Some Pre-comment Comments

On June 12 the Federal Housing Finance Agency (FHFA) issued a notice of proposed rulemaking on “Enterprise [Fannie Mae and Freddie Mac] Capital Requirements.” The proposal is lengthy—263 pages, plus another 105 pages of proposed rule text. Because comments on it are not due until 60 days after it is published in the Federal Register (which as of yet it has not been), I did not attempt to work my way though it before leaving on vacation last month. Now that I’ve been able to finish reading and analyzing it, however, I feel compelled to make some initial comments about it, in advance of the formal comment I will send to FHFA later on in the summer.

It perhaps should not have surprised me, but I found FHFA’s risk-based capital proposal for single-family mortgages to have a pronounced, troubling and entirely avoidable pro-Financial Establishment and anti-homebuyer bias. As I discuss below, the biases fall into three categories: inappropriately basing the risk-based standard on banks’ Basel standard; excessive and counterproductive conservatism in the risk-based standard, and flaws in the 2.5 percent minimum capital alternative and the treatment of credit risk transfers. Taken together, these make it difficult to avoid the conclusion that FHFA backed into its capital numbers, and engineered its proposal to produce what Fannie and Freddie competitors and critics (including careerists at Treasury) have long been asking for: requiring the companies to adhere to capital standards dictated by and advantaging large banks and Wall Street firms, and disadvantaging homebuyers.

Inappropriately basing the risk-based standard on banks’ Basel standard

Despite the fact that banks’ Basel capital standards are designed to cover a very wide range of asset categories that Fannie and Freddie are not permitted to deal in, and that have much higher and less predictable loss rates than home mortgages, “FHFA’s rule is based on a capital framework that is generally consistent with the regulatory capital framework for large banks.” FHFA claims that its proposed capital rule for Fannie and Freddie “appropriately differentiates from other capital requirements based on the actual risks associated with the Enterprises’ businesses,” but even a cursory analysis reveals it comes nowhere close to doing that.

The one place in the proposal where FHFA attempts to numerically “recognize the lower risk” of Fannie and Freddie’s business relative to banks is in its determination of a minimum capital ratio for the companies. And there, instead of using actual loss data, FHFA states bewilderingly, “Risk is defined using Basel risk weights.” In Basel, mortgages get a 50 percent risk weight, while FHFA calculates that the average risk weight of the top 34 bank holding companies (who are subject to enhanced capital standards) is 72 percent. Using these figures, FHFA asserts, “This suggests that the risk-weighted asset density for [Fannie and Freddie’s] assets is about 69 percent (calculated as 50 percent divided by 72 percent) of the risk-weighted asset density for the largest bank holding companies.” Put differently, FHFA is claiming, based on the Basel risk weights, that banks’ assets are only one and a half times as risky as the mortgages owned or guaranteed by Fannie and Freddie.

That is preposterous. There is no justification for FHFA to use Basel risk weights to assess the relative riskiness of Fannie and Freddie’s assets when historical loss data are readily available for the same purpose. And the differences using real data are staggering. In the 20 years before the 2008 mortgage crisis, credit losses at FDIC-insured banks averaged 82 basis points of total assets per year, twenty times the 4 basis point average credit loss rate at Fannie and Freddie. The 2008 mortgage crisis was a true “stress event” that affected losses at Fannie and Freddie (whose assets are limited to mortgages) disproportionately to banks, but even including post-2008 credit losses in the comparison Fannie and Freddie’s 1988-2017 average credit loss rate of 14 basis points is just one-sixth the 84 basis point loss rate of the banks over the same period. And if you adjust Fannie and Freddie’s 2008-2017 losses to exclude the loan products and risk features they no longer are allowed to finance (as even FHFA does in its analyses), the companies’ 1988-2017 average loss rate falls to 8 basis points—one-tenth the comparable average loss rate of commercial banks.

