ICBA Calls for Restoring GSE Preferred Dividends
Mar/100
Last week, Camden Fine, President and CEO of the Independent Community Bankers Association, sent a letter to Secretary of the Treasury Timothy Geithner asking Treasury to restore the dividends on Fannie Mae and Freddie Mac preferred stock. Reading the letter, the community bankers feel like they were sold a bill of goods by Hank Paulson. It seems that Paulson’s book has enraged the ICBA, especially the fact that Paulson was proud to keep his promise to his “Chinese friends” for making them whole on GSE senior debt and MBS.
Let me know if it feels like the political rhetoric has died down regarding the GSEs.
March 12, 2010
The Honorable Timothy Geithner
Secretary of the Treasury
U.S. Department of the Treasury
1500 Pennsylvania Avenue, N.W.
Washington, DC 20220
Dear Secretary Geithner:
On behalf of the 5,000 members of the Independent Community Bankers of America I urge prompt Treasury action to remedy the status of preferred shareholders of the Government Sponsored Enterprises Fannie Mae and Freddie Mac. As the Administration and Treasury continue to control Fannie Mae and Freddie Mac in conservatorship and seek resolution to this unique GSE status, it is imperative that community bank GSE preferred shareholders are made whole to bolster capital and lending levels in this challenging financial and economic environment.
The abrupt action by then Treasury Secretary Henry Paulson to seize Fannie and Freddie through conservatorship was unjustly done in a way that needlessly crushed the value of GSE preferred shares, injuring over a thousand community banks that purchased these shares as a safe AAArated investment at the encouragement of their bank regulators. Since banks received special regulatory capital treatment for them and since banks are generally prohibited from investing in stock of other corporations, Fannie and Freddie preferred stock were important investments with full regulatory blessing.
Shockingly, Secretary Paulson fully acknowledges in his new book On the Brink that this action constituted an “ambush.” It took place shortly after he and the GSE regulators issued statements that supported the ongoing viability and capital levels of the GSEs in their current form as “shareholder-owned companies,” in order to “calm the market fears of a government takeover that would wipe out shareholders.” Now there is no doubt the government’s action was indeed an unjustified “ambush” structured in a way that continues to have detrimental consequences on many community banks that relied on the guidance of Treasury and bank regulators and were intentionally deceived on their Fannie and Freddie preferred holdings.
Americans expect and demand much better from their government and leaders. The lCBA urges the Treasury to help restore the value of the Fannie and Freddie community bank preferred share holdings to levels prior to the abrupt conservatorship of Fannie and Freddie. Preferred Fannie and Freddie shareholders should be compensated for the government’s action of eliminating all dividend payments and placing the preferred shares in a second position.
Rather than help stabilize the financial sector and boost lending, this government “ambush” further hurt banks’ capital levels, weakened the banks and reduced available credit. Such rogue changing of the rules governing preferred stock contracts also sent the entire market for financial preferred shares into a freefall, making it even more difficult for financial firms to raise needed capital. Notably, nearly $36 billion in Fannie and Freddie preferred stock was outstanding prior to their conservatorship. An estimated $15 to $20 billion was held by the banking sector and almost one-third of banks reported holdings including many Main Street community banks.
The Troubled Asset Relief Fund devoted $700 billion to help restoring financial sector credit and to increase lending with mixed use and results to date. However, if we truly want to help stabilize the financial sector, boost small business credit and economic growth, Treasury must also restore a reasonable value to GSE preferred stock so that affected banks can again increase their lending.
ICBA urges immediately restoring the dividend payments on Fannie and Freddie preferred shares and paying injured holders the amount of suspended dividends from September 7, 2008 on an estimated $20 billion in GSE preferred holdings. As the Administration works to remove the GSEs from conservatorship ICBA urges it be done in a way that will restore a reasonable value to the preferred shares. Helping restore the $15 to $20 billion in community banks capital value crushed by the unwarranted Treasury actions perpetrated on preferred shares can foster $150 billion to $200 billion in new lending as banks can leverage this capital.
