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Hello and welcome to another episode of the Odd Lots podcast.
I'm Joe Wisenthal and I'm Tracy Alloway.
So, Tracy, something that we've touched on a few times is this sort of I guess I would say perverse situation by which you know, the FED is raising interest rates in an attempt to get inflation back to target, and you know, it seems like they're kind of having some success there and maybe we might begin a cutting cycle.
But in the process of raising raids, you constrain supply of housing in particular, which is a you know, a big affordability crisis, one of the big long term upward sources of pressure on prices.
Right, So higher rents and house prices are part of the higher inflation story. And one way of dealing with higher prices is to build out supply, right. But if you're raising rates to offset inflation, then building out that supply becomes more expensive and there's more uncertainty and people
don't necessarily want to do it. And then just to add to that against that whole backdrop of inflation, I think it's funny how fast this kind of faded into the background, but we still had that mini banking drama crisis or whatever you want to call it from last year, which did kick off some credit tightening, particularly in commercial real estate, and commercial real estate, as we've mentioned a number of times on the podcast, includes multifamily residential.
Right, So there's all this stress, and you know, in the short term, it seems like rate hikes have probably had some effect on cooling the economy, but there are long term costs associated with that. Everybody is aware of this, and it does seem to be according to many economists, the sort of deep structural housing shortage and the effort to fight inflation constraints that. So the question is, like, is there some solution here or do we just have to accept that this is the reality?
Yeah, I guess the big question is how do you get people to build more?
Yeah? Right?
Especially yes, yes, especially at a time when like there are incentives out there that seem to be working against doing that. So you have the higher interest rates, so maybe now is not the time when you want to spend a bunch of capital to build something new. Maybe you want to wait for interest rates to go down. And then also, this is a controversial statement, but I
saw you tweeting about it earlier today, Joe. But like I do wonder, you know, if you're a property development and you're building luxury apartments and there's all this question about like population density and zoning and things like that, maybe part of the incentive is you don't want to build that much because you could make money just by you know, constraining the supply and seeing prices go up.
That's right, and there's certainly like you know, the way people talk about it is that if you're a developer and you own land, you have a real option and you don't have to build the moment you acquire the land, and you can wait until a stronger conditions. So it's actually like getting the policy mix right.
You know.
People focus on zoning, and I'm sure that's an aspect, and then the housing supply chain and labor and all this stuff. It's a multifaceted challenge to do it. But you know, we need some ideas here about how we're actually going to produce more housing units in this country.
Yes, and you mentioned multifaceted. We have the perfect guests to talk about this very multifaceted and nuanced issue of how do you build more multifamily in the US.
That's right. We have truly the perfect guest, because he might even I think he's even going to give us a solution, or at least a partial solution to this challenge. We're going to be speaking with Jim Milstein. He is the co chair currently of Guggenheim Securities. Previously, he was the Chief Restructuring Officer at the Treasury from two thousand and nine through twenty eleven. So I was dealing with a lot of aig stuff at the time, right in the wake or in the sort of immediate time of
the Great Financial Crisis. Previously to that, he was at Lazard. He's also done work on Fanny and Freddy or attempted to look into the challenge of restructuring these big housing banks that we have in this country, and maybe he can shed some light on possible situations to at least alleviate some of the financing strains of the housing problem. So, Jim, thank you so much for coming on odd Lots.
Well, thanks for having me.
Why do you give us the sort of you went to Treasury and Tim Geitner called you up and said, come help us fix this gigantic mess that we have. Why do we start there? What did you do when you're at Treasure.
I came in right at the beginning of the new administration, and you know, we were in the middle. The financial crisis was in full blue. Yeah, at that point right started. Really the seeds were planted in two thousand and seven and six from the whole subprime mortgage crisis and where all of that credit risk resided in various banks and other financial institutions, including AIG. And so I was asked to get my hands around AIG first and foremost we had put by the.
Wait, can I just ask? I always wondered this, but like, how does the ask? What form does the ask? Actually just get a phone call one day and it's like, can you sort out what was it? Billions, if not trillions worth of AIG monoline insurance?
Yeah, I mean desically, there was a meeting in the Secretary's office with the team that he had assembled, a bunch of you know, financial experts that he had brought in. There were some longtime Treasury officials, but mostly a bunch of outsiders came in and he built himself a little investment bank inside the Treasury Department to deal with all of these institutions that were, you know, that were wobbling.
And so by the time I got there, the federal government, between the FED and the Treasury Department's Start program, had put one hundred and thirty billion dollars into AIG and most of that was to shore up the capital of the various insurance companies, but the bulk of it and the immediate need went to AIGFP, which had written a series of credit default insurance swaps and had relied on AIG's credit rating, which had been double A, as a
substitute for cash collateral on those trades. And when the rating agencies, in their infinite wisdom, downgraded AIG credit rating from double A to single A, it required a massive cash collateralization in order to keep those trades in place.
So within six weeks, AIG was into the FED for about one hundred billion dollars and all of that went right into AIGFB to cash collateralize their trades, so they didn't default on Goldman Sacks, on SoC Gen, on BNP, on Bank of America, on the various insurance they had written in their favor, on various structured finance products. And it was a black hole. And one of the real problems with AIG was that it was not regulated by the Fed, by the Treasury Department, by anyone at the federal.
Level of insurance is like fifty state regulators.
And AIG was expert at regulatory arbitrage. So there was a insurance regulator I think it was either in Delaware or Maryland that was the primary regulator of this worldwide. The largest insurance company in the world, it was also the largest aircraft leasing company in the world, one of the largest consumer finance companies in the world, and one of the largest participants in the credit default insurance market. So how do you end up getting settled with AIG?
So he called into his office the team and said somebody's got to take charge of it, and basically everybody else in the room took a giant step back.
That left me into the hedge exact style.
Oh thank you, Jim for volunteering. So I spent a ton of time up at Wilton, which is where AGFP was located, talking to the guys who ran the twenty two desks, which were twenty two different trades that they had put on. And I got to tell you, I think of myself as a I was worked as a lawyer for eighteen years and then as a banker for ten years before this, and I think of myself as
a reasonably smart guy who can figure things out. It took me two weeks to really just understand what they had done and what they were doing, and to whom they owed their insurance and the impacts then what we call the interconnectedness and potential contagion effects of their failing to make good on their insurance.
