February 3, 2015 Joshua Rosner 646/652-6207 jrosner@graham-fisher.com Twitter: @JoshRosner

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

Summary: In his House Financial Services Committee testimony last week, FHFA Director Mel Watt appeared to deliberately misinterpret the HERA statute to justify turning on affordable housing funds even though the GSEs have no capital with which to meet safety and soundness requirements. When Fannie Mae and Freddie Mac lose money, as they eventually will, he will have to turn these affordable housing funds off unless he negotiates a new agreement with the Treasury Department or takes other action to require them to build up capital. In executing his mission as Conservator of the housing enterprises, Fannie Mae and Freddie Mac, Director Watt has the authority to require they suspend all dividends, including those paid to the Treasury as agreed to in the Preferred Stock Purchase Agreements between the FHFA and Treasury. FHFA: The Little Agency that Could (but Hasn’t) As public focus begins to shift toward the next Presidential election and who will be the candidates, the Democrats and Republicans will inevitably begin to attempt to recast legacies and focus the public on their accomplishments and the opposing party’s shortcomings. These efforts will begin the cycle of blame games, half-truths and trial balloons to see what resonates with the public. The economy, Wall Street and housing will certainly become part of the focus. Last week we saw the beginning of one such effort to recast the record as Federal Housing Finance Agency Director Mel Watt, an Obama appointee, testified before the House Financial Services Committee and began the effort to cleanse the Administration’s record regarding unfinished business on mortgage market reform.

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In testimony, Mr. Watt stated, “there is nothing worse, I have found, in this area of the market than uncertainty, and the longer this [GSE reform] drags out, the more uncertainty there is”. In reality, uncertainty has only increased in recent months as the Director deliberately misinterpreted the Housing and Economic Recovery Act of 2008 (HERA) in a manner that offered him a legally questionable pretense for turning on the affordable housing funds that were set up under the same statute. In HERA, these funds were to be suspended if they diminished the GSEs’ capital and if they risked the further instability of the enterprises. Instead, Director Watt chose to ignore the plain language of HERA, to divert money that should have been used to rebuild the GSEs’ capital as required by the statute, and instead to justify the new flow of affordable housing funds based on the GSEs’ profitability and the Treasury’s financial backstop. The current Treasury support of the GSEs is not capital, it is not the equivalent of capital and, in fact, both the allocation of funds toward affordable housing and the sweep of the GSEs’ profits to the Treasury are directly contrary to the clear legislative intent of Congress in passing HERA – for FHFA either to restore the GSEs to solvency or to liquidate them through a receivership. Through these actions Director Watt has created a new threat to affordable housing. If either Fannie or Freddie ever lose money and have to draw once again on the Treasury backstop, and we expect that is a near certainty, he will have to be consistent in his misinterpretation of HERA and stop putting money into these funds. Alternatively, if he used his Congressionally defined power and negotiated a new support arrangement with Treasury that allowed the GSEs to begin to build capital, he could allocate funds to affordable housing and be legally grounded in doing so at this time. In the hearing, Republican committee members’ questions turned to Mr. Watt’s decision to have the GSEs begin

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contributions to the affordable housing funds when such contributions would violate HERA, as they:

‘‘(1) Are contributing, or would contribute, to the financial instability of the enterprise; (2) are causing, or would cause, the enterprise to be classified as undercapitalized; or (3) are preventing, or would prevent, the enterprise from successfully completing a capital restoration plan under section 1369C.”i

In response to repeated questions on the subject, Mr. Watt stated that the FHFA’s Preferred Stock Purchase Agreements, signed between FHFA and Treasury, “trump the law”.ii The assertion that an agreement between two Federal Agencies can supersede a federal statute passed by Congress and signed by the President is a staggering one, especially when made by the director of an agency who practiced law for 22 years and then served as a member of Congress for another 22 years (including during the time when HERA was passed by the House Financial Services Committee on which he served). The basis of these claims becomes more peculiar in the context of Director Watt’s claims that he is “not part of the Administration. The Federal Housing Finance Agency is an independent regulatory agency. We don't play out the administration's policy. We follow the statute”. Were he to actually follow the statute, as conservator he would place the restoration of capital ahead of the agreement, which transferred all profits to Treasury. After all, as the sole party to that agreement statutorily charged with the restoration of the GSEs’ capital, it is in his power either (a) to stop dividends and to inform the Treasury that now that they have received repayment of all monies provided in support of the GSEs and that he must enter into a new agreement which effectuates the statutorily required process of restoring the GSEs capital or, (b) if he deems that