Sadly, the Treasury and policymakers were forewarned of the distress and fallout that lmnecessarilv crushing GSE preferred shares would cause. For example, the attached letter dated August 271h, 2008 specifically warned of the community banks’ significant GSE preferred holdings that typically pay a fixed dividend and take priority over common stock. Unfortunately, Treasury chose to ignore the warnings when they turned the GSE preferred stock upside down when placing Fannie and Freddie into conservatorship on September 7, 2008. Mr. Paulson acknowledges in his book that he ambushed Fannie and Freddie shareholders in part to help satisfy the Chinese government, which owned billions of dollars in Fannie and Freddie bonds. Mr. Paulson notes that he called “my old friend Zhou Xiaochuan,” the head of the Central Bank of China, and China’s key financial leaders and said: “I always said we’d live up to our obligations.” ICBA believes it is now time to live up to United States obligations and help spur lending by compensating Fannie and Freddie preferred shareholders for the unjust actions of the government.
Sincerely,
/s/
Camden R. Fine
President and CEO
cc: The Honorable David Axelrod, Assistant to the President and Senior Advisor
The Honorable Lawrence Summers, Assistant to the President for Economic Policy and
Director, National Economic Council
The Honorable Eric Holder, Jr., U.s. Attorney General
The Honorable Michael Barr, Assistant Secretary for Financial Institutions
The Honorable Herb Allison, Jr, Assistant Secretary for Financial Institutions
The Honorable Barney Frank, Chairman, House Financial Services Committee
The Honorable Spencer Bachus, Ranking Member House Financial Services Committee
The Honorable Chris Dodd, Chairman, Senate Committee on Banking
The Honorable Richard Shelby, Ranking Member, Senate Committee on Banking
So Where is GSE Reform Going, Anyway?
Jan/101
by Robert W. Zimmer
This Reuters article is the rare GSE journalist piece that calls it like it is. Let’s review the options laid out and see what’s what.
In religious wars, there are no innocent bystanders. This is certainly true for the multi-year tussle over the GSEs (Fannie Mae/FNM, Freddie Mac/FRE) and how they might fit or not fit in the US economic fabric going forward—and trust me, almost every journalist has an ax to grind one way or the other. In their heyday the GSEs were so big, so popular, and so powerful, that they swept skeptics and opponents out their way with ease—creating long-lasting enemies, including among the press.
Thus it is hard to find an unbiased viewpoint. Many journalists openly root for the GSE concept to fail and never raise its egotistical head again. Others take the contrarian view for sport. But finally there’s a piece that lays it out, with no agenda, and no ax. Let’s go over the Reuters piece in some detail.
Reuters: “That timeline (the unlimited backstop announced Dec 24) gives the Obama administration time to figure out what to do with the two entities since any changes are politically difficult and most analysts see the process taking years.”
Analysis: Dead on. The complexity of the secondary mortgage markets, combined with fear of yet-to-come exploding Option ARMS and weakening CRE markets, means there is no rush to “resolve” the GSE model legislatively. Washington policymakers want low interest rates and more modifications, and the conservatorship model is delivering them.
Reuters: “FULL NATIONALIZATION -This might be the easiest option and would return the companies to their origins as a government tool to nurture the housing market. Some analysts see the Obama administration’s Christmas eve move as a signal this is the direction they are leaning, but top White House economic adviser Lawrence Summers told the Wall Street Journal in late December “that certainly would not be the direction I would expect.” “
Analysis: Correct again. The “public option” didn’t work in the health care arena, and it won’t work here, especially as Republicans will undoubtably gain seats in the 2010 elections. And no one wants to further balloon the US budget deficit, which would happen if the GSEs were to be 100 percent nationalized. (Investors owning 20.1 percent of the companies, take heart! The US government can’t afford to take you out.)
Reuters: “PRIVATIZATION WITH PAYMENT FOR INSURANCE - Policy-makers might return the companies to investors and offer to insure Fannie Mae and Freddie Mac investments.
Washington could charge the companies a fee to underwrite their debt and some of their mortgage securities as a way to nurture the housing finance sector without standing squarely behind the companies. This idea, aired by Federal Reserve Chairman Ben Bernanke, would be akin to the Federal Deposit Insurance Corporation’s protection of banks.”
Analysis: Yes, an idea in play. This option recognizes that no one will ever believe going forward that the government wouldn’t step in again in times of debt market crises. So why not make the GSEs (and their shareholders) pay for the backing?
Reuters: “COOPERATIVES WITH LOOSE GOVERNMENT TIES - Fannie Mae and Freddie Mac could be run by the companies that sell them home loans. In such a cooperative arrangement, Fannie and Freddie would focus on long-term, stable business rather than maximizing profits. The federal government might still offer to insure the companies against the most catastrophic losses. This arrangement could be akin to the Federal Home Loan Bank system where a dozen regional lenders are jointly and severally liable for any one member’s losses and the federal government acts as guarantor of the entire system.”
