FNMA: new capital agreement

As expected, FHFA and Treasury announced their negotiated letter agreements allowing Fannie and Freddie to retain more capital. The Fannie and Freddie modifications can be found on the FHFA’s website:

https://www.fhfa.gov/Media/PublicAffairs/Pages/Statement-from-FHFA-Director-Mark-Calabria-on-Letter-Agreement-with-Treasury-to-Increase-Fannie-Freddie-Capital-Retention.aspx

I’ll provide a few observations.

(1) As opposed to allowing unrestricted earnings retention, the agreements instead increase the capital reserve buffer to specific thresholds – $25bn for Fannie and $20bn for Freddie. The most recent capital buffers were $3bn for each entity. Nevertheless, this will immediately suspend dividends to Treasury.

(2) As suggested in the press, the increased capital reserve buffers will also increase Treasury’s senior preferred liquidation preference on a 1:1 basis. This means that the Fannie and Freddie senior preferred liquidation preferences will increase by $22bn and $17bn respectively. This has the effect of ensuring that none of the retained earnings actually accrue to the benefit of the junior prefs or common. This effectively continues the net worth sweep and is in conflict with the Fifth Circuit decision.

(3) Despite touting this as a key first step in rebuilding capital, a basic understanding of accounting would conclude that this step is actually capital neutral. In the press release, Calabria would incorrectly note:

“The Enterprises are leveraged nearly 1,000-to-one, ensuring they would fail during an economic downturn – exposing taxpayers once again. This letter agreement between Treasury and FHFA, which allows the Enterprises to retain capital of up to $45 billion combined, is an important milestone on the path to reform.”

Mark Calabria

The senior preferred is a cumulative dividend security, meaning that it is logically excluded from core capital ratios (the junior prefs are non-cumulative securities, so these securities conversely account for core capital). So despite Fannie and Freddie increasing retained earnings on a go-forward basis, the senior preferred capital disallowance is similarly increased, creating no net benefit to key regulatory capital ratios. As long as this quasi-net worth sweep remains in place, the GSEs cannot build capital.

(4) I think Calabria and Mnuchin fully understand that today’s announcement does not actually build capital, but instead see it as a first of many steps. Calabria would note:

FHFA commits to working with Treasury in the coming months to amend the share agreements and further advance broader housing finance reform. These reform goals include limiting the government’s role in housing finance, increasing marketplace competition, focusing on affordable housing, and sustainable homeownership. The status quo is not an option. Now is the time to act.

Mark Calabria

I continue to believe that a private capital raise – a key goal of the Treasury plan – can only be completed if the senior preferred is deemed repaid as part of a settlement. Otherwise, investors won’t put up new money. In isolation, today’s announcement does nothing to advance that plan. It does allow FHFA and Treasury to retain some negotiating leverage though. And to the extent that the senior preferred is later deemed repaid, the interim period’s retained earnings will then immediately accrue to core capital. When viewed through that sequence of events, today’s announcement actually makes perfect sense.

Managing the optics around negotiations will continue to be important. Junior prefs will want immediate value in excess of par, a preference for cash, and Treasury refunds for prior senior preferred “over-payments.” I think a senior preferred elimination and junior preferred conversion into common (at a favorable ratio) best balances the optics and negotiating leverage of each side.

All things considered, today’s announcement is exactly as expected. I’m looking forward to seeing what additional progress is made before year-end.