My previous post ended with a call to the other 18 essayists in the Urban Institute’s “Housing Finance Reform Incubator” series to “come back with their ideas on capital and pricing” for their proposed system of secondary mortgage market credit guarantees, with a focus not just on the amount of capital they would require but also on how that capital amount is determined, why they believe it is optimum, and how it would affect the availability and affordability of mortgages to a range of different borrower types. In this post I take my own advice and elaborate on the approach to capital I propose and my rationale for it.
As I said in my essay “Fixing What Works,” I believe credit guaranty companies should be required to hold sufficient capital to withstand a defined, worst-case stress scenario. My proposal was to have administration policymakers pick that scenario, but I recommended that they require guarantors to hold sufficient capital to survive a 25 percent nationwide decline in home prices over five years. I noted that while such a price decline did happen between 2006 and 2011, the two factors that fueled the bubble that preceded it—very risky mortgage types and lending practices now prohibited by the Consumer Financial Protection Bureau (CFPB), and an unregulated private-label financing mechanism that placed few limits on the risks of the mortgages it accepted—will not be present going forward, making the chance of a future 25 percent decline in home prices exceedingly small.
We can get an approximation of the amount of capital a credit guarantor would need to hold to survive such a scenario by drawing on what happened with Fannie Mae’s single-family credit guaranty business during the previous crisis. In the analysis below, I look at Fannie’s single-family business over its worst five consecutive years of financial results, using its actual credit losses, administrative expenses and guaranty fee income from 2008 through 2012 (after which the business returned comfortably to profitability). I ignore results from Fannie’s multifamily credit guaranty business and its business of managing interest rate risk on its mortgage portfolio, both of which were positive throughout the period we’re examining.
We’ll start with the raw numbers. At the end of 2007, Fannie held the credit risk on $2.55 trillion of single-family mortgages (about a quarter of which were in the company’s own portfolio, with the balance held by other investors), at an average guaranty fee rate of 26.5 basis points. On an economic basis Fannie’s single-family credit guaranty business barely broke even in 2008, and it lost significant amounts of money over the next four years. For 2008-2012, single-family credit losses totaled $75.7 billion, administrative expenses were $7.8 billion, and guaranty fees were $39.3 billion, resulting in a cumulative loss of $44.2 billion. To survive that, Fannie would have needed about 1.75 percent capital against its single-family book going into 2008 ($44.2 billion in losses divided by $2.55 trillion in outstanding credit guarantees).
Using the raw numbers from 2008-2012, however, does not give us the best approximation of the amount of capital a guarantor ought to be required to hold to survive a similar crisis in the future. For one thing, the 2008-2012 results include guaranty fee income (and credit losses) from business put on after 2007. A traditional “stress test” is done on a liquidating book, and does not assume any replacement or new business. The single-family credit guaranty book Fannie had at year-end 2007 paid off at 20.1 percent annual rate though December 2012, ending at $833 billion. The guaranty fee income from these loans during 2008-2012 was only $21.4 billion. Making this adjustment, along with a related reduction of $5.6 billion for credit losses on loans acquired after 2007 (Fannie publishes those data), the cumulative loss on the $2.55 trillion in single-family guarantees Fannie had going into the crisis rises to $56.5 billion, or about 2.25 percent of that book.
But there is one more important adjustment that needs to be made: at least one third and as much as three fifths of the single-family credit losses experienced by Fannie during 2008-2012 came from loan types and underwriting practices that no longer are permitted by the CFPB, and thus will not be present (and causing losses) in a future stress environment. Fannie publishes data on this, too. They show that 32% of its 2008-2012 credit losses came from Alt A (no- or reduced-documentation) loans and 28% came from interest-only adjustable-rate mortgages. These categories are not mutually exclusive, but they allow us to put a range on the amount of losses involved. If there were no overlap at all in the categories—that is, if no interest-only ARMs also had reduced or no documentation—then 60 percent of the $70.1 billion in losses from Fannie’s December 2007 book, or $42.1 billion, would have come from loans the company no longer accepts. At the other extreme, even if there were a total overlap between the categories, which we know there is not—not all interest-only ARMs also would have had no or reduced documentation—it still would be true that a minimum of 32 percent of the credit losses from Fannie’s December 2007 book, or $22.4 billion, would not have happened had those risk categories been prohibited back then.