I realized, we're supposed to talk about building additional housing supply.
We'll get there. We'll get there.
I have so many questions just about this particular period of time, But when you say it took two weeks to figure out just what was going on and what the network of who owed what to whom actually looked like. What was the system like back then? Was it just like actual hard copy contracts or was there an Excel spreadsheet somewhere retangle it?
They were reasonably sophisticated in terms of their digitization of
their records. But the truth is is that you know these were bespoke trades, and so without probing each of the managers of each of the desks on you know how it came to be that you had, you know, six hundred billion dollars worth of exposure on internal securitizations that European banks had done on their credit portfolios, where AIG what do they call this the capital structure arbitrage desk, where banks would basically create an internal securitization, create a
senior and subordinated trnch in their loan books, and AIG would write credit insurance credit to fault protection against the senior trench and thereby transform a book that would otherwise have had a credit rating of overall on average double B and turn the senior tranch into double A, which was where their credit rating was at the time AIG's credit rating was at the time, with the result that
the bank's capital charges on that loan book would be reduced. Yeah. Right, And AIG was paid handsomely for the privilege of helping the banks do this, and mostly it was European banks.
So this reminds me of something else that I want to ask you, But the decision to recapitalize AIGs so it could make good on some of these guarantees, and maybe this will be relevant to our conversation later about housing.
But how much discussion was there at the time about moral hazard because I do remember the headlines about how bailing out AIG was in effect a bailout of big banks, including there was a big controversy at the time about Goldman Sachs and how much it benefited from the AIG bailout. But what was that aspect of the conversation, like.
Yeah, so this let's just go back in time, Well, have.
Our producers add in a little sound effect like do dig so?
On September eighth, Secretary Paulson and the newly created regulator over Fanny and Freddy, the FAHFA, the Federal Housing Finance Authority, which had succeeded something called the FAO, which had done a miserable job of regulating Fanny and Freddy, put Fanny
and Freddy into conservatorship on September eight, two thousand and eight. Okay, On September fifteenth, AIG's credit rating was downgraded and as a result, the massive cash collateral call was required on their derivatives book, cash they didn't have, and on September fifteenth, at midnight, Lehman Brothers filed for Chapter eleven, creating really the beginning of the widespread panic in all financial markets because of the size of Lehman brother's own derivative book,
mostly the repo book right where they were both a lender and a borrower in the short term overnight repo markets. So that destabilized the financial system. And I think as a result of the impact of the Lehman filing, the New York Fed decided that to throw the largest insurance company into a receivership or rehabilitation proceeding under state law, which is where it would occur, would just creater the financial markets and accelerate the panic that occurred with Lehman.
And so the New York Fed wrote the largest loan and recorded human history in favor of AIG. Seventy five billion dollars was extended to AIG in order to make sure that it did not fail right then and there.
Imagine the junior lawyer whose tasked was like getting that loan signed by both parties.
So AIG went through that loan within six weeks, just drew the whole thing down. And on top of that, the Fed then separately extended basically a broker dealer loan. They did clateralize lending to AIG in order to give it incremental liquidity. In October, the TARP legislation would finally passed, and that gave the Treasury Department seven hundred and fifty
billion dollars of firepower to do something with. Initially, Secretary Paulson thought, and that's what he sold Congress on, that he was going to buy troubled assets off of bank balance sheets in order to create liquidity for the banks. The problem with that was the price at which you could buy those trouble assets if you were protecting the taxpayers, would reveal the deep insolvency of many of these banks if they were forced to sell their assets at highly
discounted prices. So he very quickly changed course and decided to recapitalize the entire industry by buying preferred stock. And so the one hundred and thirty five billion that I talked about the Fed being into AIG for under their
Emergency Lending authority under Section thirteen to three. There was a first recapitalization of that one hundred and thirty five billion dollars done in November and December of two thousand and eight after TARP passed, where fifty billion dollars of tart money was brought in to refinance out fifty billion
dollars of the Fed's lending to AIG. So at that point, the FED was into AIG for call it seventy five billion dollars of senior secured loan at the parent level, and the Treasury Department owned fifty billion dollars worth of preferred stock at the parent level.
I love talking about this stuff because you know, this is like where we start our career, so this is like, you know, it could go on this forever, but AIG did get cleaned up.
It's fun.
I always get a kick out of looking at the stock of AIG because if you just look at like a ten year chart, it looks like a normal thing, you know, like a normal stock price because it's still trades, but like on a split adjusted basis, So it's like a seventy six dollars stock right now, but because of the just gigantic dilution and the split, it was like a fourteen hundred dollars stock equivalent back then. So it's just you know, it was saved, but the equity was truly a visceery.
Yeah, so I'll just take you to the end of that stock. Okay, in order to pay back the FED Yeah and pay back the Treasury, we had to downsize and de risk the company. So we did a series of asset sales over eighteen months. We sold off one of the largest consumer finance companies in the United States. We sold off the aircraft leasing business. We sold the Asian life insurance businesses. They were the largest life insurance provider in Asia, including China.
They had one of the only really founded in China right.
Well, they founded, but they had one of the first licenses and only persisting licenses to provide insurance by a foreign entity in China. We sold off the Middle East
Life insurance operations. We sold off the European life insurance operations, and then having generated all of those asset sale proceeds, had could pay off the FED Alan and that left the Churchury preferred stock in place, and we then had to do a complete recapitalization, and as you noted, we converted the preferred into ninety two percent of the fully deluded common equity, diluting the existing common down from one
hundred percent ownership to eight percent. And over the next two years and twenty twelve twenty thirteen, the Teratury Department sold off that ninety two percent of the common equity. The net result of that was all in between interest dividends and asset sale proceeds and stock sale proceeds. The Government of the United States made twenty two billion dollars on its one hundred and fifty billion dollar investment in EIG.