As of the end of 2017, the banking industry as a whole, with $16.2 trillion in assets, had a total equity-to-assets ratio of 11.2 percent. (The four largest banks, with over half of banking industry assets at $8.2 trillion, had average equity capital of 10.2 percent.) The banking industry’s average capital percentage is about 13 times its average annual credit loss rate. It is axiomatic in finance that capital must be related to risk. If FHFA were to use the same 13:1 ratio of capital to annual credit losses for Fannie and Freddie as exists for the banks—which would overstate Fannie and Freddie’s required capital because these two companies take nowhere near as much interest rate risk as banks do—a true “bank-like” capital ratio for them would be between 100 and 180 basis points, with a figure at the lower end of this range being more consistent with the residential mortgage types Dodd-Frank permits the companies to finance today.

It is understandable that competitors and critics of Fannie and Freddie would want to ignore actual comparable loss experience and insist that the companies’ capital be based on the Basel bank standards, but it is not acceptable for Fannie and Freddie’s safety and soundness regulator to do the same thing. And grossly overstating the risk of the companies’ business leads FHFA to make its next major mistake—adding excessive, redundant and unjustified conservatism to its risk-based standard in order to produce a capital number that approaches the simplistic 4.0 percent risk-weighted leverage requirement applied by Basel to bank mortgage holdings.

Excessive and counterproductive conservatism in the risk-based standard

For Fannie and Freddie’s single-family credit guaranty business (the main focus of this comment), there is a simple, effective, and nondistortive way to implement the risk-based capital directive in the Housing and Economic Recovery Act (HERA). FHFA would take the companies’ single-family books at the end of each quarter, and apply the stress loss rates it developed for the various types of loans and risks (in the proposal these are done to a high degree of granularity) over a defined and realistic period of time, and incorporate projected income and expenses to determine the amount of initial capital the companies would need to survive that stress. The minimum capital percentage, and not the risk-based standard, would incorporate any capital cushions deemed appropriate, taking into account the fact that HERA gives the regulator authority to take prompt corrective action when capital falls below either the minimum or the risk-based amounts.

FHFA does determine stress loss rates by loan and risk category, but it then adds numerous and redundant elements of conservatism, both when applying the stress test and in addition to it. These include: (a) declining to count guaranty fee income as an offset to loan losses, (b) not allowing for the tax deductibility of those losses, (c) adding a fixed “going concern” buffer to all assets, irrespective of their risk, and (d) adding a reserve for deferred tax assets, or DTAs, despite the fact that the going concern buffer is designed to ensure the companies’ continued solvency, so that their DTAs always would have value. (FHFA also adds a “market risk” capital charge, but this applies only to the portfolio business.) In a fact sheet FHFA produced that shows the “impact of the proposed capital rule,” the refusal to count income as an offset to credit losses adds an estimated 113 basis points to the risk-based standard for single-family credit guarantees, while the going concern buffer adds another 75 basis points to it.

FHFA’s rationales for not counting revenues in its stress test are exceedingly weak. Its first is that the Basel capital standards don’t count them. That’s true, because Basel uses simple ratios, not a stress test. The Dodd-Frank stress test for banks does count revenues, as any legitimate stress test does and should. A second reason FHFA gives is that, “Inclusion of revenues could result in a very low or zero-risk based capital requirements for specific portfolio segments.” That’s also true, if the loans aren’t very risky. But that’s precisely why FHFA includes a minimum capital level, which kicks in if the aggregate risk-based capital numbers drop below the minimum.

The impact of not counting revenues is huge. Without revenues, FHFA calculates that stress credit losses for Fannie and Freddie’s September 31, 2017 book would be $112.0 billion, or 201 basis points of their combined assets and off-balance sheet guarantees. But with the companies’ current average net guaranty fee of 30 basis points (deducting both administrative expenses and the payroll tax fee), and the stress prepayment rates from the 2008-2012 period, guaranty fee income from that same book would be an estimated $63 billion, leaving credit losses net of revenues of $49 billion, or 88 basis points. That’s the accurate risk-based capital percentage.

