Odd Lots - A Guggenheim Executive's Radical Plan to Build Millions of New Homes

Episode Date: July 18, 2024

According to numerous estimates, the US is massively short of housing. Zillow, for instance, says America needs to build 4.5 million new homes to climb out of this deficit. But right now we're not coming anywhere near to closing that gap. And in fact, the efforts by the Federal Reserve to tame inflation have likely made things worse, with higher interest rates slowing the construction of multi-family dwellings. So is there a way to create more homes, even in a time of high rates? In this episode, we speak with Jim Millstein, co-chair of Guggenheim Securities and a former Treasury Department official who managed the restructuring of AIG after the 2008 financial crisis. Millstein has drawn up a plan whereby Fannie Mae and Freddy Mac can enter the market for construction finance and re-start it. He walks us through how — with their existing legal authority — these two entities could make hundreds of thousands of new affordable homes come to the market each year.See omnystudio.com/listener for privacy information.

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Hello and welcome to another episode of the Odd Lots podcast. I'm Joe Wisenthall. And I'm Tracy Allaway. So Tracy, something that we've touched on a few times is the 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 rates,

you constrain supply of housing in particular, which is 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 there does seem to be, according to many economists, the sort of deep structural housing shortage in the effort to fight inflation constrains that. So the question is, like, is there some solution here? 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 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 developer 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 multi-faceted 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 guess to talk about this very multifaceted and nuanced issue of how do you build more

multifamily in the U.S. 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 2009 through 2011, So he 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 Fannie and Freddie 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. What do you give us the sort of, you went to Treasury, and Tim Geithner called you up and said, come help us fix this gigantic mess that we have. What 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 at that point, right?

It started, really. The seeds were planted in 2007 and 6 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 then. Wait, can I just ask? I always wondered this, but like, how does the ask? What form does the ask actually cover? Did you 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 moneline insurance? Yeah. I mean, basically, 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 TARP program had put $130 billion 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 AA, AA, as a substitute for cash collateral.

on those trades. And when the rating agencies, in their infinite wisdom, downgraded AIG credit rating from AA 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 $100 billion. And all of that went right into AIGFB to cash collateralize their trade. So they didn't default on Goldman Sachs 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. Because insurance is like 50 state regulators, right? Exactly. 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 saddled with AIG? So he called into his office the team and said, somebody's got to take charge of AIG and basically everybody else in the room took a giant step back. That left me. Faded into the hedge, Simpson style. Oh, thank you, Jim, for volunteering.

So I spent a ton of time up at Wilton, which is where AIGFP was located talking to the guys who ran the 22 desks, which were 22 different trades that they had put on. And I got to tell you, I think of myself as a real. I was, you know, worked as a lawyer for 18 years, and then as a banker for 10 years before this. And I, you know, thinking 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. Yeah. And to whom they owed their insurance and the impacts then, we call the interconnectiveness and potential contagion effects of their failing to make good on their insurance.

I realize 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? How did you detangle it? They were reasonably sophisticated in terms of their digitization of their records.

But the truth 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, $600 billion 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 tranche in their loan books, and AIG would write credit insurance, credit default protection against the senior tranche,

and thereby transform a book that would otherwise have had a credit rating of overall, on average, double B, and turn the senior tranche 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's 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. We'll have our producers add in a little sound of effect. So on September 8th, Secretary Paulson and the newly created regulator over Fannie and Freddie, the FHFA, the Federal Housing Finance Authority, which had succeeded something called the FEO, which had done a miserable job of regulating Fannie and Freddie, put Fannie and Freddie into conservatorship on September 8th, 2008. Okay. On September 15th, AIG's credit rating was downgraders. and as a result, the massive cash collateral call was required on their derivatives book,

cash they didn't have. And on September 15th at midnight, Lehman Brothers filed for Chapter 11, creating really the beginning of the widespread panic in all financial markets because of the size of Lehman Brothers' 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 crater the financial markets and accelerate the panic that occurred with Lehman. And so the New York Fed wrote the largest loan in recorded human history. in favor of AIG, $75 billion was extended to AIG in order to make sure that it did not fail right then and there.

