Freddie Mac and Fannie Mae provide the financing for almost half of all the residential mortgages in America. When they came under severe distress in the financial crisis of 2008, they were placed by their regulator – the Federal Housing Finance Agency (FHFA) – into conservatorship, an obscure legal status whereby they continue to operate but under the direct control of the FHFA, rather than their shareholders or Board. Their longtime business model is based upon being special, Congressionally-created companies that serve a public mission. To achieve that mission, they are given government support so they can access debt markets on terms almost as good as the US Treasury itself. At the height of the financial crisis, the market lost confidence in the two companies, including in the strength of their government support as it was not codified in any legal agreements (which is why it was referred to as an “implied guarantee”). Therefore, when they entered conservatorship in September 2008, each company became supported more formally by Treasury through a new Preferred Stock Purchase Agreement (PSPA), a binding legal agreement in which Treasury promised to invest in their equity up to very large amounts to minimize the likelihood of them ever having negative net worth. This was effective in restoring market confidence in the GSEs and has successfully kept their market access at near-Treasury rates ever since.

On January 14, Treasury and the FHFA announced revisions to the PSPA agreements. Rumors had been flying since early November, as the Trump administration entered its lame duck period between the election and the inauguration of President Biden, that the Director of the FHFA, Mark Calabria, was pushing for extensive changes, which would require the agreement of Treasury Secretary Mnuchin, who was of course going to leave office no later than the inauguration. The rumors ranged widely, speculating about how the conservatorships might be ended, how Treasury might take steps favorable to the owners of the pre-conservatorship equity of the company, how they would include new restrictions on the kind of business the GSEs could do, and so on. The rumors varied from the seemingly credible to what clearly looked like wishful thinking on the part of ideological and economic interest groups.

The actual changes, announced on January 14, were indeed numerous. This article, from Compass Point Research & Trading, written by Isaac Boltansky, one of the few respected non-partisan analysts of the GSEs, provides a good summary. I will not attempt to duplicate it, or any of the other summaries that have been published in the aftermath of the changes. Rather, my goal is to provide strategic understanding about the changes, i.e. what are the real policy impacts that readers should know about?

In pushing for these changes, Director Calabria is known to have had two longstanding policy objectives: (1) push to end conservatorship sooner rather than later, with the companies becoming fully capitalized as quickly as possible; and (2) significantly reduce the scope of the GSEs’ activities, known in Washington as “shrinking their footprint.” The latter objective, in particular, reflects his free-market policy background which sees the GSEs as representing inappropriate intrusions by the government into the financing of home mortgages.

By contrast, Secretary Mnuchin during his term had not been particularly vocal about his GSE policy objectives, but from closely observing his actions and limited pronouncements over the last several years, they can reasonably be discerned to have been: (1) do not do anything that will cause financial instability or hurt the economy; (2) do not do anything that unnecessarily produces a windfall profit for the professional investors who now own significant percentages of the pre-conservatorship common equity and preferred shares of the GSEs; and (3) address GSE reform with no-rush thoughtfulness as mistakes can be extremely costly to homeownership and the economy.

With this background, I believe there are ten policy-level conclusions to draw from the PSPA revisions. Listed last, based upon the cumulative impact of the changes, is how much regulatory and executive power is being moved to Treasury from the FHFA in the long run, a potentially impactful change which I have not seen commented upon in the media to date.

1. Earnings retention continues!

This is the only significantly impactful action taken in the revisions, the rest are secondary by comparison. It will allow the GSEs to continue to retain earnings well beyond the limit set in September 2019 of $25 billion for Fannie Mae and $20 billion for Freddie Mac, which each is expected to reach sometime this year. It was never clear why those limits were set in the first place, but eliminating them is good news – and supported widely across the political spectrum, as it will make future actions with respect to the GSEs easier, no matter what path forward is taken. If earnings retention had started years earlier, it would have been even better.

2. Treasury is still not fully engaged in preparing to end the conservatorships.

The taxpayer, through Treasury, deserves compensation for their support to the companies via the two PSPAs. This eventually, but absolutely no later than the end of conservatorship, needs to be in the form of a fee (sometimes called the “periodic commitment fee”). However, Treasury has once again avoided setting a fee – for reasons that are mysterious to me – and this is conspicuous by its absence in the announced PSPA changes. Instead, Treasury is continuing to be compensated by an increase in the amount of the GSE preferred shares that Treasury owns – a non-conventional approach that may or may not, in the end, deliver much additional value to the taxpayers for their continuing support. Until Treasury sets a fee, it isn’t serious about doing what it needs to do (a list which is extensive) for the companies to exit conservatorship, since setting that fee is one of the first things that sequentially needs to be done in an exit scenario. In fact, the sooner the fee is set, the more robust and accurate planning for exit can become.