So AIG was just one of there were many troubled institutions that floated to the surface of that time all of their troubles. AIG was a huge one, and there were those ones that went bankrupt, and then there was also Fanny and Freddy, which still exists and which still also have some sort of weird equity that I don't understand. And there was for the last fifteen or so years. There's always talking about reform, and you know, there's all
these lawsuits and stuff like that. So Geitner asked you to try to figure out something with Fan what happened with that after so AIG cleaned it up, and yeah, solved that, I guess.
Yeah, And by you know, the time we got the AIG recapitalization agreed and consummated in January of twenty eleven. Yeah, all that needed left to be done on that was to sell the stock we had converted the pervert into and you know, any monkey could do that. They didn't need me for that. So I went into the secretary and suggested that it was time for me to leave, having done what I came to do and was asked to do. And I had worked on a bunch of other things along the way. They've sort of all hands
on deck kind of situation for the first two years. Sure, And he said, well, you know what about Fanny and Freddy? And I said, what about it? And he said, well, why did you take a look?
Why don't you solve another one of our Thornias financial problems.
Yeah, and there had been an ongoing interagency study group to try to figure out what to do with them, And so I looked at their twenty five volumes of work product and then came back with something not dissimilar to that which we had done with AIG. So at that time, just to sort of situate this, by twenty eleven, between Fanny and Freddy, the Treasury Department had purchased one hundred and ninety two billion dollars worth of preferred stock in the two of them, sort of one hundred and
twenty and Fanny and seventy and Freddy. But so maybe it's important to the full story here is to understand how that rescue occurred, similar to the way the TAR program was ultimately deployed, where they purchase a preferred stock in effect, and if you think of what the purchase of preferred stock does for third party investors in large financial institutions, it's basically the government of the United States saying your entire liability structure, you J. P. Morgan, you,
Fanny and Freddy, you b of A, you're good. Anybody who has a debt claim or a contract claim against a large financial institution that has a significant preferred stock investment from the federal government. The federal government is basically saying, you guys are money good because we're junior to you in the capital structure.
This was back in the time when there was still debate about whether or not Fannie May and Freddie Mack their guarantees were the same as a government guarantee.
Yeah. So, so yeah, we'll step back even further.
So we're doing this episode in reverse, getting further and further back away from the time.
Yeah, so Fanny and Freddie are so called government chartered. They have charters that derive from the Congress of the United States Financial Institutions, unlike JP Morgan, which is organized under state law I think in Delaware or maybe New York, because it's like an amalgamation of a series of New York banks and regulated by the FED and the FDIC who provides insurance to them. Fanny and Freddy were chartered by the federal government. Fanny actually derives back from the
Great Depression. They were the first troubled asset purchase program. They were organized to purchase defaulted debt mortgage loans off the balance sheets of failing banks in the nineteen thirties, and when they purchased them, they then restructured them. They actually created the first long term mortgages in the United States.
Most mortgages were of five year storation back in the nineteen thirties, and once purchased by Fanny, the way they worked out those troubled loans was to extend the maturities out first ten then eventually fifteen years in order to give the barers time to get through the depression and actually get current on their loans. So Fanny was then privatized.
It was government owned corporation throughout the thirties, forties, fifties, sixties, and as the United States entered the Great Society Programs and the Vietnam War and the deficits started to blow out. With Fanny having all of that mortgage debt on the balance sheet of the United States, they needed to get it off balance sheet, so it was privatized, I think in nineteen sixty eight, so its debts were no longer consolidated with the debts of the United States federal government.
And then Freddy was formed in nineteen seventy because the savings and loan industry thought, you know, they needed access to the securitization market, just as the big banks who were basically the customers of Vennie May. So you had now two entities in effect buying mortgages, creating a secondary market for mortgage credit that banks originated. So JP Morgan
would originate alone. As long as it met Fanny or Freddy's criteria that the loan was at least had twenty percent equity, that it didn't exceed a certain principal amount, JPM could sell it to Fanny or Freddy. So they were secondary market purchasers and ultimately in the nineteen eighties when the securitization market was first developed, and that there was a lot I was actually a lawyer at a law firm that pioneered the securitisation market at that time.
There are a lot of legal issues that had to be solved to create a trust into which mortgages could be dumped and securities issued against the cash flows of that pool of mortgages, and that market really was pioneered
and developed in the nineteen eighties. Then Fanny and Freddy, as the owner of large amounts of mortgages, thereby could create liquidity for themselves by selling mortgage securities mortgage backed securities mbs and actually are mbs residential mortgage backed securities to institutional investors and thereby do it all over again provide incremental liquidity to the banking industry for the mortgages they were originating.
Just to be clear, those bonds came with a guarantee from Fanny and Freddy that they guaranteed principal and interest payments.
Of principle and interest on those bonds, okay.
And there was a debate pre two thousand and eight about whether or not that guarantee was like effectively the same as the US government guarantee those bonds.
So how did the market infer that it was as good as treasuries that the bonds guaranteed by Fanny and Freddie. So there were two essential elements of the quote implied guarantee. One was they were federally chartered. Right, they were originally instruments of the United States government, agencies of the United States government federally charted, so in a sense they were children of the federal government, even though they were privatized
and owned by you know, private equity investors. Because they were federally chartered, the bond market thought, well, the government of the United States, you know, has ownership of these one way or another. Separately, in their charters, they had authorization to borrow two and a half billion dollars from the Treasury Department in a pinch. Now, just to size
that up a little bit. By the time I'm of the financial crisis, Fanny had probably three trillion dollars of outstanding mortgage security guarantees and Freddie probably two trillion of outstanding, So each of them could borrow for their liquidity needs two and a half billion dollars from the federal government. So that was a drop in the bucket in terms of what their liquidity needs might be compared to the
outstanding liabilities they had. But nonetheless, investors believe that that meant between the Federal Charter and the right to borrow from the Treasury Department two and a half billion dollars, that somehow there was a guarantee by the federal government of these securities.
This is so useful because I've always sort of known this, like, oh, there was an implied guarantee, but I didn't actually know that there were two specific underpinnings of where this implication came from.
That's where it came from.
So then it actually has some sort of real bank.