There clearly is merit to the concept of a going concern buffer, but FHFA errs badly in adding it to the risk-based standard; it must instead be a component of the minimum, due to the interaction of a risk-based standard that can change over time and the provision in HERA for prompt corrective action by the regulator if Fannie and Freddie do not meet both their risk-based and minimum capital standards.

Fannie and Freddie’s minimum capital standard will be a fixed percentage (FHFA’s two proposed alternatives are discussed briefly below), while the risk-based number will change counter-cyclically—requiring less capital when home prices are rising and more when they are falling. Fannie and Freddie executives know that when home prices are falling it is difficult, expensive and sometimes not possible to raise capital. For that reason they almost certainly will want to hold significantly more capital during good times than is required by their risk-based standard, because when that risk-based requirement rises during periods of stress (and it can rise quickly and considerably) they will want to continue to be in compliance with it to avoid adverse regulatory action, including restrictions on their business.

In the real world in which the companies operate, therefore, FHFA’s proposal to put multiple layers of conservatism inside the risk-based standard is highly problematic. Even though this conservatism is intended as a cushion, in reality it won’t serve as one, because the extra capital can never be drawn down—doing so would push a company under its risk-based requirement (which has the “cushions” built into it) and trigger the prompt corrective action the companies so desperately will be trying to avoid. This means that the conservative set of elements in the FHFA proposal that produced a 3.24 percent risk-based capital requirement at September 31, 2017—a time when the housing environment was very favorable—would in fact lead Fannie and Freddie to hold at least 4 percent and more likely closer to 5 percent capital, including the excess they know they will need when the cycle turns less favorable, and their (overly conservative) risk-based requirement becomes much higher.

FHFA needs to understand that if it takes a true risk-based capital number of 88 basis points, adds unnecessary cushions, and then ignores the impact of its prompt corrective action disciplines on management’s incentive to hold excess capital, the result will be actual capital holdings that cause extreme distortions in the pricing of single-family credit guarantees. Having to price mortgages that have an 8 basis point expected loss rate to earn a market return on 5 percentage points of capital will stretch the affordability of and access to credit guarantees from Fannie and Freddie beyond the breaking point. And there is no reason for it. Fannie and Freddie are not banks, and FHFA should not be trying to smother them with Basel-like required capital, unrelated to the risks of their business. Instead it should subject them to a straightforward and realistic risk-based standard, with no fudges or cushions, then add a minimum standard calibrated to the statistical risk of their business, and that incorporates a going concern buffer sized to reflect the reality that if they fall below this minimum HERA gives the FHFA director discretion to classify them as “critically undercapitalized,” and appoint FHFA as their conservator or receiver.

Flaws in minimum capital and credit risk transfer proposals

Two other aspects of the FHFA capital proposal deserve brief mention here: its alternative minimum standards and its treatment of credit risk transfers.

FHFA suggests two potential approaches for a minimum capital (or leverage) requirement: a “2.5 percent alternative,” which is 2.5 percent of all on-balance sheet assets and off-balance sheet guarantees, and what it calls a “bifurcated alternative,” which effectively is 1.5 percent of all credit guarantees and 4.0 percent of other on-or off-balance sheet items.

Between the two, it is an easy choice. FHFA derived its 2.5 percent alternative by using Basel risk weights to translate bank risk or solvency measures into Fannie and Freddie capital, thus making the egregious mistake noted earlier of ignoring actual historical risk data for Fannie, Freddie and the banks in favor of the inapplicable, imprecise and wildly inaccurate Basel risk-weight comparison. That leaves the bifurcated alternative as the only reasonable one. FHFA does not make a convincing case for why it picked the 1.5 percent and 4.0 percent numbers for this standard, but with the important caveat that these figures be viewed as including a going concern buffer, I would view them as generally acceptable. I plan to do additional work on this topic, however, and to address it in more detail in my comment letter.