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they could not become adequately capitalizediii according to the capital requirements of HERAiv, to place them in receivership and begin liquidation of the GSEs with value allocated according to the legal priority of claims. Ranking Member Waters stated in her opening statement the GSEs (Fannie Mae and Freddie Mac) have “paid the government $225 billion -- which is $38 billion more than the Treasury invested during the crisis”. Still, six years after the GSEs were placed in conservatorship under HERA, the regulator has made no effort to take the actions required by the statute “to put the regulated entity in a sound and solvent condition” or to “conserve the assets and property of the regulated entity”. In fact, while HERA explicitly requires the GSEs to each submit “a feasible plan for restoring the core capital of the regulated entity subject to the plan to an amount not less than the minimum capital level for the regulated entity and for restoring the total capital of the regulated entity to an amount not less than the risk-based capital level for the regulated entity”v, no such plan has ever been submitted, approved or carried out. To date, as demonstrated by Director Watt’s testimony, FHFA as conservator has become the biggest opponent of such plans to restore the capital of the GSEs. Instead, it appears that the Director is relying on the Treasury’s outstanding commitment to provide funds to the GSEs, on an ‘as needed’ basis, as grounds for considering the entities as adequately capitalized. Here too is the Director in clear violation of not only the intent but also the language in HERA. With all of the income generated by the GSEs swept directly to the Treasury, and into general Treasury accounts rather than a capital account earmarked for the GSEs, it is impossible for Director Watt to credibly argue that either GSE “maintains an amount of total capital that is equal to or exceeds the risk-based capital level established for the enterprise under section 4611 of this title; and maintains an amount of core capital that is equal to or exceeds the

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minimum capital level established for the enterprise under section 4612 of this title”.vi To some observers this discussion may seem abstract and esoteric, but such a view is shortsighted. After all, some day – perhaps soon – one or both of the GSEs could swing from profit to loss and, even under FHFA’s incorrect interpretation of HERA that confuses profits for capital, the affordable housing funds would have to be suspended. Moreover, if the GSEs were unable to become adequately capitalized, they would be at risk of mandatory receivership when the Treasury backstop agreement ends in 2018. As a result, the entire mortgage system could fail and the ensuing systemic risk would be impossible for financial markets, the government and the country to ignore. Given massive levels of uncertainty about the future of the GSEs, which has caused key-man risks at the enterprises as employees look for other jobs and has left investors wondering about the future validity of current GSE obligations, it seems clear that, for the safety and soundness of the mortgage system, reform must be a top priority. But these powers do not reside with Congress only and, in HERA, the director of FHFA was explicitly tasked with the power to begin this process. While Mr. Watt continues his predecessor’s effort to push the task of reform onto Congress, there is no question that should he not embrace the powers and obligations he has under HERA, the president’s legacy on financial reform will be tarnished. If, in fact, the Administration has no power to direct the “independent agency” FHFA to follow the statute that created it, maybe the president should exercise one of the few rights he has over such an agency and replace the Director.