Wow. Imagine the junior lawyer who's tasked with like getting that loan signed by both parties. Yeah. 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 brokerage. dealer loan. They did collateralized lending to AIG in order to give it incremental liquidity. In October, the TARP legislation was finally passed, and that gave the Treasury Department

$750 billion 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 of 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 $135 billion that I talked about, the Fed being into AIG for under their emergency lending authority, under Section 133, There was a first recapitalization of that $135 billion done in November and December of 2008 after TARP passed, where $50 billion of TARP money was brought in to refinance out $50 billion of the Fed's lending to AIG.

So at that point, the Fed was into AIG for, call it $75 billion of senior secured loan at the parent level. and the Treasury Department own $50 billion worth of preferred stock at the parent level. I'm Francine Lacquhar, an award-winning journalist, and I've got a new podcast, leaders with Francine Lacquois from Bloomberg Podcasts. I've interviewed everyone from Heads of State to fashion icons about the news of the moment. But I've always been curious, who are these people as leaders? I don't think there's one right way to be a leader. Make decisions. A poor decision is always better than no decision.

listen to new episodes every other Monday. Follow leaders with Francine Lacquois wherever you get your podcasts. I love talking about this stuff because, you know, this is like where we started 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 10-year chart, it looks like a normal thing, you know, like a normal stock price.

Yeah. Because it still trades, but like on a split adjusted basis, so it's like a $76 stock right now. but because of the just gigantic dilution and the split-jointed, it was like a $1,400 stock equivalent back then. So it was saved, but the equity was truly eviscerated. Yeah, so I'll just take you to the end of that story. In order to pay back the Fed and pay back the Treasury, we had to downsize and de-risk the company.

So we did a series of asset sales over 18 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... You really founded in China, right? Well, they were 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 could pay off the Fed loan. And that left the Treasury preferred stock in place. And we then had to do a complete recapitalization. And as you noted, we converted the preferred into 92% of the fully diluted common equity, diluting the existing common down from 100% ownership to 8%.

And over the next two years in 2012, 2013, the Treasury Department sold off that 92% 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 $22 billion on its $150 billion investment in the AIG. So AIG was just one of, there were many troubled incidents. that floated to the surface at that time, all of their troubles. AIG was a huge one, and there were those ones that went bankrupt. And then there was also Fannie and Freddie, which still exist and would still also have some sort of weird equity that I don't understand.

And there was, for the last 15 or so years, there's always talk about reform and, you know, there's all these lawsuits and stuff like that. So Geithner asked you to try to figure out something with Fannie. What happened with that after? So AIG, you cleaned it up and. solved that problem, I guess. Yeah, and by, you know, the time we got the AIG recapitalization agreed and consummated in January of 2011, 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 Fannie and Freddie? 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 thornyest American 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 25 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 2011, between Fannie and Freddie, the Treasury Department, had purchased $192 billion worth of preferred stock in the two of them. Sort of 120 in Fannie and 70 and Freddie. 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 with the purchase of 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, Fannie and Freddie, 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 Mae and Freddie Mac, their guarantees were the same as a government guarantee. Yeah, so, yeah, we'll step back even further. So Fannie and Fred. We're doing this episode in reverse. We're getting further and further back away from the topic, but this is helpful.

Yeah. So Fannie and Freddie are so-called government chartered. They have charters that derive from the Congress of the United States financial institutions, unlike J.P. 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. Fannie and Freddie were chartered by the federal government. Fannie 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 1930s. 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 years duration back in the 1930s. And once purchased by Fannie, the way they worked out those troubled loans was to extend the maturities out first 10, then eventually 15 years in order to give the borrowers time to get through the Depression and actually get current on their loans.

