Banking Law Prof Blog

Fannie & Freddie in Conservatorship - Another Sunday Announcement Intended to Stabilize the U.S. Housing Mortgage Market and Reassure U.S. & Global Financial Markets

The Perils of Fannie and Freddie (playing out somewhat like that old cliff-hanger series, "The Perils of Pauline") have kept financial commentators on the edge of their seats all summer.  Today, regulators made another Sunday announcement of actions taken to address the severe capital problems facing these two secondary mortgage market giants.

Treasury Secretary Henry Paulson's statement represents the most concise summary of today's government action:

1.  Jim Lockhart, Director of the newly created Federal Housing Finance Agency (FHFA), placed both Fannie Mae and Freddie Mac into conservatorship.

2. Treasury will initially be issued $1 Billion in senior preferred stock in each of the two entities (Fannie & Freddie), with the likelihood of more infusions of Treasury investments as needed.  the aim is to reassure the markets and avoid moving from conservatorship to receivership (total insolvency and liquidation).  Treasury will also be granted warrants assuring 79.9% ownership control.  Common stockholders will not immediately be completely wiped out, but the value of their holdings is now in the "junk bond" range.

3.  Treasury has established a new secured lending facility available to Fannie, Freddie, and the Federal Home Loan Banks to assure continued liquidity in the mortgage market.

4.  Treasury is also initiating a temporary program to purchase Mortgage Backed Securities (MSBs) from Fannie and Freddie -- again more liquidity.

5.  Fannie and Freddie will "modestly" increase their mortgage-backed securities portfolios through 2009 and then begin gradually decreasing their portfolios at 10% per year.  Obviously, there is a need to increase the number of players in the secondary mortgage market to avoid the current situation in which problems with these two giant GSEs have such overwhelming market impact.

Paulson reiterated three goals:  Providing stability to the financial markets; Supporting the availability of mortgage finance; and Protecting taxpayers.  Both Fannie and Freddie have experienced major stock price drops and increasing lack of confidence from the financial markets.  The U.S. housing market depends on these two Government Sponsored Entities (GSEs) for continued operation of the secondary mortgage market and the liquidity our banking system needs to continue making home mortgages.  Taking action now is intended to stop the financial bleeding and limit the inevitable bailout pricetag. 

Paulson and the Federal Banking Agencies reassured the public and the markets that these actions with respect to Fannie and Freddie should not undermine confidence in other financial institutions.  These two GSEs are different because their portfolios are limited to mortgages, whereas other financials are better diversified.  In addition, the federal banking agencies noted that they would work with financial institutions holding investments in preferred or common stock in Fannie or Freddie as these other affected financial institutions develop capital restoration plans.

This is not an outright nationalization of Fannie and Freddie -- although that issue is clearly on the table.  Paulson did say that the GSEs had been operating under a business model that created an unacceptable conflict between the interests of shareholders and the public interest in stable housing finance.  In addition, the current rescue plan was necessitated because of ambiguity over the nature of government backing for Fannie and Freddie as GSEs.

We can certainly expect debate and clarification over the next few days -- and more permanent restructuring after the November election, regardless of which party controls the White House.

Link to Paulson statement:  http://www.treas.gov/press/releases/hp1129.htm

(ag) Sept. 7, 2008, in Economy

New Federal Reserve Governor Sworn In Today

Elizabeth Duke joins the Board of Governors of the Federal Reserve System today, beginning a term that lasts until Jan. 31, 2012.  Ms. Duke is a career banker, having worked for both a community bank in Virginia (Towne Bank) and for Wachovia Bank.  She is a former Chairman of the American Bankers Association and a graduate of the Stonier Graduate School of Banking.

Link:  https://www.federalreserve.gov/newsevents/press/other/20080804a.htm

(ag) Aug. 5, 2008, in FRB

Federal Reserve Extends Extraodinary Liquidity Measures

As we all know, this economic "downturn" is not over.  The Federal Reserve has been very innovative in developing new tools to enhance liquidity in the U.S. financial system.  Check out the Fed's recent press release which lists and explains some of these new tools -- but also notes that they are still needed and their authorization is being extended.