FHFA makes great efforts to favor credit risk transfers (CRTs) in its risk-based capital standard. One of these is ironic but harmless: having relied heavily on Basel in deriving credit risk capital, FHFA ignores Basel in giving capital credit to CRTs (Basel does not do so). A second act of favoritism is much more serious. Assessing the worth of CRTs as capital substitutes requires measuring their expected benefits against their costs. In the risk-based standard, FHFA gives credit for the expected benefits of CRTs but does not take their cost into account at all—because it ignores guaranty fee income and expenses, including CRT interest payments. (I’m tempted to think that FHFA’s odd decision to ignore income and expense in the risk-based standard may have had its origin in a desire to create a regulatory incentive for the CRT securities it and Treasury have been forcing Fannie and Freddie to issue). No one disputes that CRT capital is greatly inferior to equity capital, yet the FHFA rule inexplicably and dangerously gives the companies a one-sided capital incentive to substitute the former for the latter. If the companies fall prey to this lure (and they may not, if they look at the economics of the transactions) it will make them riskier, so in the interest of safety and soundness FHFA’s CRT treatment must be changed.

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These are my most important observations on the FHFA capital proposal. I believe it is critical that individuals and groups who have an interest in and a commitment to a mortgage finance system that works well for homebuyers read the FHFA proposal, make sure they understand it, and then give FHFA their comments on it. There can be no doubt that the supporters of large banks and Wall Street interests will flood FHFA with comments praising the wisdom and fairness of its proposal, so it will up to advocates for the ordinary consumer—the affordable housing groups, community banks and others—to point out the flaws and failings of FHFA’s capital plan, and to offer advice as to how it can be fixed in a way that reverses its pro-bank and Wall Street bias, which if not undone will deal a severe blow to the low- moderate- and middle-income homebuyers Fannie and Freddie were chartered to serve.

48 thoughts on “Some Pre-comment Comments

    1. 1. I think SCOTUS will review it because of circuit conflicts (5th and DC circuits)

      2. I don’t understand why a major decision of an unconstitutional FHFA is not voided. This conflicts with recent SCOTUS decision on Lucia v. SEC.

      Liked by 3 people

      1. in collins 5th circuit granted relief on the constitutional claim limited to striking for cause removal prospectively. this even though HERA doesn’t have a separability clause. So NWS not stricken on constitutional claim. But this opinion on the constitutional claim likely to be appealed by fhfa, and the APA claim denial and the denial of invalidation of NWS as relief for the constitutional claim also likely to be appealed by Ps, and I think scotus takes case.

        question is whether scotus reviews denial of APA claim (both dc and 5th circuits had one judge dissenting) or only the separation of powers claim. assuming Kavanaugh is confirmed, he is a solid vote for upholding the unconstitutionally structured argument, but he called for severing the for cause provision prospectively in his cfpb case (PHH). however, the cfpb statute had a severability clause in the statute and HERA does not, and scotus has said recently in Lucia that in a separation of powers case (appointments clause), relief should be granted that encourages Ps to bring challenges.

        so thin gruel, but gruel nonetheless. up to now, we have been grueless, just like Oliver Twist.


        Liked by 4 people

        1. A violation of a restaurant issued by a FAKE inspector is still VALID.

          I could not imagine FHFA, if managed by a board, would sign 3rd amendment. Not even the 79.9% warrant.


      1. couple more thoughts on collins if I may.

        there is a small chance that fhfa may not appeal. this is the result the administration (solicitor general) wanted, and presumably cfpb, which is also affected by this decision by analogy, now has a director who is fine with it as well. but fhfa is still an independent agency, and the administration also would probably prefer this holding from scotus than just from 5th circuit, so lets assume both parties appeal and scotus grants cert.

        assuming kavanaugh is confirmed, I think there is a lock of 5 votes affirming the separation of powers/unconstitutionally structured holding. kavanaugh plowed this field initially with his merits panel opinion in PHH, and it is clear to me that Roberts approves of this line of thinking from the Free Enterprise/PCAOB case in which Roberts wrote the majority opinion tracking Kavanaugh’s dissent below. Gorsuch hasn’t written an opinion on point but it is clear he is not enamored with the growing administrative state, so he would be a solid third, which leaves you Alito and Thomas as arch conservatives supplying the last two votes. by implication, if Kavanaugh is not confirmed then you have a 4-4 vote and the 5th circuit holding still stands.