So, where does that leave us on an experience-based estimate of the amount of capital Fannie (or another credit guarantor) would have to hold against its single-family credit guaranty business to survive a repeat of the 25 percent home price decline of the past crisis? Using actual 2008-2012 administrative expenses ($7.8 billion), guaranty fees only from loans on the books at December 31, 2007 and outstanding through the end of 2012 ($21.4 billion), and reducing that book’s $70.1 billion in credit losses by the smallest possible estimate—32 percent, or $22.4 billion—of high-risk loans the company no longer is permitted to acquire (resulting in adjusted credit losses of $47.7 billion), Fannie’s required stress capital on December 31, 2007 would have been $34.1 billion, or 1.34 percent of its $2.55 trillion book of business. Adjusting Fannie’s 2008-2012 credit losses to remove a more realistic 50 percent of losses on high-risk loan types and combinations would lower the stress capital requirement to 84 basis points.
In doing this analysis I do not mean to imply that one percent capital is the right amount for a reformed single-family mortgage credit guarantor (although it may be). FHFA would need to redo the exercise using detailed Fannie and Freddie data, and produce a capital requirement not just for the books of business the companies had at the end of 2007 but also for categories of risk by loan type. And it’s possible that policymakers may choose a stress scenario other a 25 percent drop in home prices as the basis for the credit guarantors’ capital requirement. But I do want to emphasize that credit guaranty capital requirements have to be based on something that can be objectively evaluated; they can’t just be made up. Capital requirements have too important an impact on which types of borrower can get a fixed-rate mortgage financed in the secondary market, and at what price.
One of the aspects of the essays submitted for the “Housing Finance Reform Incubator” series that struck me was how little attention was paid to the way the recommended or assumed capital requirements and structure of the proposed credit guaranty systems would affect the mortgage rates quoted to different classes of borrower. In most essays, the authors simply state that their proposed systems would be good for affordable housing because the guarantors will be given housing goals. Yet housing goals will have little effect if the guarantor has no practical way to turn them into business that can be financed on the ground.
In evaluating how efficiently a proposed credit guaranty system might work, Fannie’s pre-crisis configuration is a useful reference point. Fannie had a risk-based capital requirement for its single-family business, subject to a 45 basis point minimum. Everyone focused on the (very low) minimum figure, but in fact the binding constraint was the risk-based standard. That standard was based on work done in conjunction with former Federal Reserve Board Chairman Paul Volcker in 1989 and 1990; it required Fannie and Freddie to hold enough capital against their guaranteed single-family loans, by product and risk category, to survive a scenario in which the worst credit defaults and loss severities experienced by the companies over any two-year period in any region of the country with at least 5 percent of the U.S. population were repeated nationwide, for all books of business. (This standard proved adequate until private-label securitization became the dominant form of residential mortgage financing in 2004, and underwriting disciplines collapsed.)
By managing its product menu and underwriting so that its risk-based requirement remained at or below the minimum, Fannie was able to keep its average charged guaranty fee at around 20 basis points through 2004. At this level, Fannie could do what it called “profile pricing” for its larger lenders: a lender would tell Fannie what its expected mix of business would be in the coming year, and based on that mix Fannie would quote a fixed guaranty fee (typically with a provision for adjustment should the profile delivered differ materially from what was envisioned). With a known average guaranty fee, lenders were free to set mortgage rates for individual borrowers as they pleased. Generally, they would heavily or totally subsidize higher-risk borrowers by quoting them rates close to or the same as the rates for lower-risk borrowers. Lender cross-subsidization was critical in enabling Fannie to meet its affordable housing goals during this time.
What made profile pricing possible, and cross-subsidization effective, prior to the crisis were that Fannie’s (and Freddie’s) average guaranty fees were relatively low, and the differences between capital and fees on the companies’ lower- and higher-risk loans were not that large. That no longer is true. Fannie and Freddie now price to about a 3.5 percent average capital requirement, and data from FHFA show that in the first quarter of 2014 their “fully priced” guaranty fee for the riskiest third of their business was 112 basis points, while the fully priced fee for the least risky third was 43 basis points. The 69 basis point difference between the riskiest and least risky one-third of Fannie and Freddie’s business overwhelmed their ability to use cross-subsidization effectively. The fee they actually charged for the riskiest one-third of their business was only 70 basis points, while their charged fee on the least risky one-third was 53 basis points. Because they had to cut fees by 42 basis points to attract higher-risk business, but only were able to raise fees on lower-risk business by 10 basis points to avoid losing it, Fannie and Freddie together undershot their “fully priced” average fee by 12 basis points in the first quarter of 2014. Even at that, just 16 percent of their business had credit scores of less than 700, and only 23 percent had down payments of less than 20 percent (with those borrowers having to pay an additional cost for private mortgage insurance).