Link to FRB Press Release:  https://www.federalreserve.gov/newsevents/press/monetary/20080730a.htm

(ag) Aug. 5, 2008, in FRB

Oxford Roundtable Working Paper: NAFTA, 9/11, and the Subprime Mortgage Meltdown-A Disastrous Combination from a Human Rights Perspective

My powerpoint and working paper as presented to Oxford Roundtable, Aug. 3-8, 2008.

Link to powerpoint:  Download OxfordRoundtable.ppt

Link to working paper: Download oxford_roundtable_working_paper.doc

CRA: It's Not Just for Low to Moderate Income Anymore

Comptroller of the Currency John Dugan emphasized the new housing legislation's expansion of focus, encouraging national banks to lend to middle income areas in addition to low and moderate income. 

Link: http://www.occ.gov/ftp/release/2008-92.htm

(ag) July 31, 2008, in CRA/Lending Issues

Asking for Mortgage Foreclosure Forbearance Until Oct. 1

The Hope for Homeowners Act portion of the comprehensive Mortgage Reform Bill will go into effect on Oct. 1, 2008, and House Financial Services Committee Chairman Barney Frank is asking lenders to delay taking action on mortgage foreclosures until Oct. 1, 2008, when the new programs become available to at-risk homeowners.

Link:  http://www.house.gov/apps/list/press/financialsvcs_dem/press072508.shtml

(ag) July 31, 2008, in Lending Issues

Capital Adquacy in a Time of Bank Failures - Basel II, Pillar Two

As the probability of increasing bank failures looms large in the public consciousness, more attention will appropriately focus on capital adequacy.  How Basel II implementation will square with the need for an adequate capital buffer against hard times is an even more critical question today than it has been over the past couple of years.

Take a good look at the Federal Banking Agencies' issuance of Final Guidance on Basel II, Pillar Two (which covers supervisory review of capital adequacy):  http://www.federalreserve.gov/newsevents/press/bcreg/bcreg20080715a1.pdf

Remember that the three pillars of Basel II are:

Pillar One:  Minimum risk-based capital requirements;

Pillar Two:  Supervisory review; and

Pillar Three:  Market disciplinethrough enhanced public disclosures.

(ag) July 29, in Capital Adequacy/Basel II

One Step Closer to a "Mortgage Rescue Bill"

Today, the U.S. House of Representatives passed H.R.322, the American Housing Rescue and Foreclosure Prevention Act of 2008, by a vote of 272 to 152.  Now the bill goes back to the Senate, where it is expected to pass quickly -- and President Bush now says he will not veto the bill.

Key provisions:

• Shoring up public confidence in Fannie Mae and Freddie Mac - By granting the Federal Reserve express authority to extend an unlimited line of credit to these two troubled mortgage market cornerstones for the next 18 months as well as the authority to buy their stock if necessary to stabilize housing finance markets, Congress hopes to stop the downward spiral in the U.S. residential mortgage sector.
• The pricetag for this new backstop authority is estimated by the Congressional Budget Office (CBO) to be $25 BILLION -- of course, that's pulling numbers out of a hat.  CBO says there's a 50% chance Freddie and Fannie won't need to be bailed out, in which case the number would be $0.  However, there's a 5% chance the number is $100 Billion -- according to CBO, but really, who knows, it could be more.
• Creates the Federal Housing Finance Authority (FHFA), a new independent federal regulator for these two GSEs and the Federal Home Loan Banks -- with the authority over capital, corporate governance (including executive compensation). operations, activities, and safety and soundness.  (This new agency will absorb the Office of Federal Housing Enterprise Oversight and the Federal Housing Finance Board -- which are both abolished.)
• Requires the GSEs to provide affordable credit to the underserved markets of manufactured housing, housing preservation and rural housing; encourages and measures GSE home refinance loans to low income borrowers.  That's Community Reinvestment on steroids!
• Establishes new affordable housing programs, including a new Housing Trust Fund and a Capital Magnet Fund.
• Provides an increased role for the Federal Housing Administration (FHA), raising FHA loan limits up to $625,000 -- and puts a one-year moratorium on FHA risk-based pricing.  This likely means that FHA just won't guarantee loans at all for high risk borrowers or that it will charge all borrowers a higher interest rate since it can't charge a higher interest rate for more risky loans.  How is this a prudent lending standard????  In addition, the seller-funded Gift Downpayment Program is elminated. 
• Creates the "Hope for Homeowners" Program, enabling the Federal Housing Administration (FHA) to refinance mortgages of "at risk" borrowers -- up to $300 Billion in new 30-year fixed rate mortgages if lenders write down the loan balance to 90% of current appraised value.  Borrowers will pay a premium to FHA and agree to share profit on sale.  This program has been estimated to keep 325,000 to 400,000 families from losing their homes.
• Sets nationwide standards for a nationwide mortgage licensing and registration system for mortgage brokers and bank loan officers.  This addresses the problem demonstrated in the present crisis when just anyone could hang up a shingle and proclaim themselves a mortgage broker, accountable to no one.
• Provides $4 Billion in emergency assistance to states and cities to redevelop abandoned and foreclosed homes.  This provision was anathema to President Bush and precipitated a "battle of the press releases" between U.S. Representative Spencer Bachus, who is the ranking Republican member of the House Financial Services Committee, and the Committee Chairman Barney Frank.  See the House Financial Services website:  http://www.house.gov/apps/list/press/financialsvcs_dem/press071508.shtml