        now comes the question of the relief granted on the separation of powers holding. in PHH, Kavanaugh found that the cfpb had violated the statute, so the merits panel could grant the P its relief on the statutory basis. Kavanaugh was able to take the politically easier route of applying a prospective only remedy for the constitutional claim therefor, since P already had its relief. not so with this collins opinion, in which statutory relief was denied. so collins tees up the constitutional claim relief question in a stark manner.

        I think the collins majority is wrong when it says it can excise the unconstitutional term and HERA still hangs together as a coherent statute. the first sentence of HERA with respect to the fhfa is:
        (a) Establishment- There is established the Federal Housing Finance Agency, which shall be an independent agency of the Federal Government.” shall be an INDEPENDENT AGENCY.

        plus there is no severability clause in HERA (as there was in dodd/frank) so the judicial act of rewriting the statute instead of invalidating it has not been preapproved in advance by congress.

        plus scotus just last month in Lucia indicates that courts should provide Ps remedies that encourage constitutional separation of powers claims. prospective relief offers no encouragement to Ps.

        so I think collins gets cert and scotus will need to address the constitutional relief question directly, and I will look forward to this.


        Liked by 2 people

        1. ROLG: Thanks; that’s very useful and insightful analysis.

          I’ve just finished reading the decision (and no, I’m not that slow a reader; it took me a while to get to it….) and was struck by the extreme contrast in how the majority addressed the two issues before it: the APA claims and the constitutionality of FHFA as an independent agency.

          I found the discussion on the constitutionality question accessible, informative and lucid. I learned a lot from reading it, and after doing so found the majority’s decision to be persuasive (and Judge Stewart’s dissent less so).

          The majority’s decision on the APA claims was another matter entirely. It said, “The Shareholders’ statutory [APA] claims mirror the claims made against the FHFA that the D.C., Sixth, and Seventh Circuits have all rejected. We reject the Shareholders’ statutory claims on the same well-reasoned basis common to those courts’ opinions.” That might have be a defensible position had it not been for the stinging dissent authored by Judge Willett amended to the majority decision, to which the majority obviously had access.

          Willett begins by stating, “This case concerns whether the net worth sweep falls within the scope of the FHFA’s statutory authority as conservator. To answer the question before us, we need only look at HERA’s plain text.” I won’t attempt to summarize or excerpt from Willet’s argument–readers should read it for themselves (it begins on page 58)–but I find it very hard to understand how the other two judges (Chief Judge Haynes and Judge Stewart) could have read Willet’s dissent and said, “Sorry, we don’t agree with any of that; we read HERA as being free of the judicial history of the FIRREA statute upon which it is based, and that it allows FHFA to blur the distinction between conservator and receiver in whatever manner it chooses, with no judicial review permitted.”

          On the silver lining side, in addition to the likelihood of SCOTUS accepting cert on the constitutional aspects of the decision (assuming FHFA appeals it), the Collins appellate judges finding that, “Divesting the Shareholders’ property rights caused a direct injury [to shareholders]” is a very good one for the regulatory takings claims now being pursued (with “all deliberate speed”) in Judge Sweeney’s court.

          Liked by 4 people

          1. Tim

            I would love for scotus to grant cert on the APA claim as well. not likely in the absence of a split in the circuits, though the willet and brown dissents certainly provide scotus the type of “analytic percolation” that it looks for in multiple circuit court opinions…just no conflict between circuits (so for scotus, which normally doesn’t reach out to decide cases it doesn’t “have” to decide, this would be a situation where at least four justices want to say something about statutory interpretation…and scouts cares more about constitutional than statutory interpretation).

            as for the separation of powers claim, Mark above is right in that there is now a conflict in the circuits; while the dc circuit held with respect to the cfpb and 5th circuit with respect to fhfa, the principle at stake is the same and the difference in agencies is a distinction without a difference for purposes of constitutional analysis. I don’t see how scotus doesn’t grant cert on that claim.