Analysis: Dead wrong. The capital dedicated to cooperatives is not viewed as sufficiently flexible to support a dynamic mortgage market. More importantly, constituencies such as the Realtors and small bankers use the GSEs as a bulwark against the ever-larger, Federal-Reserve-leveraged, TARP-assisted Wall Street banks (does anyone believe THEY wouldn’t be bailed out again in a debt crisis?) that increasingly control the US mortgage market origination business—and these constituencies won’t tolerate the big banks controlling Freddie and Fannie via a coop model.
Reuters: “UTILITIES MODEL - Just like power and water companies that provide vital services, Fannie Mae and Freddie Mac could be run as private entities that have strong government oversight. The companies would aim to turn a profit and would have no government backing, but a conservative board would set earnings payments and customer fees.”
Analysis: Can’t rule this out. Stronger government oversight would have saved the GSEs from over-extending themselves in the bubble years, and a controlled ROE wouldn’t be the end of the world. And even guarantee fees could be subject to public rulemaking.
Reuters: “PRIVATE MORTGAGE-FINANCE COMPANIES - Although Fannie and Freddie are in government hands, their regulator is still trying to keep their shares trading. The agencies could emerge as large mortgage finance companies that bundle home loans for investors and raise funds in the traditional capital markets. Without government ties, though, the companies would not have lower funding costs and so would not enjoy the competitive advantage they do now. The federal government would also lose one of its most powerful tools for helping low-income home buyers. GAO said privatizing or terminating Fannie Mae and Freddie Mac would disperse mortgage lending and risk management through the private sector.”
Analysis: Not a chance. Full privatization would result in mortgage rates rising across the board by 50-100 basis points, and long-term, fixed-rate mortgages would be more difficult, if not impossible, to obtain. How many politicians want to get in front of THAT wagon? As for the GAO’s optimism of the private sector filling the space…really? Last time we checked, those guys checked out at the first sign of market instability. Anyone who has worked a day in finance knows that pure financiers are herd animals, which works well in most finance markets, but not the mortgage one.
Reuters: “COVERED BONDS - Covered bonds could become a mortgage finance tool to rival the influence of Fannie Mae and Freddie Mac. Unlike traditional mortgage-backed securities, which are frozen blocks of home loans, covered bonds allow banks to manage a dynamic pool of mortgages. This financing tool is popular in Europe but has a weak foothold in the United States because of regulatory constraints and the competitive advantages of Fannie Mae and Freddie Mac. The fate of those companies will have a direct impact on the future of covered bonds. “
Analysis: Covered bonds certainly have a place in the market going forward, but for reasons beyond the scope of this article, they can’t replace the securitization and retained portfolio model of the GSEs entirely. They will supplement, not replace, the function of the GSEs.
Conclusion: The Reuters piece is an excellent piece of reporting. With an overlay of basic political analysis, we can further narrow the scope of the ultimate options that will be debated by policymakers in Washington. And someday—believe it or not—the religious wars over the GSEs may actually reach an end. And we’ll all be better off for that ending.
Robert W. Zimmer is Principal at TVDC, a Washington-based financial services consulting firm.
Rebuttal to GSE Worthless Analysis
Oct/092
On Monday, the respected financial services boutique brokerage firm, KBW, published a report declaring the common and preferred shares of Fannie Mae and Freddie Mac to be “worthless.” The conclusion of the report was based on a contrived scenario where Fannie and Freddie are separated into good-bank/bad-bank entities and the future profits are diverted away from paying down the government’s ownership stake in the companies. If this scenario were to happen, it would be another huge subsidy for the big mortgage banking firms at the expense of taxpayers like you and me.
Bank Co-operative Model is a Bad Idea
Fannie and Freddie should not be restructured into bank-owned co-operatives. The brokerage report held up the FHLB System as a model for the future structure of Fannie and Freddie. The FHLB System is a poorly constructed system and is not an enviable model. The FHLB System allows the large banks to borrow money at government subsidized rates. The banks can use this borrowed money for any kind of lending they want such as auto loans, commercial loans, boat loans or even loans to foreign countries. This system has not prevented the FHLB Banks from posting large losses during the housing crisis. Another reason the FHLB System is bad is that it presents sizable systemic risks because it has no permanent capital. Members of the FHLB system can withdraw their capital on 90 days notice. In spite of nominally higher capital levels, the fact that FHLB capital is withdrawable makes the banks less stable than Fannie and Freddie. Moving Fannie and Freddie to a less stable capital structure is a bad idea.