Link to House Financial Services Summary of HR 3221:  http://www.house.gov/apps/list/press/financialsvcs_dem/press072308.shtml

(ag) July 23, 2008, in Economy

Covered Bonds - A New Solution or an Old Danger?

In response to the liquidity crisis, particularly with regard to home mortgages, the FDIC last week announced new guidance for covered bonds.  So what are covered bonds?

Here's how the FDIC describes covered bonds:
"Covered bonds are general, non-deposit obligation bonds of the issuing bank secured by a pledge of loans that remain on the bank's balance sheet. Covered bonds originated in Europe, where they are subject to extensive statutory and supervisory regulation designed to protect the interests of covered bond investors from the risks of insolvency of the issuing bank. By contrast, covered bonds are a relatively new innovation in the U.S. with only two issuers to date: Bank of America, N.A. and Washington Mutual. These initial U.S. covered bonds were issued in September 2006."

Unlike the legal and regulatory framework in Europe, which is extensive, U.S. regulators find that our banks do not need express statutory or regulatory authorization to issue covered bonds. 

So why don't U.S. banks just go ahead? Well, in light of the current crisis involving residential mortgages, investors are understandably reluctant to go anywhere near something that could represent more of the same risk as the subprime mortgage derivative investments.

Here's where the U.S. regulators step in.  The FDIC and the Federal Reserve are taking steps to reassure investors that the covered bond product is not so risky.  The FDIC's July 15, 2008, Covered Bond Policy Statement tells investors how the FDIC will treat covered bonds in the event the bank that issued the covered bonds fails:

FDIC says, "As conservator or receiver for an IDI, the FDIC has three options in responding to a properly structured covered bond transaction of the IDI: 1) continue to perform on the covered bond transaction under its terms; 2) pay-off the covered bonds in cash up to the value of the pledged collateral; or 3) allow liquidation of the pledged collateral to pay-off the covered bonds."

This is designed to reassure potential investors in covered bonds that even if the issuing bank fails, they will still get paid or have access to the underlying mortgages which have been pledged as collateral.

Concerns that Fannie Mae and Freddie Mac will be unable to provide sufficient liquidity, given their own precarious financial conditions, to allow the U.S. housing market to recover underly this new regulatory "reassurance" to the market.