            Liked by 2 people

          2. Judges know well how other judges make decisions. And they may gently expose the motivation and mistakes.

            “I cannot conclude the anti-injunction provision protects FHFA’s actions here or, more generally, endorses FHFA’s stunningly broad view of its own power. Plaintiffs — not all innocent and ill-informed investors, to be sure — are betting the rule of law will prevail. In this country, everyone is entitled to win that bet.”

            After reading this, you know why most of those judges do not like plaintiffs — opportunists taking advantage of government’s mistakes.


            There is a textual hook in finding that Congress granted the FHFA discretionary authority. HERA provides that the FHFA “may . . . take such action as may be . . . necessary to put the regulated entity in a sound and solvent condition; and . . . appropriate to carry on the business of the regulated
            entity and preserve and conserve the assets and property of the regulated entity.” Typically, “may” implies discretion. I do not doubt that “may means may” or that “‘may is, of course, ‘permissive rather than obligatory.’” But courts seeking a forthright interpretation should not myopically focus on “may” at the expense of reading HERA as a cohesive, contextual whole. In divining statutory meaning, courts must never divorce text from context.

            Liked by 1 person

  1. Tim: I understand that Mnuchin mentioned in testimony today that he favors competition for the GSEs. I’m curious if you think it’s possible to have a solution, perhaps with the right capital requirements, that fosters competition, but doesn’t increase the price of mortgages for ordinary consumers?


  2. Tim – As you may have read, the FHFA has asked a number of questions in their proposed rule making.

    Having worked with government entities, this is how they communicate where they have latitude.

    It would be my humble suggestion that you submit your comment as a PDF (attachments are allowed). In this PDF you should write your comments with references to that it answers question 1, question 2, etc.

    Someone, at a lower level is going to have to read this and summarize this for their boss, who will have to present it to their boss, who will then bring it to the Director for a decision (look at who was on the call, who their boss is, and the degrees of separation from the director).

    To make their jobs easier, I would include an appendix (reference that there is one at the beginning) that lists FHFA’s questions, verbatim, and concise answer, and a reference back to the longer answer in the main document.

    Assume they take your comments, in whole, they can use your appendix for a summary to their boss, who then can make a presentation to their boss using the “short answers” in a PowerPoint to their boss, and finally, use the PowerPoint for their the Director, relying on the “short answers”, and attaching the long answers as their appendix. It will look well researched by the FHFA employees by simply reverse engineering your work.

    My main point, you have excellent information. It has to be consumable by the 34 year old reading it and actionable enough for them to use it, over other comments, to sell it up the food chain.

    Let me know if you have any questions.

    Liked by 2 people

    1. Brolin–That’s helpful; thank you.

      I haven’t started working on the comment letter yet. My preliminary thought is that I’ll have three or four major points that I’ll tie to specific questions out of the 40 they’ve asked, and also have comments on a few other minor points (also tied to specific questions)–although as I get to work on the comment letter this may change.

      As for getting my comments in front of the right people, I’m intending to use an informal as well as the formal channel. A couple of senior FHFA officials are on the mailing list for my blog (and read my posts), and I know there are other FHFA employees who follow me as well. Because of this current post the basic substance of my official comments won’t come as a surprise to them, but as I did with my comments on guaranty fees (July 2014) and credit risk transfers (September 2016) I’ll send a copy of my comment letter directly to the two senior FHFA officials (in addition to the formal submission), so they’ll know it’s been sent in as well as what it says.

      Liked by 2 people

      1. Tim

        in my over 30 years negotiating deals, I have found that the strongest position for any advocate to maintain is that of an honest broker. that honest broker can (and should) have a point of view, strongly held, but if the analysis is fair and incisive, and the advocate proceeds in good faith, that advocate rises above mere client-interest advocacy and accomplishes a beneficial result. this is not easy to do, and I wish you continued success in doing just that.