So Fannie was then privatized. It was government-owned corporation throughout the 30s, 40s, 50s, 60s. And as the United States entered the Great Society programs and the Vietnam War and the deficit started to blow out with Fannie 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 1968. So its debts were no longer consolidated with the debts of the United States, federal government. and then Freddie was formed in 1970 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, Fannie Mae. So you had now two entities in effect buying mortgages, creating a secondary market for mortgage credit that banks originated. So J.P. Morgan would originate a loan as long as it met Fannie or Fred's. Freddie's criteria, that the loan was at least had 20% equity, that it didn't exceed a certain principal amount. JPM could sell it to Fannie or Freddie. So they were secondary market purchasers. And ultimately in the 1980s, when the securitization market was first developed, and I was actually

a lawyer at a law firm that pioneered the securitization market at that time, there were 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 1980s. And Fannie and Freddie, as the owner of large amounts of mortgages, thereby could create liquidity for themselves by selling mortgage securities, mortgage-backed securities, MBS, and actually our 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 Fannie and Freddie, that they guaranteed principal and interest payments. The prompt payment of principal and interest on those bonds. Okay. And there was a debate pre-2008 about whether or not that guarantee was, like, effectively the same as the U.S. government guaranteeing those bonds. So how did the market infer that it was as good as treasuries that the bonds guaranteed by Fannie 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 chartered. So in a sense, they were children of the federal government, even though they were privatized and owned by 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 of the financial crisis, Fannie had probably $3 trillion of outstanding mortgage security guarantees. And Freddie, probably $2 trillion of outstanding. So each of them could borrow for their liquidity needs $2.5 billion 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 to $2.5 billion 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 that it actually has some sort of real thing. So we're now in 2008. In the summer of 2008, the Congress of the United States passed the Housing and Economic Recovery Act of 2008, which was basically a complete redo of the regulatory arrangements around Fannie and Freddie. 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 Fannie and Freddie into receivership or into conservatorship, receivership being a liquidation proceeding, conservatorship being a conservatorship to conserve its operations and assets. And the Treasury Department under Hera, the Housing and Economic Recovery Act of 2008, was given authority to purchase preferred stock in order to ensure the solvency of Fannie and Freddie. So the implication became real, or the, that was the moment that it was no longer ambiguous. Exactly. And, 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. In September 8th of 2008, the conservatorships were created. And very quickly, by the first quarter of 2009, the preferred stock authority the Treasury had was deployed. and the first big draws on that. And ultimately, by the end of 2010, $192 billion of preferred stock had been put into the two entities. Now, the markets recovered, right? In 2011, the equity market took off in May of 2009, after the stress tests were announced.

And the interbank market sort of recovered by the end of 2009. 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. No, that market is almost completely dead. I have to say my expertise in housing finance ends in 2015 when I left FTE and I came to Bloomberg. However, as far as I can tell, not much has changed since 2015. So the GSEs 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 macro 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 $50 trillion. If you took the aggregate value of the housing stock,

the residential housing stock in the United States, it's about $50 trillion. That's the house value. There's $12 trillion of mortgage debt outstanding against that $50 trillion of house value. And of that $12 trillion, seven is on the balance sheet of Fannie and Freddie as guarantees of mortgage-backed securities. Those are mortgages. Seven trillion of that 12 has been securitized by Fannie Mae and Freddie Mac and guaranteed by them. Another $2 trillion is on the balance sheet of another government-sponsored entity called Ginnie Mae, which is controlled by the federal government.

And it securitizes FHA and Veterans Authority administration loans. So there's about $2 trillion there. So when you add it up, of the $12 trillion of mortgage credit risk that is out there against the housing stock of the United States, $9 trillion is on Fannie Mae, Freddie Mac and Ginny May's balance sheets. So the government basically is the biggest player in the mortgage finance markets. None of these entities originate mortgages. That's all done by non-banks and banks. But most of the mortgage credit risk resides on the balance sheets of one of these three entities. You can get the news whenever you want it with Bloomberg News Now.