So we're now in two thousand and eight. In the summer of two thousand and eight, the Congress in the United States passed the Housing and Economic Recovery Act of two thousand and eight, which was basically a complete redo
of the regulatory arrangements around Fanny and Freddy. A new regulator was created, the Federal Housing Finance Authority, that succeeded the former regulator, which had proven to be weak, and its authorities were buttressed it was given authority to place Fanny and Freddie into receivership or into conservatorship, receivership being a liquidation preceding conservatorship being a conservatorship to conserve its operations and assets, and the Treasury Department, under HERA and
the Housing and Economic Recovery Act of two thousand and eight, was given authority to purchase preferred stock in order to ensure the solveignty of Fanny and Freddy.
So the implication became real or the yeah, that was the moment that it was no longer ambiguous exactly.
And when Paulson went to the Congress to ask for this authority, he said, look, if I have a howitzer, I won't have to use it. But shortly thereafter he had to use it, and September eighth of two thousand and eighty the conservatorships were created, and very quickly, by the first quarter of two thousand and nine, the preferred stock authority the Treasury had was deployed and the first big draws on that, and ultimately by the end of twenty ten, one hundred and ninety two billion dollars of
preferred stock had been put into the two entities. Now the markets were covered. Right in twenty eleven, the equity market took off, and you know, May of two thousand and nine after the stress tests were announced and the interbank market sort of recovered. By the end of two thousand and nine, they were the banks started to trust each other again and lend to each other overnight.
You still didn't have private label mbs, right.
And you still don't know that market is almost completely dead.
I have to say my expertise in housing finance ends in twenty fifteen when I left the FT and I came to Bloomberg. However, as far as I can tell, not much has changed since twenty fifteen, So the gsees are still under conservatorship. You still don't have much private label mbs. There used to be proposals for sorting out housing finance, but I don't even see those that much anymore.
Yeah, So let me give you the macroh because it goes to the housing supply issues. So if you took the aggregate market capitalization of the public equity markets in the United States, that's about fifty trillion dollars. If you took the aggregate value of the housing stock, the residential housing stock in the United States is about fifty trillion dollars. That's the house value. There's twelve trillion dollars of mortgage debt outstanding against that fifty trillion dollars of house value.
And of that twelve trillion dollars, seven is on the balance sheet of Fanny and Freddy Is guarantees of mortgage backed securities. Those are mortgages. Seven trillion of that twelve has been securitized by Fannie May and FREDDIEMAC and guaranteed by them. Another two trillion is on the balance sheet of another government sponsored entity called Ginny May, which is controlled by the federal government, and it securitizes faj and
Veterans Authority Administration loans. So there's about two trillion there. So when you add it up, of the twelve trillion dollars of mortgage credit risk that is out there against the housing stock of the United States, nine trillion is on Fannie MAE, FREDDIEMAC, and Ginny May's balance sheets. So the government basically is the biggest player in the mortgage
finance market. None of these entities originate mortgages. That's all done by non banks and banks, but most of the mortgage credit risks resides on the balance sheets of one of these three entities.
So we have to get to the present tense. Although again you talk about this for three hours, but before we just do because this is I think the last step in understanding how we got to this point. Just describe real quickly the current institutional and economic arrangement of Fanny and Freddy. Because there is this like little stub equity that trade. I think all the profits that they may go to the government. There's all kinds of lawsuits. But what is the form that they exist as today?
Okay, so the good news is the two entities have been substantially reformed during this sixteen year conservatorship. One of the biggest problems that they faced in two thousand and
eight was that they had become a huge buyer. Not only they have this guarantee business where they guarantee mortgage backed securities that are securitized out to institutional investors, but they also had a huge portfolio investments where they borrowed money at basically a slight premium to treasuries, so they could fund a portfolio very cheaply, and they went out and bought not so much the subprime private label securities, but they bought all day, which was the sort of
next step, right exactly, So they bought a lot of all day and they made it was a huge carry trade. They were making a huge spread on those portfolios. Their portfolios exceeded a trillion dollars combined between the two of them, and that's how they were juicing their earnings in two thousand and four, five, six, and seven, as the subprime securitization market was taking market share away from the prime
or conventional securitization market that they ran. So during the course of the conservative ships, the portfolios have been wound down to the point where they're really now just transaction portfolios where they borrow money to buy mortgages off bank balance sheets before they can securitize them and repay that borrowing.
So the portfolios are down to, you know, one hundred and fifty billion, you know, or two hundred billion at most between the two of them, from the trillion dollars they were coming at the beginning of the financial crisis. So that's a major reform that's gone on. They've also new capital standards have been imposed by their regulator and conservator. The SHFA, and they are slowly through retained earnings recapitalizing
and building capital. So today I Fannie MAE has eighty billion dollars of capital on its balance sheet and Freddy probably has fifty billion. But they're still from a regulatory capital point of view, under capitalized. They need more capital based on the capital rule that was created to govern
them during the concern readership. So how did they even get to the point where they could and conservership have that much capital as they have today in twenty twelve, I believe it was after I was gone from the Treasury Department. The Treasury Department changed the deal and instead of a fixed dividend on that one hundred and ninety two billion dollars worth of preferred stock, it became a so called profit sweep, so whatever profits they made went
to the Treasury Department. And by twenty nineteen, seven years later, after the profit sweep was instituted and over which there's much litigation pending by existing shareholders, then existing shareholders. By twenty nineteen, when the profit sweep was suspended, the Governor of the United States received three hundred and two billion dollars worth of dividends so they made one hundred and ninety two billion dollar investment. The Treasury Department's already received
three hundred and two billion backs. They've made more than one hundred billion. They've way out done my AIG profits. But it was suspended. So the Secretary Manuchin, President Trump's former President Trump's Secretary of the Treasury, determined he was going to try to recapitalize them and actually end the conservatorship, and towards the end of that goal, he suspended the profit sweep so they could build capital. And these two
entities have become fabulously profitable. Fanny makes you know, on average, over the last four or five years, has been making net after tax, net after a special charge that was created as a pay for for an offset of one of the Trump tax cuts. After all of that special assessment against their income and after tax, they're making sort of fifteen billion dollars a year, and Freddy's making about eight or nine bi million a year.