This is a crippled system, and it shows how difficult a challenge a “reformed” credit guarantor will face if it has an average capital requirement even close to 3.5 percent. If it underprices its credit guarantees (as Fannie and Freddie now are doing), it will not hit its return target. If it prices all its business at the average fee (which for Fannie and Freddie is 72 basis points), bank originators will keep their lowest-risk mortgages in portfolio and sell their highest-risk loans to the guarantor, sending its risk profile soaring. The guarantor will have no real alternative to pricing all of its business close to the fees dictated by its risk-based capital requirements, because the extreme spread between the “fully priced” fees on its higher- and lower-risk loans will limit its scope for lowering fees on higher-risk loans before the offsetting fee add-ons to lower-risk loans cause that business to drop off significantly. Inevitably, the guarantor will end up with very small amounts of affordable housing business, at very high mortgage rates to the affected borrowers.
It doesn’t have to be this way. Capital is the key. In theory, adding “cushions” of extra capital—or being unrealistically conservative in designing a stress test (by not counting any guaranty fee income as an offset to credit losses, for example)—may seem to be a good thing. In practice, however, these impose very real costs on the low- moderate- and middle-income borrowers the system is intended to serve. The unavoidable reality is that to give maximum flexibility to guarantors and lenders to provide the greatest amount of affordable financing to the widest possible range of borrowers, capital requirements must be set at realistic levels—high enough to meet a rigorous, defined, stress standard, but no higher. That should be the goal of all reformers.
HOWARD ON MORTGAGE FINANCE 
Do you believe that the net worth sweep was predicated upon the ACA? This is a damning report. http://waysandmeans.house.gov/wp-content/uploads/2016/07/20160707Joint_Congressional_Investigative_Report-2.pdf
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I don’t have a point of view on this, but I also don’t think it’s relevant to the court cases, where the issue of the legality of the net worth sweep will be decided. (I did note, by the way, both that the “Joint Congressional Investigative Report” is 157 pages long and that it’s authored by members on only one political party, with a well documented history of opposition to the Affordable Care Act, so it may take me a while to tackle it.)
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Can you comment on the letter by Corker et al to Watt re not to recapitalize FNF? Court is quiet and looks like the battle to keep a reformed FNF is lost (?)
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I have a different interpretation of the July 7 letter from Corker and five fellow members of the Senate Banking Committee to FHFA Director Watt than you do, and I’ll elaborate on that interpretation in the next post on this site, which I intend to put up early next week.
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Hi Tim , Do you have an opinion on DeMarco’s lender owned plan for GSE?
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DeMarco hasn’t yet put out many details on his proposal; all he’s produced is a 9 page power-point summary. That summary does not give an explanation for why having “multiple sources of credit enhancement” providing guarantees on many different loan types– conforming, jumbo, FHA and VA–for a wide range of lenders and aggregators issuing Ginnie Mae-guaranteed securities is likely to be the best way to provide the greatest amount of low-cost financing to the widest range of low- and moderate-income borrowers that Fannie and Freddie were serving prior to the crisis (and could serve again if used as the basis of the secondary market system of the future). But perhaps DeMarco will surprise me when he does put out his full proposal, along with its rationale.
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I am afraid that DeMarco does not have the answers.
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Tim I have a question concerning a future draw from Treasury. If Fannie or Freddie were to need a draw from treasury in the upcoming quarters what would be the ramifications? Would this lead to certain people pointing out the “flawed nature of the business model” and the real need to do away with F&F or would this lead to Congress officially acting on housing finance reform? Even though HERA allows Mel Watt to act unilaterally.