Good-Bank/Bad-Bank Proposal Doesn’t Make Sense
Separating Fannie and Freddie into a good-bank/bad-bank as the KBW authors propose will not work because it is not a classic good-bank/bad-bank restructuring. First, in this proposal, the bad bank can’t support itself. Second, the authors transfer ownership of the good-bank to new owners. The concept of a good-bank/bad-bank split only makes sense if both entities are viable and self-supporting and have identical owners. The good-bank is a clean entity and can be more easily valued by the stock market. The bad-bank is capitalized to be self-standing and management can workout problem assets over time to realize maximum value without worrying about the timing of accounting gains or losses. The classic practical application was Mellon Bank in the 1980’s. In this report, the authors propose setting up the bad-bank as a non-viable entity from the start, and they assume a transfer ownership of the good-bank without any compensation. I submit that you can claim any financial institution in the country is worthless under the authors’ version of a good-bank/bad-bank scenario.
Holes in the KBW/GSE Model
There are multiple problems with KBW’s model that shows Fannie and Freddie having problems paying back the Treasury.
1. Bad-Bank Focus– As discussed earlier, as long as Fannie and Freddie are not separated into good-bank/bad-bank entities, they will be able to use revenue from new business to payoff the Treasury’s ownership position. Using the revenue from the good-bank will add $38 billion to Fannie and $25 billion to Freddie.
2. Double Counting Operating Expense – KBW’s model has operating expenses double counted. This adds $14 billion in expense to Fannie and $10 billion in expense to Freddie.
3. Severity Assumption is Too High – KBW uses 60% severity in its base case compared to John Hempton’s severity assumption of 45%. (BTW, the definitive analysis of the current value of Fannie and Freddie can be found in John Hempton’s series of blog postings on Fannie and Freddie.) I trust Hempton’s assumption more than KBW’s as he builds it up by vintage year. This accounts for $29 billion at Fannie and $15 billion at Freddie.
4. Mortgage portfolio run-off is much greater than mandated by Treasury – KBW assumes a run-off of the current on-balance sheet mortgage portfolio at a rate faster than mandated by the Treasury agreement. This accounts for $18 billion in lost revenue at both companies.
5. Assumed NIM is low – KBW assumed a 1% net interest margin which is low given the steep yield curve. If we assume Fannie and Freddie can keep their current margin for a three more years then revert to a 1% margin, it adds another $19 billion of revenue to both companies.
With these changes to KBW’s model, I calculate both companies can payback the Treasury:
($ billions) Fannie Freddie
Assumed shortfall from KBW model -49 -39
No good-bank/bad-bank separation +38 +25
Not double counting expenses +14 +10
Hempton’s severity assumption +29 +15
Slower portfolio run-off +18 +18
Current NIM +19 +19
New Capital Surplus +69 +48
With any model, the results are heavily dependent on assumptions. The user of a model must be well-versed in the assumptions before relying on its output. This analysis shows that by changing (and/or correcting) a few assumptions in the KBW/GSE model that the companies have plenty extra capital to pay back the Treasury, which is the opposite conclusion of the KBW report.
Another important assumption in the KBW model, which makes the GSEs’ capital positions look weaker is the assumption that they cannot raise capital from the public markets. Once the GSEs return to profitability, they may be able to raise equity to repay the Treasury.
Conclusion
The GSEs aren’t worthless until Congress restructures them and shareholders no longer have valid claims. Until Congress passes a law, the GSEs are working hard to mitigate their problem loans and to provide continued credit support to the housing market. Their income statements will flip from posting losses to reporting positive net income as we pass the peak loss years on the mortgages of 2006-2008. Freddie reported a profit in the last quarter, and it will be difficult to wipeout Fannie and Freddie shareholders once they return to sustained profitability.
Fannie and Freddie Model from Bronte Capital
Aug/091
John Hempton of Bronte Capital has written a fascinating series of articles on Fannie Mae and Freddie Mac. He models Freddie’s credit losses and revenues and comes to the conclusion that the company will earn its way to paying back the Treasury. He concludes that the way for investors to position themselves is to buy preferred stock in Fannie and Freddie.