Fanny the equity is worth eight billion dollars total. So you could see why private investors would love some legal ruling that gives them access to these profits.
Yeah, well, let's talk. It's not that's a little misleading. Okay, sorry, So what is the Treasury Department own It owns one hundred and ninety two billion. It's actually more because of the way it accretes. But they own a one hundred and ninety two billion dollars for their one hundred and ninety two billion dollars an investment of senior preferred stock. Under that is about thirty two billion of junior preferred stock that third party investors own.
Okay.
And these are most of the guys who were litigating, funding the lawsuits against the various actions that were taken both to start the conservatorship and during the conservativeship, like the profit sweep, and under that is the common stock, but the common stock that trades only represents twenty percent of the fully deluded equity because on top of the senior preferred stock, the Treasury Department has a penny warrant that can be exercised for one penny to buy seventy
nine percent of the stock of each entity. Okay, And this is very similar actually to the way AIG was set up. The tart money went in as senior preferred, but we also had a warrant entitled the Treasury Department to seventy nine percent of the stock. So today the stock that trades really represents only twenty percent of the total captainization.
Got it.
But still the equity account is teeny because why is it teeny? Because you have that huge senior preferred stock that sits above all of the junior preferred and the senior preferred and the common Okay.
I'm going to resist the temptation to ask more questions about the design of like the capital stack of some of these things. But let's go back to the beginning of this conversation about how do we increase housing supply in the US. So we are already in a situation where as you mentioned, nine of the twelve trillion I think it was, mortgages outstanding in the US effectively reside
on the balance sheet of government sponsored entities. So what more can these agencies do to support the housing market? What more would you ask of them?
Yes? Well, all right, so let's begin with the limitation under which they operate. So, in order to protect the banking industry's franchise to make mortgages, to originate mortgages, these entities are barred from being in the primary market. They couldn't go out and start lending to developers directly. But just as they do in the residential mortgage market and as they do in the multifamily mortgage market, they could create a secondary market for construction loans and thereby increase
liquidity in the construction finance market. And if you look today at the real constraints on supply as a result of the inflation problems we've had over the last couple of years, and they fed interest rate hiking, the construction
finance has become incredibly expensive. But not only. The other impact of high interest rates is that cap rates for once a project is completed, because the financing costs are so much more expensive, the projects have less value to the equity owners, and so that market is almost frozen.
There's been a surge of multi family constructions post pandemic, so in cities like Austin, rents are actually starting to come down because there were so many people moving to Austin and like communities that multifamily developers went in before the interest rate hikes and started projects, And the supply constraints in some markets are being eased by a surge of multifamily construction. But that's not true in all markets.
There is real supply demand and balance, and the only way depends on who you talk to, but there's a shortage of supply of somewhere between a million to five million units is the best estimates I've seen nationwide. So you know that on the margin, right, when supply and demand are out of balance like that, you get the enormous house price and rent price increases. And that's what
we've seen over the last post pandemic period. There's been a huge surge in house prices and huge surge and rents because there's just more demand than there is supply to meet it. So going back to what these entities could do again, I want to just take one further step back. Sure, what does a federal government do today to try to augment the supply of housing. Well, they have a bunch of demand side programs, which you would say today are counterproductive. We've got more demand than we
can handle. But the government subsidizes demand in a variety of ways, in part by making cheap mortgage credit widely available through the government sponsored entities, and through programs for veterans, and through programs for first time home buyers and lower middle income persons. Through the FAJA and through a rental voucher program administered by HUD. They also on the supply
side provide. There's a tax credit program, the Low Income Housing Tax Credit Program, which is subject to annual appropriations by Congress and is one of the most incredibly cumbersome bureaucredit processes. To get your hands on these tax credits, they get allocated by HUD to the state finance agencies. The state finance agencies set up programs to qualify for
those tax credits for new projects. But if you have the patients and the lawyers to do the paperwork, and you can go through the competitive bidding process, you can get a tax credit that can basically foot the bill of new construction. About somewhere between twenty five to fifty percent of the cost of new construction is basically being subsidized through the tax code of the United States the
sale of tax credits. So a developer can build a project, all the tax credits to somebody who needs them, and offload about twenty to fifty percent of the construction costs. But that's it. That's what the federal government does today. I think a much more efficient way would be to create a new finance program somewhere in the federal government to provide mezzanine financing. Then how could we do this
and why mezzanine financing? Right, So, if you want to build a new apartment building, or you want to build a house, if you put up forty percent, you as the builder or developer, put up forty percent of the construction cost. You can get a loan for sixty percent of the construction costs from a bank, so your equity is levered one and a half to one sixty forty.
If the government were to provide twenty percent of the construction cost and a mezzanine financing, so you could still get sixty percent senior debt because the mezzanine would be expressly subordinated. It's the equivalent of equity from a senior lenders born in view. But now the equity holder, the developer, only has to put up twenty percent. It's like a conventional mortgage. Right, you put twenty percent down, you get
an eighty percent loan. So here the government could actually expand financing for new construction and thereby lever the equity of the developer for to one rather than traditionally one and a half to one, and if the government were to pass on its own relatively cheap borrowing costs as opposed to what the market would charge for mezzanine financing, the developers and we've done this math, could build affordable housing, you know what qualifies as affordable housing and still earn
the same kinds of return on equity that they earn from market rate housing. So it would create a massive incentive to build new supply for where it's really needed.
Let's hear the math both in terms of why affordable housing be comes more profitable under this, and then also the math of like how many units we're talking about potentially this could unlock.
Yeah, so this is you know, private equity guys who listen to you will understand. Gals will understand this. Right, So if you're levering your equity four times, yeah, you can effectively earn the same rate of return building lower priced units.
It makes sense.
I mean, the math is pretty straightforward. And I tested this out with a variety of multifamily developers directly and just said, hey, you know, if the government had a mezzanine financing program, could you build to eighty percent ami average median income? What's affordable in government parlance, is someone earning eighty percent of area median income if their rent cost is only thirty percent or less of that, right, AMI,
that's affordable. And so we tested this with a series of the large multi family developers, and you know that they're if they could lever their equity four to one with cheap mezzanine financing, they could build to those metrics. I want to give you some more numbers, system.