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A future draw by one of the companies almost certainly would lead to some making the “flawed business model” claim; the question is how credible would such claims be. In the four months since I did a post on this topic (“Some Context, and the Coming Bailout Charade”), documents released by Judge Sweeney have shown Treasury cynically manipulating Fannie and Freddie’s financial condition to suit its own policy objectives, while at the same time asserting publicly that it was acting in the best interests of the companies. Given the recent revelations about Treasury’s behavior, a senior preferred stock draw forced by Treasury’s own requirement that Fannie and Freddie reduce the capital they are allowed to keep (before the rest is swept to Treasury) from $3.0 billion on December 31, 2013 to zero four years later will be harder to sell as anything other than what it is: a “crisis” created by Treasury to further its goal of gaining support for winding down the companies.
If I were Mel Watt I would not allow Treasury to play this game. By the terms of the Preferred Stock Purchase Agreements, senior preferred dividends only can be paid to Treasury at the approval of the boards of directors of Fannie and Freddie. Watt would be perfectly within his rights to cite safety and soundness considerations as the reason for requiring the companies’ boards to decline to authorize payment of senior preferred stock dividends to Treasury that cause the companies’ capital to fall below a level they, the boards, believe is required to serve as a cushion against the quarterly volatility in GAAP net income to which the companies are subject. Fannie and Freddie do not have a problem with the economic results of their businesses; they have a problem with the way those results are affected on a quarterly basis by the accounting they are required to use, which records most of the components of their balance sheets at historical cost, but requires some to be marked to market. The most effective way for the companies to prevent quarterly accounting-driven GAAP losses from pushing them into a negative net worth position is for them to hold enough capital that this does not happen. Watt should permit them to do this.
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Good evening Tim
Lately I read that government asserted executive privilege on four documents only. What about the other 11,200 ? Did they produce those documents yet?
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You’re referencing the documents the government has withheld from plaintiffs’ counsel in the Fairholme case in the Federal Court of Claims. My understanding–and I’m not following the various legal cases nearly as closely as many other observers–is that the government has claimed three types of privilege as justification for withholding the 11,000-plus documents: deliberative process privilege, bank examination privilege, and presidential communications privilege. Judge Sweeney is trying to figure out a way to determine whether these claims of privilege have been made properly (and, at least in my opinion, the defense is doing its best to ensure this determination takes place as slowly as possible). We now know of four documents for which the government has claimed presidential communications privilege, but to the best of my knowledge, we don’t know whether Sweeney has accepted, or will accept, that claim. And I don’t have any information on the status of all of the other documents on which the government has claimed either deliberative process privilege or bank examination privilege. If anyone else has more current or better information, however, they should feel free to offer it.
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thank you
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Tim
About one year ago, or maybe more than that, some three congressmen came up with a proposed bill that would replace FnF with Ginnie Mae. The idea did not take off but anyway I ask you: is there any chance of it to happen and to be a solution?
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Never say never, but it’s highly unlikely. This sounds to me like a political “solution” offered by individuals who don’t have much knowledge of the problem they’re purporting to solve. Ginnie Mae securitizes loans that already have been guaranteed by the U.S. government (FHA and VA loans); it has no credit analytic expertise or capability whatsoever. How that qualifies Ginnie to replace Fannie and Freddie–and why that would be a sensible thing to do–is beyond me.
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This requires Gov to buyout or nationalize FnF with congressional authorization.
BTW GNMA are 100% Gov corporations.
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Please excuse me if you have already answered this question.
What is your thought or opinion on this presentation from Millstein and Co?
Click to access Treasury-Correspondence-Millstein-Presentation-on-GSE-Reform.pdf
Thank you very much for your time and thoughts.
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I hadn’t seen this before. Given when it was done, and the audience to whom it was presented, I think it is excellent. Millstein recognizes the danger of making big changes to the secondary market structure (which most others at that time seemed not to have done), and I think his plan generally is workable. He deals with the government guaranty issue by (a) recognizing that some sort of government support is beneficial if not essential to a healthy international fixed-rate MBS market, and (b) having Fannie and Freddie recapitalized and privatized, then having the government guaranty come from a new Federal Mortgage Insurance Corporation. Depending on how you capitalize Fannie and Freddie (the subject of this post) and what you charge for the government guaranty (my quick read didn’t see that Millstein gave figures for either one), and how you manage the transition from the current conservatorship to the envisioned new system, it’s not that much different from what I would suggest we do.
