HERA obligates FHFA to conduct the conservatorships of FNMA and FMCC in a way such that FHFA, as conservator, is not subject to direction by any other agency. Moreover, HERA envisions that the conservatorship will be temporary, during which the conservator will either rehabilitate FNMA and FMCC, or transition into receivership if rehabilitation is not possible.
It is patently clear, however, that FHFA as conservator should not conduct the conservatorships in a manner that frustrates the very objective of rehabilitation that is the mandate of the conservator.
It is not often that a conservator publicly admits that a transaction, the net worth sweep (NWS), has made the goal of a successful conservatorship impossible. Especially when that conservator has been charged by statute to accomplish a successful conservatorship independent of any control or direction by another agency.
But that is what FHFA conservator Melvin Watt essentially did on February 18, 2016 in prepared remarks.
"By giving this speech today, I am signaling my belief that some of the challenges and risks we are managing are escalating and will continue to do so the longer the Enterprises remain in conservatorship. Consequently, I believe that I have a responsibility, both as regulator and as conservator, to identify and discuss this concern more openly…The most serious risk and the one that has the most potential for escalating in the future is the Enterprises' lack of capital…Fannie Mae and Freddie Mac are currently unable to build capital under the provisions of the PSPAs. The agreements require each Enterprise to pay out comprehensive income generated from business operations as dividends to the Treasury Department, and the amount of funds each Enterprise is allowed to retain is often referred to as the Enterprises' capital buffer. This capital buffer is available to absorb potential losses, which reduces the need for the Enterprises to draw additional funding from the Treasury Department. However, based on the terms of the PSPAs, this capital buffer is reducing each year. And, we are now over halfway down a five-year path toward eliminating the buffer completely."
Conservator Watt's statement is important for two reasons.
First, it reveals the lie inherent in Treasury's claim that the planned decline of the GSEs' capital buffer to zero is immaterial given the existence of Treasury's line of credit upon which the GSEs can make future draws. Conservator Watt is right to make clear that the market expects that GSEs rehabilitated in conservancy are to be financially sound without resort to continual Treasury funding. Indeed, it is irresponsible to run a housing finance industry in such a jerry-rigged fashion.
Second, Conservator Watt's statement that "the most serious risk…is the Enterprises' lack of capital" is a risk that has not occurred despite the conservancy, but rather because of the conservancy. This is the remarkable situation in which the conservator is admitting that the planned evisceration of the GSEs' capital is counter-productive to his role as conservator…which, of course, is what the GSE plaintiffs have been saying in court all along.
In essence, Conservator Watt is confirming that the GSE conservatorships were doomed to fail from the start.
FHFA Conservator Watt went on to highlight three risks posed by the Treasury requirement under the NWS that FNMA and FMCC are not entitled to retain capital, which may require the GSEs to borrow additional funds from Treasury (and as early as May 2016). First, any such future capital draws may impair the public market's confidence in the financial integrity of the GSEs, reducing their willingness to purchase GSE debt securities and GSE-guaranteed mortgage backed securities. Second, this loss of market confidence in the GSEs may induce Congress to engage in legislative reform "in haste or without the kind of forethought it should be given." Third, the longer the GSEs remain in conservatorship, the longer they will be insulated from "market discipline" that informs and improves the GSEs' business operation.
This last point that Conservator Watt makes is an important but somewhat subtle point. For example, what is the right amount that the GSEs should charge as a guarantee fee? So-called G fees are the most important source of revenue derived by the GSEs, and if the G fee rate is too low or too high, this may adversely affect housing finance liquidity. Under conservatorship, G fees are set by administrative fiat. Ideally however, GSEs should price G fees in order to satisfy their requisite cost of capital. Under the funding arrangement the GSEs have with Treasury, however, the GSEs pricing of their products and services bear no relationship to market forces.
In effect, the huge segment of the United States' economy dedicated to enhancing housing finance liquidity is managed not by free market capitalist principles, but by the government command dictates more comfortably found in a communist regime.
My guess is that the Perry plaintiffs are currently preparing a motion to be filed with the DC Circuit of Appeals asking the court to take judicial notice that the Conservator himself has publicly stated that the NWS makes the goal of a successful conservatorship impossible. A party's best evidence is out of the mouth of the adverse party.
Disclosure: I am/we are long FNMA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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