In addition to spelling out how covered bonds will be treated in a bank liquidation, the Policy Statement prescribes the "eligible collateral" -- setting the standards for the underlying mortgages:

• The issuing bank must retain the underlying mortgages on its books -- although the bonds themselves are nonrecourse.
• The mortgages which secure the covered bonds must be perfected security interests in performing (paying as agreed) one-to-four family residential properties, underwritten at the fully indexed rate, and based on documented income.
• In addition to eligible mortgages, the covered bonds could be secured by a limited volume (up to 10%) of AAA-rated mortgage securities and certain substitution collateral (cash, Treasuries, and agency securities).
• Securities backed by tranches in other securities or assets such as CDOs are not acceptable collateral for covered bonds.
• An issuing depository institution (IDI) may issue covered bonds that comply with FDIC's Policy Statement only up to 4% of its total liabilities after issuing the bonds.

Okay, so the FDIC's Policy Statement has identified and excluded some of the risky (or stupid) loan characteristics, such as "teaser rate" loans where the borrowers can qualify at the initial rate only -- and may have no idea that they will be unable to afford mortgage payments when the loan reprices.  No-doc or "liar's loans" are also out.  And exotic, poorly understood, and extremely risky products involving CDOs are not eligible collateral.

BUT there remains substantial room for poor underwriting.  It used to be said that no banker intends to make a bad loan.  Even in the old days when prudent underwriting was a precept honored in the observance, lenders make mistakes in evaluating capacity to repay and borrowers' financial conditions change. So these eligible mortgage pools could still contain loans that turn out to be losses.  And given the real estate market, some properties may continue to decline in value. 

CAUTION:  Investors need to recognize that these covered bonds are NOT risk-free.

It is to be fervently hoped that the regulators are more on top of the risks these covered bonds may present than they were with subprime mortgages and their derivatives, which were also addressed in Policy Statements.

On the one hand, I applaud the FDIC and the Federal Reserve for thinking creatively to find solutions to the liquidity crisis in home mortgage lending which continues to threaten the overall U.S. economy (not to mention global markets).

On the other hand, I hope covered bonds won't be another source of "imprudent investments."  We can't stand another innovation that solves one problem (just like subprime mortgages were intended to solve the problem of no access to home ownership for those with less than stellar credit) but lands us in a bigger mess.

I'm not saying this can't work.  I'm saying banks, regulators, and investors need to retain their common sense as well as "safe and sound" implementation.

Link to FDIC Covered Bond Policy Statement:  http://www.fdic.gov/news/news/press/2008/pr08060a.html

Link to Treasury Secretary Henry Paulson speech describing and supporting covered bonds:  http://www.treas.gov/press/releases/hp1070.htm

(ag) July 23, 2008

IndyMac - Second Largest Failure in FDIC History

Subprime lender IndyMac was closed by FDIC on Friday.  Check out my comments before and after the closing as quoted in Reuters News Service articles:

News story on July 9, 2008:  "IndyMac's Fate Could Test Banking Regulators" http://uk.reuters.com/article/ousiv/idUKN0932999520080710

News story on July 12, 2008:  "IndyMac Seized As Financial Troubles Spread"  http://news.yahoo.com/s/nm/20080713/bs_nm/indymac_dc

(ag) July 14, 2008, in FDIC

Fannie, Freddie, & the Fed - A Sunday Announcement

Two of the biggest participants in the U.S. secondary mortgage market, Fannie Mae and Freddie Mac, are experiencing serious repurcussions from the subprime mortgage debacle -- and their problems spill over into financial market drops and general mortgage lending liquidity concerns. 

Today, the Federal Reserve made a special Sunday announcement intended to shore up public confidence in these two major mortgage market players.  The Federal Reserve Bank of New York has been granted special authority to lend to them "to promote the availability of mortgage credit during a period of stress in financial markets."

Link to FRB Announcement:  http://www.federalreserve.gov/newsevents/press/other/20080713a.htm

Link to news story:  http://news.yahoo.com/s/ap/mortgage_giants_crisis

Last week the debate concerned former St. Louis Federal Reserve Bank President Bill Poole who has called for "nationalizing" Fannie Mae and Freddie Mac.

Link: http://www.bloomberg.com/apps/news?pid=20601087&sid=a7NPAG.LEjHQ&refer=home

(ag) July 13, 2008, in Economy/FRB

BBA Announces Libor Reforms - What's the Impact?

