February 3, 2015

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

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 Hasnt)

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
partys 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 Administrations record regarding unfinished business on
mortgage market reform.

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

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February 2015

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 Treasurys 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. Watts decision to have the GSEs begin

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February 2015

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 FHFAs 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 Watts 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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February 2015

they could not become adequately capitalized iii according to the

capital requirements of HERA iv, 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 Watts 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 Treasurys
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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February 2015

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 FHFAs 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 predecessors 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 presidents 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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February 2015

http://www.gpo.gov/fdsys/pkg/BILLS-110hr3221enr/pdf/BILLS110hr3221enr.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
Yes.
A TWell,
T : no.
D
Kind
U FFY
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 wellcapitalized, not undercapitalized; correct?
W
They
A T--T :
(CROSSTALK)
D
Before
U FFYyou
: can fund the Housing Trust Fund,
you have to find that the GSEs are not undercapitalized; correct?
W A T T : No, I don't think that's the case. DUFFY: You think the GSEs
--W A T T : 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
Can
U FFY
you :direct me to the section of
the statute that says unless the GSEs are in conservatorship?
W A T T :
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
BegA T T :
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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February 2015

Fund. Is that --W A T T : 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 mortgagebacked 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/BILLS110hr3221enr.pdf

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February 2015

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