Introduction

In Fannie and Freddie: A Modest Proposal to "Reform the GSEs", I set forth a proposal (the Modest Proposal) to “reform” Fannie and Freddie that is easily accomplished with minimal disruption to their businesses and the secondary mortgage finance market. It could be implemented while Fannie and Freddie are in conservatorship and would not require Congressional approval. It would nonetheless represent a comprehensive and highly functional reform that would be intended to “once and for all” end the conservatorships, and “de-federalize” Fannie and Freddie, putting them on a path after conservatorship release that would be free from heavy-handed regulation and partisan antagonism.

The Modest Proposal involves separating the two lines of business Fannie and Freddie currently conduct, what I call the “conventional” mortgage finance business and the “low-income housing” mortgage finance business.

These two lines of business that Fannie and Freddie currently both conduct would be conducted in the future by Fannie and Freddie with respect to the conventional line, and new guarantors (LIH Cos) with respect to the low-income housing line that would be formed pursuant to the transactions implementing the Modest Proposal, as described below.

The Modest Proposal would i) serve to “level the playing field” and remove explicit and implicit federal subsidies arising from the Fannie and Freddie federal charters with respect to the conventional line that Fannie and Freddie would continue to operate and guaranty after the Modest Proposal transaction, and ii) permit the government to provide focused support for the low-income housing line that the LIH Cos would start to guaranty upon closing of the Modest Proposal transaction.

While there would be many significant terms of the Modest Proposal that would need to be negotiated, the actual documentation and closing of the Modest Proposal transactions could be accomplished within one week. Inasmuch as the Modest Proposal should provide Fannie and Freddie litigants relief that, in my view, would be superior to what the courts can reasonably be expected to provide on a risk- and time-adjusted basis, I believe all of Fannie’s and Freddie’s litigation could be settled in connection with the Modest Proposal.

I have received very positive engagement over the Modest Proposal, but it is clear that some reviewers had a significant misunderstanding as to the actual transactional elements of the Modest Proposal as I initially described it, for which I assume blame. Indeed, since the Modest Proposal involves terms that require negotiation, some details relating to these transactional elements can only be posited now in conceptual terms…but let this post serve to provide a clearer understanding as to what the Modest Proposal might look like.

The Elements of the Modest Proposal

The objective of the Modest Proposal is to transform Fannie and Freddie from companies that currently underwrite, operate, manage and guaranty MBS for both the conventional and low-income lines of business into companies that, from and after the closing of the transactions comprising the Modest Proposal set forth below, would:

i) continue to manage, operate and guaranty both the the historical conventional and historical low-income lines of business that were conducted prior to the Modest Proposal closing (all MBS from both lines of business have already been pooled and sold off to investors and guaranteed by Fannie and Freddie, and the low-income portion of the historical books of Fannie’s and Freddie’s businesses cannot be separated from the conventional line of business;

ii) underwrite, operate, manage and guaranty MBS for the conventional line of business from and after the Modest Proposal closing (all new MBS guaranteed by Fannie and Freddie after the Modest Proposal Closing would be for conventional line of business mortgages); and

iii) source and operate the low-income line of business on behalf of the LIH Cos pursuant to a license and administrative services agreement. Fannie’s and Freddie’s current infrastructure for sourcing low income mortgages would remain in place. However, after the Modest Proposal closing, those mortgages would be securitized, sold and guaranteed by the respective LIH Cos.

The various transaction steps comprising the Modest Proposal would be as follows:

Defining the conventional and low-income lines of business

• As an initial matter, the mortgages that comprise the conventional and low-income housing business lines would have to be defined in order for the former to be securitized and guaranteed by Fannie and Freddie, and the latter securitized and guaranteed by the LIH Cos, from and after the Modest Proposal closing. I expect that this categorization would be made based upon a set of rubrics or algos consisting of creditworthiness data that Fannie and Freddie develop and use as an ongoing part of the business.

• The separation of the lines of business by means of data scoring would lead to the future low-income housing business being operated by Fannie and Freddie on behalf of the LIH Cos pursuant to the license and administrative services agreement discussed below.