3. The suing investors got nothing.

When the GSEs were placed in conservatorship in 2008, their publicly-owned equity outstanding at the time (i.e. common stock and some preferred stock) was not extinguished. There was, however, no certainty that equity would be worth anything, as it is subordinate to the advances Treasury has made to support the two companies since then. Over the years, the ownership of these pre-conservatorship shares have become dominated by professional investors (e.g. hedge funds, private equity firms) looking to make a large profit on some sort of conservatorship exit, as the two companies (contrary to original expectations back in 2008) became significantly profitable again beginning around 2013. To that end, these professional investors have sued the government extensively (one such case is currently in front of the Supreme Court) and also engaged in classic Washington-style lobbying and influencing activities. In recent months, rumors were rampant that the PSPA changes would be favorable to these investors – although it was unclear if such rumors represented insider knowledge versus self-serving gossip. In the end, the investors were ignored – they got exactly zero. They will instead have to focus on other ways to create their opportunity for a profit.

4. The remaining changes have a surreal quality to them, because of their likely short shelf life.

Most of the PSPA changes presume that they are, as part of a legally-binding document, going to be in place for a long time. However, since the PSPAs can be changed by future Treasury Secretaries acting in concert with future FHFA Directors, the question is how long these new changes will last. Less than a week after the revisions were concluded, we have a Democrat in charge of Treasury; at FHFA, we will have a Biden-appointed Democratic official in place most likely later this year (if the Supreme Court decides the FHFA Director is not an “independent” position, which is believed highly likely) or at most in three years, when Director Calabria’s term ends. Because he has been vocal about his desire to shrink the GSE footprint, including via the newly-approved regulatory capital treatment that is considered by most to be too high by maybe $100 billion or more, the current thinking in Washington is that the Democrats will immediately move to undo or modify most of the changes made by the PSPA revisions. Thus, the new limits and other changes will likely be little more than an inconvenience for 2021. And the details of the PSPA’s revisions that would impact three or more years out are hardly worth taking the time to understand – they are unlikely to survive that long. This, to me, is what makes it all a strange mix of fantasy and reality. The revisions may in fact end up mainly acting as Director Calabria’s declaration that he was successful in pushing conservative-libertarian policy objectives. (I am sure some will argue that, once these changes are in the PSPA, they become harder to change. That is true, but not materially so in the near future. I expect, as others do, that the Democrats who run Treasury and FHFA, when the time comes, will quickly remove most of the new revisions, as they are counter to their policy objectives.)

5. Treasury memorializes its lack of focus and progress on GSE reform.

Along with the PSPA revisions, Treasury issued the two page document, Treasury Department Blueprint on Next Steps for GSE Reform. Given that the department got new leadership a few days after the blueprint was issued, it’s little more than a low-impact statement of what the Mnuchin Treasury might have done, had it stayed in place, and it does not bind future Secretaries. In reality (and presumably contrary to Treasury’s intent), it symbolizes how depressingly little was accomplished by the department over the past four years, besides issuing a general plan for reform in September 2019. It states the obvious (Build GSE Equity Capital), lists what should likely have already been done (Set Commitment Fee for Ongoing Government Support), and repeats points made in the original Treasury plan (Assess Appropriate Market Concentration). The one new item of substance is that it supports some sort of utility-style regulation (“pricing oversight”) of guarantee fee pricing by the FHFA post-conservatorship – which was conspicuous by its absence in the September 2019 plan – but only in the most general way, with no detail about how to do so.

6. “Footprint status quo” is in, “footprint shrinkage” is out.

There are many clauses in the PSPA revisions that were clearly aimed at shrinking the GSE footprint – but in fact did not. The multifamily lending caps, the purchase by the GSEs of mortgages on second-homes or investment properties, the size of the retained investment portfolios, credit risk restrictions on new loan purchases, and more – all of these seem to have been specified in the PSPA revisions to be at current or slightly less restrictive levels than today. This is not footprint shrinkage as pursued by Director Calabria; this is footprint status quo, consistent with Secretary Mnuchin’s objectives to not hurt the economy or cause financial distress. Their inclusion in the revisions, then, appears more about political optics than substance.

7. The political power of small lenders is confirmed.

Given the extensive direct and indirect involvement of the government in America’s $12 trillion mortgage system, many housing finance groups engage in large-scale Washington lobbying. Among them, small lenders stand out: I was told by Senate staffers in 2014 that “both the R’s and D’s love small lenders,” and there are over a thousand such lenders, with offices in every state and congressional district. Indeed, small lender industry organizations (yes - there are more than one) have had a major policy objective since before conservatorship: ensure that the guarantee fees charged by the GSEs do not put smaller lenders at a competitive disadvantage by being lower for larger lenders (a policy called “level g-fees”). In fact, that policy was implemented in the early years of conservatorship (about a decade ago) by the FHFA. Nevertheless, small lender industry organizations have continued to push for more solidity to the requirement for level g-fees – and they got it in the PSPA revisions. It has no operational impact, as level g-fees have been in place for many years, but it would be harder to change now because it has broad political support, unlike most of the other new revisions.