Part I - Introduction and Where Losses Came From
Part II - Write Downs on Private Label Securities
Part III - Default Curves
Part IV - Estimates of Lifetime Defaults by Loan Vintage
Part V - Net Interest Margin
Part VI - Putting the Model Together
Part VII - Answering Criticsms
Part VIII - Risks
Not surprisingly, I completely agree with his analysis. I own a substantial amount of GSE preferred stock in Gator Financial Partners. In fact, it is, by far, my largest position.
Make Fannie’s Deal No Worse Than TARP
Aug/090
Given Freddie Mac’s recently report profitable 2nd quarter earnings report, it is time for Treasury Secretary Geithner to amend the terms of Fannie Mae and Freddie Mac’s Senior Preferred Stock Purchase Plan with the Treasury to be comparable to the preferred stock purchases the Treasury made in commercial banks last October under TARP.
Reasons to Change Fannie and Freddie’s Deal with the Treasury
1. Fannie and Freddie should not have a materially worse deal than the banks just because their deal was cut 4 weeks before TARP.
2. Fannie and Freddie are critical to the domestic economy as they have been the only source of mortgage capital for the past 12 months.
3. The mortgage market will need private capital in the future and cannot rely on government support forever, so Fannie and Freddie will have to raise more capital in the future. If the GSEs are going to raise capital in the future, the Treasury is going to have to treat existing capital better than its current deal with the GSEs.
4. Fannie and Freddie incurred higher expenses because they were team players and supported the Obama Administration’s economic recovery plan. Changing their deal would be a small payback for the support they have given the country and the Administration.
5. Recognition that placing the GSEs in conservatorship was a political attack by led by former Treasury Secretary Paulson.
6. Recognition that former Treasury Secretary Paulson caused a decline in the GSEs stock prices by not outlining the terms under which he would provide capital to the GSEs in the July 2008 legislation. Sec. Paulson then used circular reasoning in claiming that the GSEs had to be taken over because they had low stock prices and couldn’t raise capital. In fact, they couldn’t raise capital because he would not state the terms of a potential future Treasury investment.
7. Paulson’s reasoning for the harsh treatment of GSE shareholders was that shareholders had to pay for the poor risks taken by the companies’ management teams. I disagree since many shareholders were giving advice to the respective managements to raise capital and reduce risk. Rich Pzena was the most outspoken shareholder on this point. Plus, Paulson reversed his position on this issue once he was proven wrong with his handling of the Lehman situation and treated the bank shareholders on much more friendly terms.
8. Eliminating the dividend on Fannie and Freddie’s preferred stockholders was a failed experiment on the part of Sec. Paulson and destroyed the new issuance market for preferred stock. It also hurt many small banks that held Fannie and Freddie preferred stock in their portfolios.
9. GSE preferred stock is still primarily owned by small banks. When dividends are restored, the value of the preferred stock will increase by 10x. This will add approximately $30 billion in restored capital to the commercial banking industry. If banks levered this capital 12x, this raises industry lending capacity by $360 billion.
10. The losses by the GSEs since entering conservatorship have been inflated because a) they are mostly write-downs of deferred tax-assets which the companies still retain and b) the credit reserve build was bigger than expected because Sec. Paulson sent the economy into a tailspin by not providing an orderly wind down to Lehman Brothers.
Terms to Change
1. Lower Preferred Stock Coupon to 5% from 10%. There is no justification for the GSEs to pay a higher coupon than the banks.
2. Change the Treasury’s warrant from 79.99% of the GSEs’ equity to terms identical to the warrant deal received by the banks under TARP. Similar to the preceding point, there is no justification for the GSEs to give the U.S. a higher equity stake for than the banks did.
3. Make the Treasury’s preferred stock pari passu with existing preferred stock. This is another move to equal the banks’ deal under TARP
4. Eliminate asset size restrictions on Fannie and Freddie’s mortgage portfolios. This provision proves my Republican conspiracy theory for placing the GSEs into conservatorship. There is no reason to shrink the GSEs at this point. We need the GSEs to expand their balance sheets. The Fed has temporarily stepped into the breached left by the GSEs not growing. But, what is going to happen when the Fed steps back from the mortgage market? We need the GSEs to support the market as the Fed reduces its balance sheet.
The GSEs deal with the Treasury Secretary should be updated to be similar to the deal the banks received under TARP. Based on the nobler GSE housing mission, there is an argument that they should be treated better than the banks. The banks have no legs to stand on because the FDIC insurance they receive from the federal government is a larger subsidy than the implicit guarantee Fannie and Freddie enjoy.