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i http://www.gpo.gov/fdsys/pkg/BILLS-110hr3221enr/pdf/BILLS-110hr3221enr.pdf ii House Financial Services Committee Holds Hearing on FHFA Update on Sustainable Housing Finance, CQ CONGRESSIONAL TRANSCRIPTS Congressional Hearings Jan. 27, 2015 - Final (See: “I want to follow up on Mr. Royce's line of questioning in regard to the funding of the Housing Trust Fund. Now, you're obviously aware of section 1337. And basically, we have a discussion about whether the GSEs are well capitalized. And if they're undercapitalized, you really can't fund the Housing Trust Fund. Would you agree with that? W A TT: Yes. Well, no. D U FFY : Kind of? WATT: Not undercapitalized. Be if they are not making a profit, I -- I absolute agree with you. DUFFY: They have to be well-capitalized. WATT: Capital is a whole different issue that basically when -- when the -- Fannie and Freddie were put into conservatorship, the capital considerations went away. Because basically, we don't have any capital at this point. DUFFY: One of the drawbacks of statutes is you don't get to split hairs. The language is usually pretty clear. And you would agree that the language in the statute requires that the -- that the GSEs are well-capitalized, not undercapitalized; correct? W A TT: They -- (CROSSTALK) D U FFY : Before you can fund the Housing Trust Fund, you have to find that the GSEs are not undercapitalized; correct? W A TT: No, I don't think that's the case. DUFFY: You think the GSEs --W A TT: It says I can't make a decision causes or would cause the enterprises to be classified as undercapitalized. But the decision about capital was not on my plate. That was -- in the letter that I wrote that reinstated the contributions, I specifically said that that provision nor the third provision was applicable anymore, because they were in conservatorship. It was the only -- only the first provision that -- that was applicable to my decision. D U FFY : Can you direct me to the section of the statute that says unless the GSEs are in conservatorship? W A TT: Well, there's nothing in there that says unless they're in conservatorship. But we --D U FFY : Where did you come up with that? W A TT: Beg your --D U FFY : Where did you come up with that? That -- WATT: The conservatorship statute tells us what authorities we have in conservatorship. It wouldn't be in the Housing Trust Fund statute. DUFFY: So is your testimony that that trumps section 1337(b)? WATT: I think the preferred stock purchase agreements trump (b)(2), yes. DUFFY: So you're saying, just to be clear, that 1337(b), it doesn't really apply and that you have the authority to fund the Housing Trust

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Fund. Is that --W A TT: That's correct, yes. If I hadn't -- If I hadn't concluded, that I wouldn't have done it. DUFFY: Would you mind sending me the legal analysis on that? Because the statute -- the statute seems pretty clear. And I want to follow the statute for your testimony. So you would -- if you would help me out on how you've reasoned --” iii http://www.law.cornell.edu/uscode/text/12/4614 iv http://www.law.cornell.edu/uscode/text/12/4612 (a) Enterprises For purposes of this subchapter, the minimum capital level for each enterprise shall be the sum of— (1) 2.50 percent of the aggregate on-balance sheet assets of the enterprise, as determined in accordance with generally accepted accounting principles; (2) 0.45 percent of the unpaid principal balance of outstanding mortgage-backed securities and substantially equivalent instruments issued or guaranteed by the enterprise that are not included in paragraph (1); and (3) 0.45 percent of other off-balance sheet obligations of the enterprise not included in paragraph (2) (excluding commitments in excess of 50 percent of the average dollar amount of the commitments outstanding each quarter over the preceding 4 quarters), except that the Director shall adjust such percentage to reflect differences in the credit risk of such obligations in relation to the instruments included in paragraph (2). v http://www.law.cornell.edu/uscode/text/12/4622 (See: Each capital restoration plan submitted under this subchapter shall set forth a feasible plan for restoring the core capital of the regulated entity subject to the plan to an amount not less than the minimum capital level for the regulated entity and for restoring the total capital of the regulated entity to an amount not less than the risk-based capital level for the regulated entity. Each capital restoration plan shall—(1) specify the level of capital the regulated entity will achieve and maintain;(2) describe the actions that the regulated entity will take to become classified as adequately capitalized;(3) establish a schedule for completing the actions set forth in the plan;(4) specify the types and levels of activities (including existing and new programs) in which the regulated entity will engage during the term of the plan; and (5) describe the actions that the regulated entity will take to comply with any mandatory and discretionary requirements imposed under this subchapter.) vi http://www.gpo.gov/fdsys/pkg/BILLS-110hr3221enr/pdf/BILLS-110hr3221enr.pdf

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