        Liked by 3 people

  3. Tim–It doesn’t change the challenge for the “pro-GSE” types, but the ugly truth is that there has been since Day 1 of OFHEO/FHFA regulation a cadre of “GSE haters,” at the Fed, Treasury, and most certainly FHFA.

    To pick one person, Treasury Secretary Steve Mnuchin, what is his incentive to finally get this stuff right and encourage the regulatory decisions which you suggest??


  4. Tim, Have you ever considered using graphic data? I presume that official comment on the FHFA plan may, but as I read the following:

    “In the 20 years before the 2008 mortgage crisis, credit losses at FDIC-insured banks averaged 82 basis points of total assets per year, twenty times the 4 basis point average credit loss rate at Fannie and Freddie. ”

    People familiar with the narrative can get that, but a 20-year plot illustrating the trickle of credit loss on F&F assets when compared to the muddy river of credit loss at the FDIC-insured banks might be powerful. Just curious, and thanks for the blog!


    1. I unfortunately am a victim of my past status as a long-time senior financial executive; whenever I needed an eye-catching (or any sort of) graphic, I had access to very capable people who could produce and format it for me. I’m sure I could teach myself how to do those things, but to date that hasn’t been high on my priority list. Perhaps I should move it up, though, because I agree with you that a compelling graphic can drive home a point better than prose, even if that prose is well written.


    1. That’s not practical. Fannie and Freddie are wholesale, specialized institutions, dealing in a single asset type (residential mortgages) in one country, with about 7000 employees each (Fannie a little more, Freddie less). The large banks that are driving efforts to curtail their activities are multi-product, multinational companies with huge retail operations, and the four largest (JP Morgan Chase, B of A, Wells and Citibank) each have over 200,000 employees worldwide. There is no reason to think that the executives of Fannie and Freddie would be able to acquire the skills, knowledge and experience to successfully turn their companies into full-service banks. Giving them bank charters and telling them, “Good luck,” would be a prescription for their demise.

      Liked by 1 person

  5. Great commentary Tim.

    A question I know the layman will ask.

    What’s wrong with imposing say a 5% capital requirement for the GSE’s?

    Yes it is unfair to impose bank standards to a non banking entity. But that’s life. After some time the GSE’s will reach that requirement. They will be extremely well positioned for the future.

    Politically the cost to homebuyers in the short term will be bigger. But they won’t understand any of this. They already don’t notice the hidden surcharge that treasury imposed.


    1. As your comment illustrates, there is some degree of misalignment in the objectives for mortgage reform of investors in Fannie and Freddie common and preferred stock and the affordable housing community, but it is not as much as you might think.

      The crude expression of the investor perspective is, “I don’t really care about the cost or availability of Fannie and Freddie’s credit guarantees, as long as the companies are released from conservatorship, allowed to recapitalize, and I can make money on my investment,” and besides (as you say), “homebuyers…won’t understand any of this.” The affordable housing groups (and most economists and policy analysts) obviously view that differently.

      The intersection of the two groups’ interests, though, is that if you require Fannie and Freddie to overcapitalize too much, the system doesn’t work for anyone– investors or homeowners. As I’ve alluded to in past posts and comments, I believe the agenda of the big banks in mortgage reform is to cripple Fannie and Freddie’s credit guaranty function so that bank-owned originators control both the underwriting and pricing of mortgages, to their advantage.

      To earn a market rate of return on 5 percent capital, Fannie or Freddie would have to charge an average guaranty fee rate of about 70 basis points. A high quality residential mortgage will have an expected loss rate of about 2 basis points. A bank originator will say, “Why should I pay 70 basis points to insure a loan with an expected loss of 2 basis points? I can keep it in portfolio, save the 70 basis points, and at the same time earn 300-400 basis points of spread income without incurring any extra capital cost at all, because my Basel capital requirement doesn’t explicitly charge me for taking interest rate risk.” These good loans won’t come to Fannie or Freddie to be guaranteed. As for the riskier loans, the problem will be the borrower, who will say, “I can barely afford a mortgage now; how can I afford the extra 70 basis points (or more, if the low risk-loans flee and all Fannie and Freddie are left with are the riskier ones) it’s going to cost me to get a credit guaranty?” For this reason, Fannie and Freddie will get fewer high-risk loans, too.