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And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast. podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts. We're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify, or anywhere you listen. So we have to get to the present tense, although, again, we 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 Fannie and Freddie, because there is this 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 16-year conservatorship.

One of the biggest problems that they faced in 2008 was that they had become a huge buyer. Not only do, 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. I'm getting flashbacks. Right, exactly.

So they bought a lot of all day, and 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 2004, five, six, and seven as the subprime securitization market was taking market share away from the prime or conventional securitization market that they ran. Yeah. So during the course of the market. the conservatorships, 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, 150 billion, you know, or 200 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 FHFA, and they are slowly through retained earnings, recapitalizing and building capital. So today, Fannie Mae has $80 billion of capital on its balance sheet, and Freddie probably has $50 billion, but they're still, from a regulatory capital point of view, undercapitalized. They need more capital.

based on the capital rule that was created to govern them during the conservatorship. So how did they even get to the point where they could, and conservatorship, have that much capital as they have today? In 2012, 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 $192 billion worth of preferred stock, it became a so-called profit sweep. So whatever profits they made went to the Treasury Department. And by 2019, seven years later, after the profit sweep was instituted and over which there's much litigation pending by existing shareholders, then existing shareholders. By 2019, when the profit sweep was suspended, the governor of the United States received $302 billion worth of dividends. So they made $192 billion investment.

The Treasury Department's already received $302 billion back. So they've made more than $100 billion. They've way out done my AIG profits. But it was suspended. So the Secretary Mnuchin, 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.

Fannie makes, you know, on average over the last four or five years, is 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 $15 billion a year. And Freddie's making about $8 or $9 billion a year. Fannie, the equity is worth $8 billion 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 does the Treasury Department own? It owns $192 billion, it's actually more because of the way it accretes, but they own $192 billion for their $192 billion of investment of senior preferred stock. Okay. Under that is about $32 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 conservatorship, like the profit sweep. And under that is the common stock, but the common stock that trades only represents 20% of the fully diluted 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 79% of the stock of each entity. Okay. And this is very similar actually to the way AIG was set up. The TARP money went in as senior preferred, but we also had a warrant. warrant entitled the Treasury Department to 79% of the stock. So today, the stock that trades really represents only 20% of the total capitalization. Got it. Got it. But still, the equity account is

teeny. Because why is it teeny? Because you have that huge senior preferred stock. Yeah. 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 U.S. So we are already in a situation where, as you mentioned, nine of the 12 trillion, I think it was, of mortgages outstanding in the U.S., 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 the Fed's interest rate hiking, the

construction finances 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 multifamily constructions post-pandemic. Yeah. 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, 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-pendemic period. There's been a huge surge in house prices and a huge surge in 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 the 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 FHA, 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 bureaucratic 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 patience 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 25 to 50 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, sell the tax credits to somebody who needs them and offload about 20 to 50% 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. And how could we do this?

And why mezzanine financing? Yeah. Right. So if you want to build a new apartment building or you want to build a house, if you put up 40% You is the builder or developer put up 40% of the construction cost. You can get a loan for 60% of the construction cost from a bank. So your equity is levered 1 1 1, 6040. If the government were to provide 20% of the construction cost in a mezzanine financing,

so you could still get 60% senior debt because the mezzanine would be expressly subordinated. It's the equivalent of equity from a senior lender's point of view. But now the equity holder, the developer, only has to put up 20%. It's like a conventional mortgage, right? You put 20% down, you get an 80% loan. So here, the government could actually expand financing for new construction and thereby lever the equity of the developer four 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 becomes 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.

Okay, good. And gals will understand this, right? So if you're levering your equity four times, you can effectively earn the same rate of return, building lower priced units. That 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 80% AMI average median income? What's affordable in government parlance is someone earning 80% of area median income.

if their rent cost is only 30% or less of that E. That 80% of ARI. Right. AMI. That's affordable. And so we tested this with a series of the large multifamily developers. And, you know, 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.

