May 11, 2017

Joshua Rosner
646/652-6207
jrosner@graham-fisher.com
@joshrosner

FHFA’s Dir. Watt on The Hill: Of Prudential Regulators & Political Interference:

Today, the Director of the Federal Housing Finance Agency, Mel Watt, appeared before
the Senate Banking Committee to discuss “The Status of the Housing Finance System
After Nine Years of Conservatorship”. The hearing raised several important policy
issues that should be further considered.

Director Watt gave an opening statement that was deferential, reasoned and fully
cognizant of the separation of powers between his role as a prudential regulator and the
role of legislators. To that end, Director Watt detailed his key responsibilities, as
conservator of the GSEs, as defined in the Housing and Economic Recovery Act of
2008 (HERA). Director Watt pointed out:

“These statutory mandates obligate us to:

• Conserve and preserve the assets of the Enterprises while they are in
conservatorship;
• Ensure that the Enterprises provided meaningful assistance to the millions
of borrowers who struggled to save their homes in the midst of the
economic and housing crisis, as required in the Emergency Economic
Stabilization Act; and
• Oversee the prudential operations of the Enterprises and ensure that they
continue to carry out their on-going statutory missions in a safe and sound
manner; in a manner that fosters liquid, efficient, competitive, and
resilient national housing finance markets; and in a manner that is
consistent with the public interest.”

Director Watt then went on to state:

“However, it is important for all of us to recognize that the
conservatorships have led to numerous reforms of the Enterprises and their
operations, practices, and protocols that have been extremely beneficial to
the housing finance markets and have reduced exposure and risks to
taxpayers. It is critically important for the members of this Committee to be
well aware of these reforms because you will have the responsibility to
ensure that the reforms are not disregarded or discarded because of
assertions some will make that the Enterprises now are the same or mirror
images of the Enterprises that FHFA placed into conservatorship almost
nine years ago. I can assure you that such assertions would be

Please refer to important disclosures at the end of this report.
May 2017

unfounded. While many reforms of the Enterprises' business models and
their operations have been accomplished through conservatorship, FHFA
knows probably better than anyone that these conservatorships are not
sustainable and we also know that housing finance reform will involve
many tough decisions and steps that go well beyond the reforms made in
conservatorship. So I want to reaffirm my strong belief that it is the role of
Congress, not FHFA, to make these tough decisions that chart the path out
of conservatorship and to the future housing finance system”.

Director Watt then went on to state his affirmative obligation and sole authority, as
a prudential safety and soundness regulator, to consider actions necessary to fulfill
his mandate and stated he believed the GSEs should retain some level of capital to
protect the taxpayers and avoid the risk of draw against the Treasury line of credit:

“Like any business, the Enterprises need some kind of buffer to shield
against short-term operating losses. In fact, it is especially irresponsible
for the Enterprises not to have such a limited buffer because a loss in any
quarter would result in an additional draw of taxpayer support and reduce
the fixed dollar commitment the Treasury Department has made to support
the Enterprises. We reasonably foresee that this could erode investor
confidence. This could stifle liquidity in the mortgage-backed securities
market and could increase the cost of mortgage credit for borrowers.
FHFA has explicit statutory obligations to ensure that each Enterprise
"operates in a safe and sound manner" and fosters "liquid, efficient,
competitive, and resilient national housing finance markets." To ensure
that we meet these obligations, we cannot risk the loss of investor
confidence. It would, therefore, be a serious misconception for members
of this Committee, or for anyone else, to consider any actions FHFA may
take as conservator to avoid additional draws of taxpayer support either
as interference with the prerogatives of Congress, as an effort to influence
the outcome of housing finance reform, or as a step toward recap and
release. FHFA's actions would be taken solely to avoid a draw during
conservatorship.”

After the opening statement of Director Watt, Senate Banking Committee Chairman
Crapo (R – ID) asked Director Watt if he had the authority to suspend the dividend sweep
without prior approval from the Department of the Treasury and Director Watt stated that
he did. Senator Crapo asked Director Watt if he would provide, or come back to him,
citing the basis of that authority and Director Watt agreed to. It is important to note that
the Director’s authorities and the authorities of the Conservator are enshrined in law,
while the dividend sweep agreement is contained in a contract between Treasury, FHFA
and the Directors of the two GSEs. Obviously the law takes priority over private
contracts between two parties. HERA specifically states:

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POWERS AS CONSERVATOR.—The Agency may, as conservator, take
such action as may be—
‘‘(i) necessary to put the regulated entity in a sound and solvent condition;
and
‘‘(ii) appropriate to carry on the business of the regulated entity and
preserve and conserve the assets and property of the regulated entity.

Furthermore, HERA states:

‘‘(7) AGENCY NOT SUBJECT TO ANY OTHER FEDERAL AGENCY.—
When acting as conservator or receiver, the Agency shall not be subject to
the direction or supervision of any other agency of the United States or
any State in the exercise of the rights, powers, and privileges of the
Agency.