Today, the British Bankers Association (BBA) announced two measures to strengthen Libor as well as calling for comment on several other possible changes.  Libor (the London Interbank Offered Rate) is the most widely referenced interest rate index in the world, used as the benchmark for $350 Trillion in interest rate swaps and $10 trillion in loans.

Libor originated in 1985.  It is the interest rate participant banks in the London market report that they would be charged by other banks if they sought to borrow funds on an unsecured basis.  Libor is set at 11:00 A.M. UK time in 10 currencies for 15 maturities.  The four most significant Libor currencies are: U.S. dollar, Sterling, Euro, and Yen.  Data is compiled and calculated by Reuters for BBA.  BBA's oversight committee for Libor is the Foreign Exchange and Money Market Committee; it is composed of selected participant banks.  BBA asks for volunteer banks active in the London market in the relevant currencies and in "reasonable amounts" and then establishes panels of banks for each currency, which report interest rates they "perceive" they would be charged.

The following striking facts about Libor highlight the fact that this benchmark interest rate was not originally intended -- nor is it presently constructed in a way that lends itself -- to such global importance:

• The British Bankers Association is not a government agency but an unregulated, voluntary trade association.
• Banks volunteer to join a panel of banks and voluntarily report the interest rates they would expect to pay.  Until now, reporting has been more or less on the "honor system" to report accurately.
• BBA and Libor are focused on the London market, yet this benchmark interest rate is used world-wide.  Of course, a risk premium and premiums for other factors are expected to be added on top of any benchmark rate.

Previous complaints about Libor:

• Beginning in about August 2007, as the U.S. subprime mortgage market crisis developed, concerns about the accuracy of Libor began to be expressed.  Reporting banks had an incentive to understate the interest rate they said they would be charged because if they reported a high interest rate, the market would conclude that their financial condition was distressed.
• In November 2007, the Bank of England reported that the actual cost of interbank borrowing was higher than Libor indicated.
• In March 2008, the Bank for International Settlements warned that banks could be understating their borrowing costs to appear to be in stronger financial condition.
• In April 2008, BBA announced a "fast-track" review of Libor, stating that any members deliberately misreporting interest rates would be banned.
• While European banks are concerned that Libor may be understating interest rates, some U.S. critics contend that Libor is actually too high because UK banks are risk averse and there is an inadequate supply of dollars in the London market.

Today's recommendations to strengthen Libor:

• BBA announced that it would require discrepancies between interest rates reported and those actually paid to be reviewed by the oversight committee -- and justified by the reporting bank if they were found to be inaccurate.  In my opinion, this change is long overdue.  Given the hundreds of trillions of dollars in exposure and the world wide use of this benchmark, it can no longer be an unverified number.
• BBA intends to widen membership of the Foreign Exchange and Money Market Committee and increase the size of currency panels -- including more U.S. perspective. This may or may not be necessary since Libor is clearly derived from the London market and includes global financial institutions that also have a significant U.S. presence already.  Perhaps we simply need to recognize that Libor is a London-market-based index and adjust with additional premiums as appropriate -- or choose another index.

BBA REQUESTS FOR COMMENT:

• Should there be additional dollar benchmark fixes?  In addition to the 11:00 A.M. fix of the U.S. Dollar Libor, should there be another London fix later in the day, after the U.S. financial markets have opened?  Would two fixes present insurmountable legal issues because of the vast number of existing contracts that reference the 11:00 A.M. fix?  Would two fixes create market confusion?
• Should there be an additional European dollar index to capture U.S. Dollar trading in Europe even though the majority of Euro dollar trading takes place in London?
• What about continuous, real time interest-rate reporting?
• Is it appropriate to reduce the stigma that comes from reporting high interest rates by moving to anonymous reporting?  Currently BBA reports each reporting institution and the rates it reports.  In my opinion, any move to anonymous reporting would undermine transparency, as well as accuracy -- and would be detrimental.