Treasury didn’t accept this plan, I would guess because they don’t want to retain Fannie and Freddie in any form. And of course I did notice Millstein pointing out to the Treasury staff in attendance at his presentation–in February 2012– that “the FHFA projects that Fannie and Freddie will start to out-earn their dividend obligations to Treasury starting in 2013.” Coming six months before Treasury imposed the net worth sweep on the companies, that’s yet another “bad fact” for the government in the sweep cases.
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Tim,
Will Politicians ever allow independent FMIC (like FDIC) and give up on affordable mortgage loans for their constituents? Will it not also duplicate the role of FHFA?
As long as FnF are designated as companies for public policy goals, politicians will continue to impose unfunded mandates on FnF, compromising the independence of FMIC. FMIC will also end up like FnF.
Politicians have to chose between
1. Current model with incremental improvements
2. Totally independent FnF system under FMIC
3. Pre-FnF private money lender system
It is easy to guess that Politicians and Bureaucrats will never want to give up control on on private FnF where they do not have to worry about national debts and appropriate money thru budgets.
Best bet would be choice# 1.
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I don’t believe you need an institution like the various versions of the FMIC that have been proposed in order to provide a catastrophic government guaranty to mortgage-backed securities. I continually read that these proposed FMICs would be “like the FDIC”. They won’t be. The FDIC operates on the classic principle of insurance: charging a very large number of people (or institutions) a small amount of money to fund the payment of a large amount of money to a small number of people (or institutions) expected to have claims. You can’t have “insurance” for two, or even a handful of, companies. What you can and should do instead is set capital requirements for these companies at a level you believe will be adequate (based of some objective assessment of worst-case loss), then back them up with a catastrophic guaranty in case you’ve misestimated what that worst-case loss really is. If it makes you feel better to charge them a modest annual fee for this backstop–or if you feel it’s necessary to do so for appearance purposes–go ahead, but you shouldn’t call it insurance. (If you’re thinking of it as “insurance,” it means you’ve set your capital requirement too low.)
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Tim,
Thanks. Your explanation dispels the myth of FMIC as a solution.
Only viable option seems to be, to have reasonable capital reserves and catastrophic backstop under exceptional circumstances.
Currently all the systemically important companies have this catastrophic backstop in one form or the other from the Gov (unwritten implicit backstop). But the problem is, some people are not happy about this catastrophic backstop only in case of FnF.
Looking back, even in 2008 exceptional financial crisis, FnF capital reserves (even though considered low by many), liquidity and profit cash flows were enough to meet their financial obligations for many quarters. In addition if one considers their readily available credit line from Fed/Tsy and option to raise more funds from markets, FnF were never in dangers of defaulting.
Gov commandeered FnF as the emergency vehicles and imposed conservatorship / SPSPA on FnF to triage 2008 catastrophic crisis. When shareholders and media trusted the Gov promises and did not even file a token protests, emboldened political appointees planned to distribute the spoils to their favored ones.
When it comes to paying fees for this catastrophic backstop, it is only FnF that are paying back in a big way to Gov. All other companies do not even pay a dime to Gov for this catastrophic backstop.
It is worth considering the following on how FnF are paying back Gov for this catastrophic backstop:
1. FnF are fully funded by private shareholders, but Gov uses them for public policy purposes
2. FnF carry out expensive unfunded Gov social mandates
3. Gov uses FnF as a readily available emergency vehicle without ever paying for it.
4. FnF are trusted and reliable vehicles for Gov to implement economic, housing and monetary policies.
One needs to look at costs benefit analysis to correctly understand the payback to Gov.
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Tim,
Thanks for painstaking efforts to present analysis based on realistic facts.
You are way ahead of others in your thought leadership.
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Wonder if Tim can consider sending a copy of the essay to Huffington Post and New York Times. Format and style can be made to be read faster. Numbers are emphasized.
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2008-2012 administrative expenses ($7.8 B)
guaranty fees only from loans ($21.4 B) (QUESTION: should this be affected by the deduction of high risk loan exclusion below?)
book’s credit losses $70.1B loss due to high-risk loans no longer permitted to acquire: $22.4B ($ 35B more realistic)
7.8－ 21.4 ＋ 70.1 － 22.4 （35） ＝ 34.1 （21.5）
Fannie’s required stress capital on December 31, 2007 would have been $34.1B conservatively, 21.5B realistically
$2.55T book of business
Required capital: 1.3 % of its book. (more realistically 0.8%)
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Mark: Yes, I should have deducted the guaranty fee income on the high-risk loans I excluded from my loss calculations. It makes some but not a huge amount of difference in the required capital figures.