Senator Crapo, in his opening statement, made the comment that the GSEs were the
“last piece of unfinished (legislative) business” from the crisis. This assessment is, in
fact, incorrect. The HERA statute, which specifically addressed the GSEs, was the first
piece of legislation during the crisis and was a rare bipartisan accomplishment. As
Barney Frank pointed out in May 2010, in response the claim that new legislation
specific to the GSEs was needed:

“What it ignores is that we have in fact acted first on Fannie Mae and
Freddie Mac, and Fannie Mae and Freddie Mac are operating, as you
know, in a manner entirely different than they had been during the crisis
period, precisely because Democrats acted – in collaboration with the
Bush administration… Fannie and Freddie are in fact much more
drastically changed in their method of operation than any of the financial
institutions we are not talking about. So the argument that we have
ignored the need to change the operation of Fannie and Freddie in our
rush to do financial reform is of course backwards. We did Fannie and
Freddie first.”

Within two months of the July 2008 passage of HERA, a law intended to prevent
future crises and bailouts of the GSEs, Fannie Mae and Freddie Mac were placed
into conservatorship. As a result, most of the reforms required under FHFA have
been implemented on two companies in conservatorship (in what former Secretary of
Treasury Hank Paulson termed a “time out”). Still, nine years later, due to the deliberate
actions of Watt’s predecessor, FHFA has not promulgated the capital standards required
by law and the GSEs have no capital – placing the taxpayers at risk of a future bailout by
the Treasury.

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Policy Concern 1: Political Interference with a Prudential Regulator:

Although Director Watt made it clear that any decision to suspend the sweep of the
profits of Fannie Mae and Freddie Mac would be made in accord with his legally
mandated authorities as a safety and soundness regulator and as conservator, several
members of the Committee pushed back on his inclination to exercise those authorities.
This is a very dangerous position on several counts:

• As the Director of FHFA’s predecessor regulator, Armando Falcon, noted
in testimony in 2003:
o “The need for regulatory independence was borne out of
Congress’ experience with the savings and loan crisis. I had the
privilege of serving as Counsel to the House Banking Committee
during that difficult period. One of the clear lessons learned was
that all safety and soundness regulators should be objective,
nonpartisan, and protected from political interference. This is
especially critical at times when regulators must make difficult
and sometimes politically unpopular decisions. In addition,
independent regulation protects Congress’ ability to receive the
regulator’s best judgment on regulatory matters unfiltered and
without delay. With billions of dollars of potential taxpayer
liability at stake, it is in everyone’s interest that this important
safeguard not be weakened”;
• As the Bank for International stated in its “Essential Criteria” for
effective banking supervision:
o “The operational independence, accountability and governance of
the supervisor are prescribed in legislation and publicly disclosed.
There is no government or industry interference that
compromises the operational independence of the supervisor. The
supervisor has full discretion to take any supervisory actions or
decisions on banks and banking groups under its supervision”;

• As the International Monetary Fund has noted:
o “Strong supervision is premised on the ability and willingness of
supervisors to take timely actions (Viñals and Fiechter, 2010),
according to an IMF staff position note. To have the ability to act,
supervisors must possess sufficient legal authority and resources, a
clear strategy, and strong working relationships with other
regulators. To have the willingness to act, supervisors must have
a clear mandate, operational independence, accountability,
skilled staff, and a healthy relationship with the banking industry

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that still is distant enough to avoid regulatory capture (in which
the regulator identifies more strongly with the regulated than the
public interest); and

• This exchange recalls the history of the Savings and Loan Crisis,
specifically the improper political interference in prudential
supervisory authorities, by the “Keating Five”, on behalf of a
financial and political supporter.

• One must not forget the ethical lapses and, according to the Department of
Justice “substantial evidence of serious and sustained misconduct”
by Rep. Fernand J. St Germain (D-R.I.), a former Chairman of the House
Banking Committee, on behalf of political donors.

Political interference with safety and soundness regulators on behalf of financial services
companies they regulate, as detailed in my co-authored book Reckless Endangerment:
How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, was
absolutely central to the financial crisis. It was disturbing to see today how quickly
legislators have forgotten the need for the independence of prudential regulators. It is
equally disturbing to see that several senators are pushing so-called “reform” plans
created by the same institutions at the heart of the crisis, which plans will not effectively
protect the public and will actually increase the risks of future government bailouts.

Policy Concern 2: Confusing Credit with Capital:

One of the key arguments made by a couple of senators who sought to persuade Director
Watt not to require the GSEs to build capital buffers as a means of avoiding future draws
against the Treasury is the inaccurate claim the GSEs currently have “adequate
capital” as they have “over $258 billion in capital available to them” from Treasury.

This misconceived argument demonstrates how little is understood in Washington about
the difference between assets and liabilities and between equity and credit. This
misunderstanding is why so many do not appreciate the currently operationally reformed
but financially un-capitalized state of the GSEs, and why they reject the idea of tangible
permanent equity capital at the GSEs in favor of an explicit government guarantee behind
mortgage-backed securities issued by bank and non-bank lenders and aggregators.