No, I love it. We're here for numbers. Yeah, yeah, yeah. Yeah, just to impress upon you just 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 1974 to deal with urban renewal because the inner cities were falling down in the 1960s. It's total budget today for new housing for playgrounds for urban renewal. Its total budget is about $4 billion. The military budget, just by contrast, is $800 billion. So we're investing $800 billion in our national defense and $4 billion in housing and urban renewal.

Now we also have the tax credit program, and the tax credit program is responsible for building about $110,000 new units a year, which is big. but if we have a 5 million unit shortfall, if that alone is not going to fill that shortfall, it'll take, you know, 50 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? You 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 Fannie and Freddie, who do takeout 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 would be a revolving loan program. So 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 could make a major impact on new supply of new housing. So just to size it, if there were $100 billion of mezzanine lending authority, and so $20 billion a year, because it takes five years from permitting to construction, so we'd put out $20 billion a year in effect in a revolving fund. So in year six, you get the year one loan paid back, you put it back to work in year six.

So 20 billion a year, and that 20 billion is 20% of the total construction cost. So you're now facilitating or turbocharging $100 billion of new construction a year. A hundred billion dollars of new construction a year would get you 250 to 400,000 new units a year, which would 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 2008, I think people hear 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 2023, I think there was a drop of. like 40% 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 U.S. government could effectively hold them through the cycle of interest rates. but can you talk a little bit more about what risk the U.S. government will 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 Fannie and Freddie 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 Fannie and Freddie can't buy a mortgage that has a loan to value higher than 80%, right? So you've got to put as a new home buyer, you've got to put 20% down in order to get a mortgage that ultimately ends up on Fannie and

Freddie's books. Now, there's some exceptions to that, but 95% of the mortgage credit that's on their books is on that basis of 20% equity, 80% down. There, 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 2008, you're going to have, you know, a higher rate of delinquency in default. Although I think even in 2008, multifamily. Yeah, the multi-family books was fine, right? It was fine.

Yeah. 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 shrink, then 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 20% equity underneath the government, the risk of, you know, a mezzanine lending program are very manageable. Why don't banks do more construction loans, though? They do, but they do it only up to 60%. There is a mezzanine market, but the mezzanine market is expensive. and liquidity constrained. You can get another 5% of your construction cost, but that's going to cost you 12 to 18%. And that's eating into the equity holders rates of return.

So we already know that there are all kinds of legal fights going on with the Fannie and Freddie 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 a loan. 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. Okay. They're charters, those federal charters that created the implied guarantee. Those federal charters prohibit them from entering. So they would have to be a secondary market. Got it. Right. But if I'm, if I'm JP Morp. Morgan. Yeah. And I know I can dump this mezzanine loan that I wrote to Fannie Mae. As long as it meets Fannie Mae's criteria, I can sell it immediately to Fannie Mae. They'll 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 Fannie and Freddie 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 Fannie could create a secondary market and construction loans because, in fact, they did some of that back in the 1980s. So there's actual precedent for them buying construction loans.

In the case of Freddie, it'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 in 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 is bipartisan recognition that we got a housing supply problem in the United States. So even if you don't use Fannie and Freddie as vehicles, you know, the hardest thing in America to do today is get a piece of legislation passed. So I'm not, you know, some wild-eyed optimist about the ability to create a new federal financial. financing banked 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 50 billion. And against a $7 trillion budget, could they not find $50 billion to augment housing supply in America? I think they probably could. 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 GSEs doing direct lending into the mortgage market, but what they're effectively doing is using their balance sheet and their credit rating and their association with the U.S. government and their subsequent cheap capital costs to subsidize these

mortgages effectively. So why not just go whole hog and have them extend the finance? Tracy, I'm with you. I'll bring you to the next meeting down to D.C. It's just politically infusible. 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 there's, 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, this is, you know, I didn't invent this. There are a variety of

people who have thought this mezzanine lending by state or federal agencies could help lever developer equity and augment the supply or turbiturizes the supply of new housing. But I think even at the federal level, this is getting some interest. The problem is we're in election season. and try as we might to get new initiatives passed by an existing administration. You know, they're a little diverted on getting reelected. Dave, all their stuff going on. So just to be clear then on this, right, there are theoretically multiple ways that the U.S. government could use its borrowing authority or its lending capacity to facilitate this.

