated.
Five years after enactment
100 percent of DOE mortgage and MBS portfolio should have been liquidated.
Remaining mortgages backing outstanding MBSs are transferred to trusts.
Debt not yet extinguished is defeased. Charters sunset.
The phase-down of Fannie and Freddie’s securitization will not necessarily result in any diminution in the total amount of securitization activity in the market. First, if Fannie and Freddie comply with two requirements outlined later, they will be permitted to set up non-GSE affiliates, under ordinary state-chartered corporations functioning as holding companies, to continue securitizing mortgages. These companies, as will be described, can engage in any other activity permitted by the laws of the state of their chartering. Second, once Fannie and Freddie (as GSEs) no longer occupy the entire field for securitization of conventional and conforming loans, many other companies that currently securitize mortgages in the so-called jumbo market will be able to compete for product in the conventional and conforming market.
The Establishment of Holding Companies and Affiliates. Immediately after the enactment of the act, Fannie and Freddie will be permitted to establish holding companies—ordinary corporations chartered under the law of a state. These companies will be authorized to engage in any activity permissible for corporations chartered in that state and will be the parent companies of both Fannie and Freddie and their non-GSE affiliates that, among other things, will be permitted to engage in acquiring and securitizing mortgages.
However, although the various corporate steps can be taken to create these holding companies and their non-GSE subsidiaries, neither the holding companies nor any non-GSE subsidiaries will be able to engage in any business activity (other than acting as the parent companies of Fannie and Freddie) until their respective GSE subsidiaries have taken two steps: (1) achieved a level of capitalization that the then regulator of Fannie and Freddie considers equivalent to the level of capitalization a company would have to maintain for its debt to be rated AA by a recognized debt rating agency; and (2) spun off, to separate companies owned, respectively, by the shareholders of Fannie and Freddie, copies of their automated underwriting systems and copies of all information in their databases that pertain to the business of underwriting, acquiring, or securitizing mortgages. The regulator of Fannie and Freddie is required by the plan to certify that all relevant information has been spun off and Fannie and Freddie continue to maintain what would be the equivalent of an AA rating on their debt.
INTRODUCTION AND SUMMARY
The purpose of requiring an AA-equivalent rating is to prevent Fannie and Freddie from using their continuing GSE status to attract capital and support their operations, while transferring most of their assets to the holding company. The purpose of requiring that they spin off copies of their automated underwriting systems is to assure that, even as privatized companies, Fannie and Freddie are unable to dominate the mortgage market through their superior data on conventional/conforming mortgages or the fact that many originators have become accustomed to working within the parameters of their automated underwriting systems. By requiring that these assets be spun off to independent companies owned by their shareholders, the plan intends to give the shareholders of Fannie and Freddie an opportunity to realize the value of these assets. The spun-off companies, which will be required to maintain their independence from the GSEs, the GSEs’ holding companies, or any other participants in the mortgage market, can engage in any activity, but they will be required to license the automated underwriting systems and the databases to all comers, on essentially comparable terms.
Thus, at the conclusion of this process, Fannie and Freddie will have been liquidated and their charters revoked. However, they will be succeeded by fully private companies that can engage in any activity, including the same businesses in which Fannie and Freddie engaged as GSEs. The residential finance market, in addition, will have become considerably more competitive. Instead of two companies dominating the market and earning oligopolistic profits, many companies will compete, seeking to make what are now classified as conventional/conforming loans, to hold them as investments or securitize them. It is likely that this competition and the innovations it will spawn relatively quickly will drive mortgage costs down to a level equivalent to the level that prevailed when Fannie and Freddie dominated the market. However, in this case, the shareholders of the competing companies, and not U.S. taxpayers, will bear the risks associated with this business.
This privatization program bears a strong resemblance to that of Sallie Mae, which was implemented in the mid-1990s. Sallie Mae was also privatized through the creation of a non-GSE holding company and the gradual runoff of its GSE portfolio. As the GSE portfolio declined, the business of the holding company grew, so that, after a period of years, the holding company was operating without the restrictions applicable to a GSE.
However, there are important differences between the two structures. Sallie Mae was permitted to continue buying and selling student loans through the GSE for ten years from the date of enactment, and few controls were placed on the transfer of assets from the GSE to the holding company, so that the holding company received significant benefits, courtesy of the taxpayers. In this plan, the portfolios of mortgages and MBSs held by Fannie and Freddie are not permitted to grow and are required to meet a phase-out schedule that will result in the liquidation of the entire portfolio within five years. In addition, by requiring that the GSEs maintain an AA-equivalent rating if they want to be affiliated with operating holding companies, the plan will prevent them from transferring assets to their holding company parents until they are fully liquidated.
As it happens, we believe the mortgage market can be further improved through the establishment of mortgage holding subsidiaries for banks and other entities. That concept, developed by Bert Ely for the American Enterprise Institute, is discussed later in this monograph. At this point, however, we proceed to a discussion of the privatization of the FHLBs.
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