No, I love it. We're here for numbers.
Yeah, yeah, just to impress upon you how small. The federal government's role in housing other than through the mortgage markets is HUD, the Housing and Urban Development Agency, which was created in nineteen seventy four to deal with urban renewal because the inner cities were falling down in the nineteen sixties. It's total budget today for new housing, for playgrounds, for urban renewal. Its total budgets is about four billion dollars.
The military budget, just by contrast, is eight hundred billion dollars. So we're investing eight hundred billion dollars in our national defense and four billion dollars in housing an urban renewal. And now we are also have the tax credit program, and the tax credit program is responsible for building about one hundred and ten thousand new units a year, which
is big. But if we have a five million unit shortfall, if that alone is not going to fill that shortfall, to take you fifty years to fill that shortfall at that level of subsidy, a mezzanine financing program put aside for the moment where we would do that. Who could do it? A mezzanine financing program, which would be basically a revolving loan program, right, because we're talking about construction finance, that would be taken out the way construction is done. Right,
get you finance the construction. As soon as the construction's done, the buildings leased up, you get takeout financing because you now have a stable set of cash flows from rent payments coming in on the property. And therefore a different set of lenders will give you longer term financing, including Fanny and Freddy who do take out financing for new construction.
So if there were a mezzanine lending program at the federal level, generally it's three to five years from permitting to completion on a new apartment development of any size, so that mezzanine loan would get taken out and could go right back and do it again. It'd be a revolving loan program. So it's a it's not a one off, it's not a one off, and it's also not a
continuing hit to the federal budget. So from a deficit point of view, this is a one time capitalization and you've done, and now you have a program, depending on its size, that can make a major impact on new
supply of new housing. So just to size it, if there were one hundred billion dollars of mezzanine lending authority, and so twenty billion dollars a year, because it takes five years from permitting to construction, so we'd put out twenty billion a year in effect in a revolving So in year six you get the year one loan paid back. You put it back to work in year six, so twenty billion a year, and that twenty billion is twenty
percent of the total construction cost. So you're now facilitating or turbot charging one hundred billion dollars of new construction a year. One hundred billion dollars of new construction a year would get you two hundred and fifty to four hundred thousand new units a year, which means that one to five million dollar housing shortfall unit shortfall could be filled over the five year period.
So just on this point, I'm sold. Okay, wait, I'm going to ask all the Devil's advocate questions then, So I understand the role of leverage in this. However, given the history of two thousand and eight, I think people here leverage in the housing market and maybe start to get a little bit nervous. How risky are those construction loans because I assume, you know, in twenty twenty three, I think there was a drop of like forty percent
in construction financing. I assume there's a reason for that, and it's either, you know, banks being reticent to extend this type of credit, or maybe they're constrained by higher capital charges around this particular issue, or maybe it's simply that with the interest rate uncertainty, the numbers don't pencil out, and so it's not that the loans themselves are inherently risky. It's the idea that the US government could effectively hold
them through the cycle of interest rates. But can you talk a little bit more about what risk the US government would be taking on its balance sheet if we were to do this.
Yeah. So the way I look at this is, if the standards that Fanny and Freddy now operate under for their mortgage purchases, right, they buy mortgages from banks, Those mortgages have to meet certain basic criteria both in terms of the DTIs of the borrower, the debt service to total income of the borrower that the mortgage represents, and
the loan to value. So Fanny and Freddy can't buy a mortgage that has a loan to value higher than eighty percent, Right, So you've got to put as a new home buyer, you got to put twenty percent down in order to get a mortgage that ultimately ends up on Fanny and Freddy's books. Now there's some exceptions to that, but ninety five percent of the mortgage credit that's on their books is on that basis of twenty percent equity
eighty percent down. Their history over their lives on those kinds of mortgages, in terms of credit, losses are negligible. Obviously in the cycle, you know, in a massive downturn like we had in two thousand and eight, you're going to have you know, a higher rate of delinquency and default.
But no, I think even in two thousand and eight, multifamily.
Yeah, the multi family books was fine, was fine. So generally, as long as we have a growing population, you're going to have increased demand for housing, right, I mean, if the population started to strengthen, the holder of a construction loan on the other end of that five year construction period might face a market that's very soft. But we
have a growing population. Even though you know, we're only adding half a million people a year by way of birth, We're you know, adding a couple of million people a year by way of immigration, legal and illegal. But nonetheless we have a growing population, and therefore you could expect the housing market it'll have ups and downs based on you know, interest rates and the like. And location. Location,
location is important for housing always. But I think with twenty percent equity underneath the government, the risk of you know, a mezzanine lending program are very manageable.
Why don't banks do more construction loans?
They do, but they do it only up to sixty percent. There is a mezzanine market, but the mezzanine market is expensive and liquidity constrained. And get another five percent of your construction costs, but that's going to cost you twelve to eighteen percent, and that's eating into the equity holder's rates of return.
So we already know that there are all kinds of legal fights going on with the Fanny and Freddy already, and you're sort of introducing a new market for them or your idea that has never existed. So there are sort of two things. One, you mentioned that in residential mortgages, you know, they don't go out and extend alone. They buy a loan from a bank. Yeah, and so it
sounds like that in this case. So a they're entering a new space, or they would be entering a new space mezzanine lending for multifamily, and it sounds like there would be a direct interface.
No, they're charters, those federal charters that created the implied guarantee. Those federal charters prohibit them from so they would be entering. Okay, so it have to be a secondary market, got it right. But if I'm JP Morgan, Yeah, and I know I can dump this mezzanine loan that I wrote to Fanny May as long as it meets Fanny May's criteria. I can sell it immediately to Fanny may delf Spread Dell write that loan.
I have to imagine there are other legal questions, and you mentioned your lawyer, but you know you can always get multiple opinions from multiple lawyers. So when you are talking about these ideas, are there any concerns about is this actually allowed?