It doesn't necessarily have to be through Fannie and Freddie. But if it were through Fannie and Freddie, would that require legislation? legislation or who, so why don't you walk us through that component? Yeah. Who 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, Fannie and Freddie 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 $192 billion 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 Fannie and Freddie. But as I said, you know, getting it. But they are not necessary to vote affirmatively for this. Yeah, so this is, so when Hera was passed in 2008, it created authority to create the conservatorships and end the conservatorships.

You know, the purpose of the conservatorships 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, you know, re-IPOs if they were released from conservatorship. Congress is an unnecessary party. Congress has already authorized the release from conservatorship subject to meeting the standards that Congress laid out in 2008.

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 conservative. servitor 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 Mnuchin 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 under a different, 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 Treasury and the FHFA. It could also be done post-conservatorship if the capital rule permits it. The regulator then, not the conservator, were to permit it. And, you know, it seems

based on what I've heard about what a second Trump administration would do, I think ending the conservatorship 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 16 years of conservatorships. 12 of them had been under Democratic administrations. The Democrats haven't shown a real appetite to end the conservatorships. It seems to me the policy crowd around the Democrats seem to, you know, like how. having these as direct instruments of policy and under the thumb of the executive director

in the Treasury Department. But I think even the group of policy advisors around the Democrats in 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 let 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. Yeah, that's interesting. 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 thinking about this for a long time and working on it in various different guises. So I know a little bit about it. Yeah, 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 in our economy. And so, you know, using these things that have been successfully reformed as instruments to address this fundamental need would be something that it 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 Milstein, fantastic conversation. Learned so much. 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 on a lot of life. Thanks for having, yeah. 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.

ball moment in that conversation, lingering things that I didn't really understand where the source of that implicit guarantee for Fannie and Freddie came from. The arrangements of, you know, I sort of got the preferred stock bit, but that was just, that was fantastic. I had forgotten the juicing earnings through, like, using your cheap funding to buy Alt A in pre-2008. 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 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 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 2008, 2009, there was a vibrant and heated discussion about, you know, whether letting Lehman 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 a hundred billion dollars because of just the sheer number of financial instruments all over the world. some of the U.S., 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 U.S. like, social programs, I guess, for lack of a better word, are wrapped up in, like,

tax credits and tax incentives versus direct funding? 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 you're a money losing entity, which many, again, this is in the IRA context, many of them are because they're 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 can sell that tax credit to someone who does want to reduce their bill. Like that market is booming. And so we should do an episode on that at some point. I would be totally up for that.

But we have to have Jim back on just to talk more about the treasury experience and all of that. Yeah, he would be a good one for like a live episode to like do something like about, you know, the history of whatever. So we should keep that in mind. Oh, that's a great 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 J.P. Morgan would be more than

happy to step into that market and flip it for a small premium to Fannie or Freddie. 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. And the math 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 have effectively get 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 I imagine 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 in 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 this crazy. You don't hear concrete proposals. You certainly don't hear Fannie or Freddie 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 this incredible disconnect to me. Well, also to Jim's point early on, this is one of the few areas where there 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, should we leave it there? Let's leave it there. This has been another episode of the All Thoughts podcast. I'm Tracy Alloway. You can follow me at Tracy Alloway. And I'm Jill Wisenthall. You can follow me at the stalwart. Follow our producers, Carmen Rodriguez, at Carmen Erman, Dashel Bennett at Dashbot, and Kelbrooks at Kel Brooks. Thank you to our producer, Moses, on Dom. For more Oddlots content, go to Bloomberg.com slash Oddlots, where we have transcripts, a blog, and a newsletter.

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