The Treasury line of credit is not capital in any form. It is a line of credit. Consider
the difference between retained equity in one’s home and a home equity line of credit,
which is a liability against that equity. Nobody can ‘take’ the equity from your home --
you own it -- but they can withdraw their extension of credit, leaving you vulnerable to a
liquidity shock. Similarly, consider the difference between buying a toaster with a debit

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card backed by bank deposits vs. a credit card that is a claim against future income. The
difference is between being an owner and a debtor. This is the reason that financial
regulators have strict requirements on banks to hold permanent equity capital.
Prudential regulators, and those in Congress that supervise them, should recognize
the risk of allowing financial institutions that pose moral hazard to exist without a
required leverage ratio limiting the amount of liabilities that can be positioned
against those assets.

Less than a decade after the financial crisis, legislators are strangely too complacent
about the reality that the GSEs with their $5 trillion of assets currently hold less capital
than the smallest and least well capitalized banking institutions in the country.

Taxpayers are not capital. They are protected by capital.

Policy Concern 3: Now I’ve Seen it All, A Senator Actually Pushing for a Bailout:

In what has to be the most disturbing exchange of the hearing, Senator Bob Corker (R –
TN), who has close relations with Wells Fargo and other financial institutions that are
pushing to replace the GSEs, actually begged Director Watt to ignore his legally
directed mandates to do what he determined was in the best furtherance of protecting
the stability of the U.S. housing finance system, i.e. reducing taxpayer risk and rebuilding
capital at the enterprises.

Sen. Corker suggested that the Treasury lines provided Fannie and Freddie with ample
capital and that taxpayers should be relied on to meets the GSEs’ financial obligations,
instead of having the firms build real capital through earnings retention. When Director
Watt highlighted the difference between the credit line and capital, and his
responsibility to reduce the risks to the mortgage markets that could ensue if the
GSEs were forced to go back to Treasury for a bailout, Sen. Corker said that it
wouldn’t cause instability, demanded the Director make the GSEs take a $10 billion
draw from Treasury (which is not permitted under the PSPAs) to see if that would
lead to instability, and assured Director Watt that the markets would be fine.1

Senator Corker’s statements may well be the most peculiar I have ever witnessed from an
elected official. One could clearly label them an outrageous and flagrant dereliction of his
duties to the public. Simply put, a Republican senator demanded that a safety and
soundness regulator ignore its own legal mandates and independent determinations.
Sen. Corker demanded that Director Watt should instead deliberately and
unnecessarily cause the first taxpayer bailouts of financial institutions since the

1
https://www.banking.senate.gov/public/index.cfm/hearings?ID=CA80DC0D-C337-
4204-9E51-399AB13AC5B1 (See beginning at 44:10)

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financial crisis. Furthermore, Sen. Corker demanded that the Director exceed his
legal authority and the language of the PSPAs by directing the GSEs to take draws
from Treasury voluntarily, when they are only entitled to take draws when their net
worths drop below zero.

Policy Concern 4: Overnight Repo’s, an Alternative to Capital? Ask Lehman:

In another bizarre exchange, Senator Corker highlighted the use by his own company (in
the construction and real estate development business) of reverse repurchase agreements
for short term funding and suggested that the GSEs could run the same way: “I ran a
pretty large company that I started. Our money went into overnight repos, we kept no
cash, none, each day when we needed it we drew it out. And in essence you have exactly
that same type of thing available to FNM, FRE….”

For Sen. Corker to suggest that two of our nation’s largest financial institutions, with
multi-trillion-dollar balance sheets, should or could rely on overnight repos to finance
holdings of 30-year mortgage loans is naïve and problematic, to say the least. Essentially
an overnight repo agreement is where a financial institution buys securities with the
agreement that the seller will repurchase them the following day. It is used as a
mechanism to raise short-term capital. As we saw during the financial crisis, these fragile
repo markets can quickly become discontinuous in times of increasing counterparty risk
or economic downturns. When counterparties could no longer stand opposite each other
due to heightened perceptions of credit risk, the government was forced to step into the
middle, act as an intermediary guarantor and clear the market – all while taking on new
risks to the public. Sen. Corker’s idea that financial institutions like Fannie and Freddie
rely entirely on short-term funding sources like the repo market instead of permanent
equity capital, requiring the government to step in to save them again at the next crisis, is
practically and politically insane.

Conclusion: Oversee the Regulator, Don’t Direct it:

As Director Watt appropriately pointed out in his testimony:

“FHFA has explicit statutory obligations to ensure that each Enterprise
“operates in a safe and sound manner” and fosters “liquid, efficient,
competitive, and resilient national housing finance markets.” To ensure
that we meet these obligations, we cannot risk the loss of investor
confidence. It would, therefore, be a serious misconception for members of
this Committee, or for anyone else, to consider any actions FHFA may
take as conservator to avoid additional draws of taxpayer support either
as interference with the prerogatives of Congress, as an effort to influence

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May 2017

the outcome of housing finance reform, or as a step toward recap and
release. FHFA’s actions would be taken solely to avoid a draw during
conservatorship.”

Conversely, Congress must refrain from interfering with the actions of a safety and
soundness regulator seeking to execute the legal mandates and authorities given to them
under the Housing and Economic Recovery Act of 2008.

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