My suggestions for thought:

• Are these concerns about Libor limited to the current period of market instability generally?
• Now that global financial markets have become aware of the limitations inherent in relying on a London-market-based benchmark, should new benchmarks be created or selected?  Is it enough to recognize Libor for what it is and add other compensating factors or premiums?
• Where are the regulators?  I note that among the "stakeholders" BBA consulted before announcing these reforms today, we see participant and non-participant financial institutions, hedge funds, money market funds, and brokers -- but no government agencies or central banks.
• The global nature of financial markets requires that we study these Libor (or interest-rate bench mark) issues together with other key issues impacting our global financial interactions, including global capital requirements and Basel II, as well as regulatory structures such as those raised in the U.S. by the recent Paulson Report.

(ag) June 10, 2008, in Economy

Two Recent Supreme Court Cases on Money Laundering Issues

Karen Neeley, one of Texas' best banking lawyers, recently called my attention to two recent U.S. Supreme Court cases.  Here's what she has to say:

"The Supreme Court decided two money-laundering cases on June 2, 2008. These cases do not relate to cases against financial institutions or Suspicious Activity Reports, but rather relate to the burden imposed on prosecutors in money-laundering cases. Although it is too early to tell the impact these cases will have on other contexts of money-laundering, the Court’s rulings are instructive of how it will interpret certain requirements in the federal money-laundering statutes."

"In Cuellar v. United States, the Court held that money-laundering cannot be proven merely by showing funds were concealed during transportation. Rather, the government must show the purpose of transporting the funds was "to conceal or disguise the nature, location, the source, the ownership, or the control" of the funds. Furthermore, the Court observed that the government is not required to prove a defendant attempted to create an appearance of legitimate wealth. Even though the defendant concealed money in a hidden, specialized compartment in his car, bundled it in plastic bags sealed with duct tape, and used animal hair to mask any scent from drugs, the Court found there was not sufficient evidence to show a purpose, plan, or "design" for transporting concealed funds. The bottom-line of this case is that conviction for transporting laundered money requires proof of the purpose, not the effect, of the transportation is to conceal the nature, location, source, ownership, or control of the money."

"The other money-laundering case decided on June 2nd, United States v. Santos, relates to the term "proceeds" and its interpretation in the money-laundering statutes. The Supreme Court decided the term "proceeds" means "profits" but not "receipts." Therefore, paying off winners and employees in an illegal gambling operation did not qualify as money-laundering because there was no proof the pay-offs were made with profits from an illegal operation. Because the term "proceeds" is not defined in the statute, the term’s ordinary meaning has been defined as both "receipts" and "profits," and the money-laundering statutes make sense under either definition, the Court applied the rule of lenity, which instructs the statute be read in favor of the defendant."

Karen Neeley practices banking law with Cox Smith's Financial Institutions Practice Group, in the Austin office.

(ag) June 10, 2008, in BSA/AML

Call for Papers - Treasury's Blueprint for a Modernized financial Regulatory Structure

Download u_of_m_call_for_papers.doc

The University of Memphis Cecil C. Humphreys School of Law announces a call for papers relating to the Treasury's Blueprint for a Modernized Financial Regulatory Structure.  This is a very timely opportunity!

(ag) May 23, 2008, in Federal Banking Agencies

Another Rate Cut & More Liquidity Issues

The Federal Open Market Committee (FOMC) reduced the target federal funds rate another 25 basis points to 2% on Wednesday. 

Dallas Federal Reserve Bank President Richard Fisher and Philadelphia Federal Reserve Bank Charles Prosser opposed this rate cut.

Link to FOMC Statement:  http://www.federalreserve.gov/newsevents/press/monetary/20080430a.htm

The Federal Reserve continues to battle the liquidity crunch in other ways as well.  Today, the Federal Reserve announced an increase in the amounts auctioned to eligible depository institutions under its biweekly Term Auction Facility (TAF) from $50 billion to $75 billion, beginning with the auction on May 5. This increase will bring the amounts outstanding under the TAF to $150 billion.  In response to the global nature of the liquidity crisis, the Swiss National Bank and the European Central Bank are working in cooperation with the Federal Reserve.

Link:  http://www.federalreserve.gov/newsevents/press/monetary/20080502a.htm

(ag) May 2, 2008, in Economy/Interest Rates