8. Director Calabria’s push for conservatorship exit in the near future, well before full GSE capitalization, is dead.

For the first decade of conservatorship, the universal working assumption was that if the two GSEs were to exit it, they would first have to be fully capitalized – which would take many years (possibly up to a decade). Then, beginning in 2019, newly-installed Director Calabria ran up the flagpole a different approach – whereby conservatorship would end quickly (i.e. during his term as director) while the two companies were still critically undercapitalized, but be bound instead by a regulatory “consent order” that would function as a quasi-conservatorship until they were fully recapitalized. Perhaps because the FHFA never specified what would be the content of the order, it never gained broad traction; recent questioning of Secretary Mnuchin on the matter at a congressional hearing also indicated his unease. The result is that one of the PSPA changes prohibits any such early exit until the GSEs reach a significant capital level (3 percent of assets, or about $200 billion at today’s asset levels), and with all material litigation about the conservatorships settled or resolved. This doubly stops cold Director Calabria’s consent order-based early release strategy.

9. GSE capital requirements are both clarified and confused by the amendments.

The FHFA, in November 2020, established a new regulatory capital requirement for the GSEs, to apply after they exit conservatorship. In fact, it established two capital requirement levels – a minimum needed for safety-and-soundness at $174 billion, and large buffers to get to a total of $283 billion that must be met if the GSEs wish to pay dividends and give out executive incentive awards. This seemed a bit cute, and all the focus has been on the $283 billion. The PSPA revision has the same focus (i.e. it requires the GSEs to comply with the new regulatory requirement including the buffers), indicating that the minimum required without the buffers of about $174 billion means little and can largely be ignored. However, the PSPA also creates some confusion, because it says conservatorship can end when the capital level is just 3 percent of assets – or about $200 billion – which is at the high end of what mainstream analysts have suggested is the right level, and nowhere near $280 billion. Since it is inevitable that when the FHFA is given a new director by the Biden administration (likely, but not definitely, this year) there will almost certainly be a wholesale revision to the capital rule, the 3 percent figure seems to give political cover to a revision coming in much lower than the Calabria-era level of $283 billion.

10. FHFA cedes power to Treasury.

Director Calabria has clearly pursued a strategy to utilize the PSPA to try to lock in his conservative policy views, making it harder for a successor to change them, because it now will require Treasury approval. Given the likelihood of there being Democrats at the top of both FHFA and Treasury fairly soon, it seems to me to be only a modest hindrance in the short-term, as there is a great desire in the Biden administration to move fast to undo many of Director Calabria’s policy moves, including the PSPA revisions. However, what has been established is that the FHFA now cannot maneuver or make decisions on a variety of important issues without first getting Treasury agreement (including changing its regulatory capital requirement, one of the most fundamental powers of any financial regulator). This has moved a tremendous amount of FHFA’s independent regulatory power over to Treasury, and in Washington power – the ability to make others do what you want – is the “coin of the realm,” at the core of everyday life. Once the effort to undo most of the just-concluded PSPA revisions is complete, Treasury will have leverage to extract concessions whenever the FHFA wants to change anything referenced in the PSPA. I suspect future FHFA directors will not think kindly of Director Calabria’s strategy when Treasury does such a thing. On top of that, as the PSPA might well stay in place after the GSEs exit conservatorship, it would be Freddie Mac and Fannie Mae themselves that would be directly subject to Treasury approvals – meaning Treasury would become the additional quasi-regulator of the GSEs, paralleling the primary regulation of the FHFA. Add it up, and Director Calabria’s strategy in the long run may be judged quite harshly by future FHFA directors, whether Republicans or Democrats.

The FHFA under Director Calabria, in seeking revisions to the PSPA in support of his policy objectives, naturally had to negotiate with Treasury, where Secretary Mnuchin had different policy objectives. Looking at the document in terms of how much these different objectives were reached, once past a few items where there is total consensus of what to do (i.e. allow earnings retention to continue and agree to have “level g-fees” to protect small lenders), it is clear that the bargaining leverage was entirely on Treasury’s side: the core FHFA desire for footprint shrinkage was gutted to be footprint status quo, a victory for political optics only. To get even that, the FHFA had to swallow the killing of its plan to release the GSEs from conservatorship early and for Treasury to speak out of both sides of its mouth in terms of its support for Calabria’s capital rule – confirming it on one hand and putting out an alternative to it that is much lower on the other. But the most unusual part of the PSPA revisions is how much Director Calabria transferred his agency’s independent power – violating the cardinal rule of Washington – to Treasury to get even that. 

When passions cool about GSE reform in future years, it is my belief the whole process and content of these revisions will be regarded rather poorly.