• How large would the respective future lines of business be that are securitized and guaranteed by Fannie and Freddie, on the one hand, and the LIH Cos, on the other hand? This would fundamentally be determined by negotiation by FHFA as conservator and Treasury. One estimate by a highly respected GSE commentator would put the future conventional line business as comprising two-thirds, and the low-income business line one-third, of the total Fannie and Freddie business currently done in the secondary mortgage market.

• It is important to realize that this business line division would be the result of what I refer to as a bounded negotiation. If the low-income business is defined in a manner that increases its size, the amount of capital that Treasury could realize from future Fannie and Freddie secondary sales of warrant shares that would serve to capitalize the LIH Cos would decrease.

• As discussed below, the government would capitalize the LIH Cos with cash from future secondary sales of Treasury’s 79.9% equity (warrants shares) in Fannie and Freddie. The larger the percentage of the future business that is defined as low-income housing (which generates future revenues for the LIH Cos), the smaller the relative percentage of the future business would be defined as conventional housing (which generates future revenues for Fannie and Freddie). A large low-income line of business would result, in turn, in a lesser amount of money from the future secondary sales of Treasury’s Fannie and Freddie warrant shares that Treasury would inject into the capital of the LIH Cos. Moreover, if the current litigation stemming from the 2012 adoption of the Net Worth Sweep is to be settled, litigants (as remaining Fannie and Freddie shareholders) would want to make sure that the portion of the future Fannie and Freddie is not reduced excessively.

Formation and Spin off of the LIH Cos in Redemption of Treasury’s Senior Preferred Stock

• Once the separate lines of business are defined, Fannie and Freddie would each form a LIH Co and contribute only two assets to their respective LIH Cos: the benefits arising in favor of the LIH Co under a license and administrative service agreement, discussed below, and the whole loan low-income mortgage inventory each of Fannie and Freddie have on hand at the time of the Modest Proposal transaction closing, in order to kickstart the LIH Cos’ low income businesses going forward.

• The license and administrative services agreements would provide that Fannie and Freddie would continue to source low income loans and otherwise operate the low income housing business for the benefit of the LIH Cos, using Fannie’s and Freddie’s existing infrastructure, provided that the LIH Cos. would be responsible for securitizing the low income mortgages, issuing MBS backed by these pooled low income housing mortgages, and selling, servicing and guaranteeing the low-income MBS bought by investors.

• The payment and other terms relating to the licenses and administrative services agreements would be subject to negotiation, and could range from a perpetual cost free license and cost free administrative services agreement (which would be disadvantageous to Fannie and Freddie) to a license and administrative services agreement having arms-length, fair market value terms for the nature and quantity of the services rendered. There could even be a transition period during which costs would ramp up to fair market value terms once the LIH Cos achieved a certain size.

• The stock of the LIH Cos would be distributed to Treasury in redemption of all of Treasury’s senior preferred stock and preference amount. In order for Treasury to keep off the national balance sheet the low-income housing assets and guarantee liabilities that the LIH Cos will build over time, Treasury may wish to let Fannie and Freddie retain a 20.1% common stock interest in the LIH Cos, and take a participating preferred in exchange for future infusions of capital into the LIH Cos.

• Treasury would inject additional money over time into the LIH Cos from the proceeds of its secondary sale of its 79.9% Fannie and Freddie common equity. In effect, Treasury would become a focused financial supporter of low-income housing, rather than a financial supporter of the entire secondary mortgage market generally.

• LIH Cos guaranteed MBS offer ESG-focused institutional investors the opportunity to finance low-income housing in a more focused way than they can through Fannie or Freddie guaranteed MBS.

• If Congress ever decides to provide a federal backstop guaranty for the secondary mortgage market, it would make more sense for the government to provide that backstop to LIH Cos MBS than for the much larger universe of Fannie and Freddie MBS.

Fannie and Freddie Reincorporate as State Chartered Companies

• In connection with the formation and capitalization of the LIH Cos. and their spin off to Treasury, Fannie and Freddie would consummate reincorporation forward mergers into state (presumably Delaware) chartered corporations, which would continue the respective businesses of Fannie and Freddie.