Yeah, so let's talk about the necessary steps. Okay, Right today, they don't do construction lending, so the capital rule that was developed for them during conservatorship does not address what the capital charge for a construction loan would be, particularly a mezzanine construction loan, So that would have to be
developed and promulgated and passed by the regulator. It'll take a little time, but it's not rocket science because banks do construction lending, and there's a bank capital rule for construction lending that the regulator for Fanny and Freddy could borrow from and use as a model and a precedent, but nonetheless a capital rule would have to be created. I think there's very little question whether Fanny could create a secondary market and construction loans, because in fact, they
did some of that back in the nineteen eighties. So there's actual precedent for them in construction loans. In the case of Freddie, there's probably a better argument that you know, a more conservative lawyer than me who's really being an advocate on this, might say that Freddie might be constrained and doing construction lending on a secondary market basis. But the truth is that, you know, the Congress of the United States recognizes it broadly. There's bipartisan recognition that we
got a housing supply problem in the United States. So even if you don't use Fanny and Freddie's vehicles, you know, the hardest thing in America to do today is get a piece of legislation pass. So I'm not you know of some wild eyed optimist about the ability to create
a new federal financing bank to do this. But the problem on housing is so great, and it's so widespread across red states and blue states and purple states alike, rural communities and cities alike, that I actually think if you went to the Congress and said, hey, guys, let's start small and see if it works. Let's start fifty billion and against a seven trillion dollar budget, could they not find fifty billion dollars to augment housing supply in America. I think they're probably could I think.
You possibly anticipated my next question with the wild eyed optimist comment just then, But why do we have to make it so complicated? So there are restrictions on the gsees doing direct flending into the mortgage market, but what they're effectively doing is using their balance sheet and their credit rating, and their association with the US government and their subsequent cheap capital costs to subsidize these mortgages effectively. So why not just go whole and have them extend the finance.
Tracy, I'm with you. I'll bring you to the next meeting down with Dacy.
It's just politically infeasible.
No, no, it's not. I think it's well. First of all, this idea is getting traction at the state level, right the number of the state housing finance agencies are starting to do this, recognizing the constraints on developers.
We did an episode about the Montgomery County.
Exactly, and the Massachusetts Housing Finance Agency is now gotten authority from the Massachusetts legislature to do some of this lending as well. So this is catching on. I mean, people, this isn't you know, I didn't invent this. There are a variety of people who have thought this mezzany lending by state or federal agencies could help lever developer equity and augment the supply or turbertize the supply of new housing. But I think even at the federal level this is
getting some interest. The problem is we're an election season, right, and try as we might get new initiatives passed by an existing administration. You know, they're a little diverted on getting re elected.
Hey, have all this stuff going on. So, just to be clear than on this, right, there are theoretically multiple ways that the US government could use its borrowing authority or its lending capacity to facilitate this. It doesn't necessarily have to be through Fanny and Freddy. But if it were through Fanny and Freddy, would that require legislation or who so, why don't you walk us through that component?
Yeah?
So would have to make a decision, And how would they go about making the decision where these existing banks, under their existing rules now enter a new market.
Yeah? So in conservatorship, Yeah, Fanny and Freddy are effectively there's joint control over them by their conservator, the Federal Housing Finance Agency for the person of the executive director of that agency and by the Treasury Department, because the Treasury Department has one hundred and ninety two billion dollars into them and a senior preferred stock that has a series of covenants. So both the Treasury Department and the
FHFA would have to authorize this. The FHFA would have to create a capital rule for construction lending, and the Treasury Department would have to consent to the use of their borrowing capacity, their ability to create a portfolio of loans. Would have to consent to them building a portfolio of mezzanine construction loans. But the Congress has nothing to say. I mean, they could intervene if they thought this was a stupid idea or they wanted to do it separately
away from Fanny and Freddy. But as I said, but they are not necessary, they are not for this. Yeah, So this is so. When HERA was passed in two thousand and eight, it created authority to create the conservatorships and end the conservatorships. You know, the purpose of the conservator ships was to restore the safety and soundness of the entities, and the safety and soundness of these entities has been restored. They need more capital to meet the
needs of their capital rule. But they could raise that capital as they were doing now by retaining their earnings which are substantial, and building more capital. They could raise that capital by accessing the public markets and doing reipos if they were released from conservatorship. Congress is an unnecessary party.
The Congress has already authorized the release from conservatorship, subject to meeting the standards that Congress laid out in two thousand and eight, and with regard to the creation of a new product, which is what this would be for the two entities to create a secondary market in mezzanine lending. That doesn't require Congress. That requires the authorization of the Treasury Department to permit their portfolio to be used for this purpose, and the FHFA as conservator and as regulator.
So this is something that could be done by so called administrative action.
We don't know who's going to win in November, and you mentioned that when Trump was the president, before Minuchin had started to make some steps, including ending the SWEEP to recapitalize it and essentially make it a properly for profit entity. Again, if that were to happen at some point under a theoretical second Trump administration, would that preclude this avenue or there would be no constraint this under a different Yeah, it doesn't have to be under conservatorship for this to happen.
This could be done under conservatorship by administrative action and the cooperation between Treasuring and the FHIFA. It could also be done post conservatorship. If the capital rule permits it, the regulator then not the conservator were to permit it, okay. And you know, it seems based on what I've heard about what the second Trump administration would do, I think ending the Conservative ships is something that a new Trump
administration would pursue. Trump actually submitted after in one of the litigations, he submitted an affidavit saying I would have done this had I, you know, not run out of time. And you know, the Biden administration, We've had sixteen years of conservatorships, twelve of them have been under democratic administrations. The Democrats haven't shown a real appetite to end the conservatorships.
That seems to me the policy crowd around the Democrats seem to, you know, like having these as direct instruments of policy and under the thumb of the Executive Director
and the Treasury Department. But I think even the group of policy advisors around the Democrats and the housing finance policy complex, I think even they're coming to recognize that a permanent conservatorship, which is kind of a limbo state, is really not ideal, and that I think there's a growing momentum to figure out how to end the conservatorships and that these companies recapitalize and have, you know, more normal corporate governance and a more normal relationship as a
regulated entity with a regulator, a regulator who's not also the effectively the owner.