As of December 31, 2007, about 10 percent of Fannie’s book were Alt A loans, and about 8 percent were interest-only ARMs. If we removed all the guaranty fee income from these loans, it would be $3.9 billion, but in the conservative case I remove only about half the losses—so the corresponding reduction in guaranty fee income in that case would be $2.1 billion—while in the “more realistic” case, where I remove most of them, the fee adjustment would be $3.2 billion. Making these adjustments raises the required capital percentage in the conservative case from 1.34 percent to 1.42 basis points, and in the more realistic case from 84 basis points to 97 basis points (still, but just barely, under 100). Thanks for catching that.
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Would you mind editing your post and then deleting my comments?
Your expertise can make you most influential in housing reform. Those fake experts will disappear. I thank God for your website and your contribution.
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I’d rather not start editing posts; once published, I think they should stand as they are.
At any rate, the point of the post wasn’t to make a specific recommendation on a capital requirement for a future credit guarantor, its points were: (a) that credit guaranty capital requirements need to be based on a defined stress scenario, informed by actual historical experience (which FHFA is best positioned to calculate, based on its access to detailed data), (b) that based what we can observe from Fannie’s results during the previous crisis, a risk-based requirement derived from real experience is likely to produce average capital amounts and guaranty fees that are considerably lower than the figures being proposed by the large majority of reformers, and (c) that unrealistically or unnecessarily high capital requirements and guaranty fees have real and profound impacts on cost and availability of mortgage financing, particularly for the populations Fannie and Freddie originally were chartered to serve.
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Tim,
It would also be helpful to understand, the cost benefits analysis of costs of unfunded social mandates against any benefits given from Gov. This analysis needs to be supplemented by the benefits various stakeholders reap from FnF eco-system.
Then comes the question of what should be the appropriate role for Gov in such a FnF eco-system.
Cost benefit analysis also needs to be done to determine costs and benefits for the Gov. This may removes doubts about who is benefiting from such a system.
FnF should be publishing these reports on regular basis to counter the criticisms from ideologists and market competitors. Instead of lobbying with Congress and Administration, FnF should be communicating with common people to remove any mis-perceptions.
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The capital ratios most important factor in the reform which decides everything else. Historical numbers are facts. Home finance business is distinctively different from any other finance business such as auto loans. Thus, it is treated accordingly. This research will quiet many other self-claimed “experts” who don’t have deep understanding.
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Tim, by the laws of probabilities, if the guarantors are smaller, and or regional, the needs of capital will increase. Am I right? If your answer is yes, then all the proposals that would spin GSE in several smaller companies would result in very higher cost for the home buyer is it right?
If your second answer is also yes, then the only option is a government owned corp and the liabilities should be added to the national debt ? Is it not what they wanted to avoid when GSE went private? Then why not keep the GSE?
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If a credit guarantor is regional, it very likely will suffer from reduced diversification of risk. As long as there aren’t too many national guarantors–no more than, say, four or five– they all should be sufficiently diversified across geography, risk categories and time that they’re unlikely to benefit significantly more from larger scale.
I have not yet heard a persuasive argument for having a single, nationalized credit guarantor (although there may be one). As for merging Fannie and Freddie to form a single shareholder-owned company, I think the system benefits from having at least two credit guarantors competing against each other on service, technology and innovation, and to some extent on price.
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I hope people in Congress and admin are as intelligent as Tim. Let’s continue with the rigorous math discussion. Let’s debate with Zandi. Some people’s numbers are only guesses.
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Sorry, there is no Member, Senator, or congressional staffer as “mortgage/securities smart” as Tim Howard (the real one). I would include this Administration, too.
That’s part of the problem.
The genius of his commentary on capital and structure runs into their historical (hysterical?) biases and those policy makers fall back on “We can’t let the GSEs go forward” or “We have to squeeze them with excessive capital,” no matter the facts which point to much of the pre-2008 issues being regulated out of the market in QM (qualified mortagge) mandates.
Virtually all of the UI suggestions are far worse (save Tim’s own) than some variation of what we have and which works and has worked.
It’s depressing and dismal.
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Right On!
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Bravo Tim!