• This reincorporation of Fannie and Freddie would serve to “de-federalize” Fannie and Freddie. Their federal charters would be terminated.

• This de-federalization of Fannie and Freddie would eliminate explicit benefits that flowed for their federal charters (such as not being subject to applicable state taxes), and would also eliminate implicit benefits that flowed from their federal charters, such as Wall Street’s assumption that Treasury would do what was necessary to backstop the MBS guarantees of Fannie and Freddie, as federal corporations.

Economic Effects

• Fannie held $132 billion and Freddie held $127 billion of mortgages in portfolio as of May 2021. Assuming that one-quarter of these portfolio mortgages are categorized as low-income, Fannie would capitalize its LIH Co with $33 billion and Freddie would capitalize its LIH Co with $31.75 billion as initial capital balances (together with LIH Co’s rights under the license and administrative services agreement). As so capitalized, the LIH Cos would be spun off by Fannie and Freddie to Treasury in complete redemption of Treasury’s senior preferred stock.

• Aside from Fannie’s and Freddie’s transfer of portfolio low-income mortgages to the LIH Cos, Fannie’s and Freddie’s financial positions would be exactly the same immediately after the closing of the Modest Proposal as they were before the closing.

• Over time, Fannie’s and Freddie’s historical low-income mortgages Fannie and Freddie would run off and not be replaced with new low-income mortgages., and Fannie’s and Freddie’s revenues, generally guarantee fees, would correspondingly decline.

• For the three years ended 2018, 2019 and 2020, Fannie’s net income averaged $14 billion and Freddie’s net income averaged $7.9 billion, or a total of $21.9 billion. It would be expected that depending upon how the lines of business are defined, Fannie’s and Freddie’s net income would be reduced over time, both from the run off of the retained historical low-income business and the future underwriting of only conventional mortgages. How much Fannie’s and Freddie’s net income will reduce over time would have to be modeled in a granular fashion using various assumptions, and is difficult to predict.

• Treasury would sell off its 79.9% equity position of Fannie and Freddie in the first few years after the Modest Proposal closing and use the proceeds to fund the LIH Cos. How much Treasury could be expected to realize from such sales is also difficult to predict.

• However, assuming on a conservative basis that Fannie’s and Freddie’s combined net income is eventually cut in half from pre-Modest Proposal net income, Treasury’s 79.9% common stock interest would be valued at $43.5 billion, subject to dilution for new Fannie and Freddie shares required to be issued to satisfy Fannie’s and Freddie’s capital standard going forward. This assumes an implied total Fannie and Freddie common equity valuation of $54.5 billion, based upon pro forma $10.95 billion annual net income X 8 PE multiple, which yields $87.5 billion, less $33 billion junior preferred stock. All of these sales proceeds could be invested as new capital by Treasury into the LIH Cos.

Fannie and Freddie Release from Conservatorship

• The Modest Proposal transactions would serve to prepare Fannie and Freddie for release from conservatorship. Fannie and Freddie would need to increase their current capital amounts though primary issuances of stock. To do so, FHFA should enter into consent decrees with Fannie and Freddie that would set forth the parameters of FHFA’s oversight during conservatorship. This will be necessary in order for Wall Street to invest new money into Fannie and Freddie before they are released from conservatorship, given that SCOTUS concluded in the Collins case that FHFA has near unlimited authority to manage Fannie and Freddie as it sees fit while in conservatorship.

• The capital standards for Fannie and Freddie would need to be revised to adopt a true risk based standard without excessive conservatism. The required capital amount would gradually decrease as Fannie’s and Freddies’s historical low-income business runs off.

All of these Modest Proposal Transactions can be Implemented by FHFA and Treasury without Congressional Approval

• Based upon SCOTUS’ sweepingly broad interpretation of FHFA’s conservatorship powers, all of these Modest Proposal transactions can be consummated without Congressional approval while Fannie and Freddie are in conservatorship.