If someone from the administration were to tap you on the shoulder again and say, hey, do you want to sort out the conservatorship issues and maybe implement a secondary market for construction loans, would you be interested?
You know, I didn't think I was coming here to advertise. Yeah, no, I've been, like, I've been thinking about this for a long time and working on it in various different guys. Is so I know a little bit about it? Yeah, yeah, I love a little bit. And you know, I do think that one of the major problems the country faces in terms of the stability of our civil society is providing adequate housing for our citizens, and I think it's
really one of the great sources of tension. It's one of the great sources of inflation, which is one of the great sources of tension and in our economy. And so you know, using these things that successfully reformed as instruments to address this fundamental need would be something that should be done. And whether I do it or you know, they take the work I've done and somebody else does it, it should be done.
Jim Milston, fantastic conversation, learned so much, so much fun. That was so much fun, fantastic. Hopefully it sounds like, you know, I have no opinions, but it sounds like a very promising idea. Maybe someone listening to this will pick up the ball in some ways. Thank you so much for coming out, Thanks for having me.
I really appreciate it. Yeah, that was fantastic, great.
Tracy. That was amazing. So, like we'll talk about the housing element, but just like the history and the number of like light bulb moments in that conversation, lingering things that I didn't really understand where the source of that implicit guarantee for Fanny and Freddy came from the arrangements of you know, I sort of got the preferred stock a bit, but that was just that was fantastic.
I had forgotten the juicing earnings, like using your cheap funding to buy alt A in Yeah, pre two thousand and eight, I totally forgotten about that.
The other thing that I.
Was thinking, just hearing the war stories of the financial crisis was how much letting Lehman Brothers go really did crush financial markets? Oh, in many ways, like so much so that a few days or even weeks later, like the conversations about whether or not to bail out other things seemed to have like it was just, yeah, let's do what we can because we let this one entity
go and it's caused so many problems. Yeah, that seems like an obvious statement to say in hindsight, but I remember in two thousand and eight, two thousand and nine, there was a vibrant and heated discussion about, you know, whether letting Leman fail was the right thing to do.
I know, no, it's incredible, And then you think about, like, you know, what if, like you know, just the sheer scale of AIG's role in this, and you like understand why like they felt that they had to, you know, inject one hundred billion dollars because of just the sheer number of financial instruments all over the world. Some of the US, a lot in Europe would have like gone belly up without that.
Yeah. The other thing I was thinking about again sort of big picture realization, but how much of us, like social programs, I guess for lack of a better word, are wrapped up in like tax credits. Yeah, I know, incentives versus direct fund So we.
Got to do more, you know, one episode that we should do and it's kind of in the context of the Inflation Reduction Act, but that market I'm aware for tax credits because if you don't if you let's say you have some tax credit, but if you don't pay taxes because of your money losing entity, which many again this is in the irate context. Many of them are because their startups so they don't get any value out of that, or they're sort of new companies, you know,
making batteries. But with this secondary market that's emerged for tax credit so that they can sell and Jim talked about this a little bit, that you could sell that text credit to someone who does want to reduce their bill, Like that market is booming, and so we should do an episode on that.
Yeah, I would be totally up for that, but we have to have Jim back On's to talk more totally well the Treasury experience and all of that.
Yeah, he would be a good one for a live episode. So, like there's something like about you know, the history of whatever, So we should keep that in mind. Idea on the topic at hand. You know, it certainly seems there are many constraints to housing. Clearly, finance is clearly a big one.
And if you're able to really expand that market, and it's pretty clear it makes sense that if you have the backstopping authority that then the commercial banks like a JP Morgan would be more than happy to step into that market and flip it for a small premium to
Fanyer or Freddy. But it does seem as though if you could solve that problem, like there is serious numbers, a few hundred thousand extra units per year in the math, and it sounded like it made sense to me you might actually be able to put a dent in this stuff.
I mean, here's one thing I will say, we do so many episodes here on all thoughts where we identify a problem and we ask what the solution is, and we effectively get no solution, no solution, or just crickets. It was very nice to talk about a problem that we have discussed previously on the show, the lack of housing, and actually be able to talk about a potential solution.
Yeah, and so two things on that that I had thoughts about. So one is it's very powerful that we have the vehicles already to do this in theory and
imagined that different lawyers might have different opinions. But like, at least in theory, you know, there's a lot of stuff that we could do with legislation, but nothing it's so hard to get anything passed, right, So if you have a way of doing something within an existing financing vehicle, then that automatically, you know, among pie and the sky dreams like that makes it a little less pie in
the sky. But it's also interesting to me just politically that there is so much public anxiety about the cost of housing and the housing shortage and all this stuff, and people feel very stressed about their ability to come up with a down payment or how much. And yet like at the national political level, like it never really comes up.
Yeah, and it's just crazy concrete proposals. You certainly don't hear Fanny or Freddy mentioned on like the debate stage.
No, not ever, right, or you don't hear any like I'm not going to say that Joe Biden or Trump have no policies because I'm sure I know, like you know, in Biden's budget there's something like I know, but it is not something that given the amount of public anxiety there is about the cost of housing relative to the amount that politicians talk about ideas to solve the cost of housing, it's like there's incredible disconnect to me.
Well, also to Jim's point early on, this is one of the few areas where there's seems to be some bipartisan agreement, at least in the sense of identifying the problem that housing is expensive, there is a structural shortage, and maybe we should do something about that. Well, shall we leave it there?
Let's leave it there.
This has been another episode of the Odd Lots podcast. I'm Tracy Alloway. You can follow me at Tracy.
Alloway and I'm Joe Wisenthal. You can follow me at The Stalwart. Follow our producers Carmen Rodriguez at Carman Ermann Dashel Bennett at Dashbot and Kelbrooks at Kelbrooks. Thank you to our producer, Moses onm. For more Oddlots content, go to Bloomberg dot com slash odd Lots, where we have transcripts, a blog, and a newsletter. And if you want to talk about these topics more with fellow listeners, you should check out our discord. We have a real estate channel
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