Your analysis is an excellent refutation to the GSE reform advocates who claim that the companies require 8-10% capital to remain in business without an express government guarantee. It amplifies Laurie Goodman’s earlier findings. http://www.urban.org/sites/default/files/alfresco/publication-pdfs/412935-The-GSE-Reform-Debate-How-Much-Capital-Is-Enough-.PDF
Laurie’s conclusion:
“Capital of 4–5 percent would have been sufficient for the GSEs to sustain all their losses under a 2007 home price scenario, with a much more diverse mix of business than they have now. With the current GSE book of business (which is admittedly too restrictive), a 2007 scenario would produce losses on the order of 2–3 percent. However, these capital calculations in essence assume that all GSE loans are in one giant pool. Smaller and/or less diverse pools would need quite a bit more credit enhancement to cover a 2007-type environment. ”
Of course, if the government had not drained $250 billion in equity out of the GSEs, they would be adequately capitalized today, and the raison d’etre for conservatorship would be defunct. If the government wanted its money back sooner rather than later, it could have acted like any other shareholder and sold its senior preferred stock.
Laurie alludes to a fatal flaw in GSE reform proposals, which has to do with risk diversification. It didn’t matter if the GSEs held mortgages on their balance sheets, securitized them, or held their securitizations; the credit risk never went anywhere. All credit risk resided in one big ever-changing pool , which was managed (superbly according to historical data) on a global basis.
The latest tweak of Johnson-Crapo eviscerates the ability of the government guarantor to manage credit risk on a global basis, and the credit risk assumed by private players for each individual mortgage pool is unique and deeply subordinated, just like mezzanine CDOs.
David Fiderer
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tim, outstanding post as usual.
i do get the notion that other Urban Institute incubator proposals pull their desired capital levels out of thin air, without a sensitivity to the effect on pricing the guarantee or availability of mortgage financing. also, there is some reliance on a government backed catastrophic risk bearing capacity which seems to me to confirm that the proposals have punted on the hard analysis of how much capital is enough and how much is too much.
you have been critical of credit risk sharing transactions done by fannie, but as far as i can tell based upon pricing, and based upon the assumption that this source of capital will be available in bad times as well as good. is there a way in which you would incorporate these deals on a constructive basis into your proposal, and if so at what level or portion of credit risk?
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The reason I’ve been critical of Fannie’s recent risk-sharing deals is related to the way I think about them in the context of a risk-based standard such as the one I propose. I believe that for most if not all of the CAS risk-sharing transactions Fannie has done it will pay far more in interest payments than it has any reasonable chance of expecting to receive in payments on credit losses. Fannie would be much better off not doing those deals, and keeping the interest payments as retained earnings and as a capital cushion for some future period when credit losses are more likely.
Related to this, let’s say that Fannie has a new, binding risk-based capital requirement, and that given its current book of business it has to hold 1.75 percent capital. Should it be allowed to reduce its required capital dollar-for-dollar for the “value” of any or all of the risk-sharing deals it does? I don’t think it should be. It is very likely that the loans capital markets investors will be most interested in insuring will be from Fannie’s better books of business. The interest payments Fannie makes for risk-sharing deals on those books will reduce retained earnings that otherwise would be available to cover losses on riskier books. For this reason, I believe Fannie at best should be given only a partial (50 percent?) capital credit for risk-sharing deals that replace required stress capital.
There is, however, a circumstance where a dollar-for-dollar credit would be appropriate, and sensible. That would be in the event policymakers insist upon a capital cushion over and above the percentage of capital required to pass the stress test. As an example, let’s say that required stress capital for a book of business is 2 percent, but policymakers want a guarantor to hold another 50 basis points, just to be “extra safe.” Risk-sharing transactions for losses over a first-loss threshold of 2 percent should be generally available, and relatively inexpensive. A regulator could, and should, exempt a guarantor from having to hold more than 2 percent capital on a given vintage of business, provided it does risk-sharing for losses above that threshold. (Of course, if risk-sharing for even these relatively remote losses dries up in bad times, the guarantor would have to hold hard capital to make up for the absence of the risk-sharing deals).
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The “risk-sharing” deals are done to leverage GSE IP and channel profits to crony banks. It’s a way to prop-up TBTF struggling balance sheets. Until Tsy figures how to fully hand-over GSEs to TBTF banks. Bleeding GSE future profits. Whilst the sweep takes current profits from that “bad book of business” during your years at FNMA (sarc/).
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