      And this will cycle into the value of the business. Right now Fannie and Freddie have $5.4 trillion in credit guarantees. That volume will certainly shrink if the companies’ product isn’t competitive (because of overcapitalization). At $5.4 trillion, Fannie and Freddie would need $270 billion in capital to meet a 5 percent capital requirement. Is there really a realistic chance new investors would put that amount of money into a shrinking business, controlled by the large banks, and in which Treasury has an 80 percent ownership stake (because of the warrants)?

      Everyone–investors, homebuyers, the affordable housing community, and those concerned about the health of our economy and financial system in general–has an interest in economically sensible reform of the secondary mortgage market. The challenge is going to be getting that to happen.

      Liked by 3 people

      1. Tim

        even if Fannie and Freddie are forced to overprice their guarantee relative to the risk being insured, wouldn’t most mortgage originators, especially nonbanks which seem to have a large share of the origination business, still use Fannie and Freddie (and any competition that arises) as takeout buyers, letting the originators keep their origination fee income and recoup their capital for another deployment? arguably all banks but the large tbtf banks would have to do this as well, no?

        put another way, are you saying that the tbtf banks will squeeze out small banks and nonbanks from mortgage origination because tbtf banks will underprice all originators who need to sell to Fannie and Freddie (and any competition that arises), or that overpricing the G fee simply gives tbtf banks an added profit opportunity for loans that they will keep in portfolio in any event?

        either way, I would encourage you to frame your comment to fhfa’s proposal not simply as a disagreement over financial/capital structuring best practice, but as making explicit that fhfa proposes to adopt a framework that advantages a few tbtf banks and disadvantages millions of homeowners, in direct contravention to its statutory mission.

        thanks for your work of the fhfa capital proposal and I am sure that your comment will be the best analysis that fhfa will see. (wonder why fhfa hasn’t printed its proposal in the fed reg yet?)



        1. I tend to wonder about the big banks “wanting F&F’s business” Do they not also sell to F&F? They sure settled for vast sums when sued so it seems to me they must. So what percentage of their paper is sold to F&F? What is the benefit to them? Is it only the low margin paper, and they keep the more profitable paper? And then, since they do sell to F&F, why would they want to get rid of F&F completely? There must be some benefit to them, so why kill something that also helps them? F&F tend to make everyone play by the same rules. They set up the appraisal requirements, the paperwork (which maybe could be less) but the point is they do a lot to synchronize the system, that seems to me to be a major benefit of F&F since without them there is no “ref calling the game”. Everyone starts making their own rules, and forms and it would quickly be a mess. As for rates. I checked a few advertised today. Wells is at 4.625 for 30 Fixed, BB&T at 4.75, BofA at 4.5, one of our local credtit unions at 4.90, Quicken at 4.56. So Quicken is by a hair the least and I would assume they sell a lot to F&F as they are not a bank. The point to take though in reply tor rule of law guy is what would Quicken’s rate be if they couldn’t sell to F&F? I imagine higher as any private money is going to want more return. So yes F&F do benefit the smaller players. Am I wrong in any of those ideas? If I am not can anyone tell me why other than ideological hatred they want to get rid of F&F?


          1. The big banks don’t want to “get rid of Fannie and Freddie,” because they do want to be able to use them as credit guarantors. But as I’ve mentioned in both blog posts and in responses to comments, having the companies be overcapitalized–and have to unnecessarily raise their guaranty fees– helps the large banks financially in two primary ways. First, the higher guaranty fees will get built in to lenders’ mortgage quotes (as they already have), and this will widen the spreads on the loans banks choose to keep in portfolio. Banks have greatly increased their holdings of residential mortgages and MBS in the last few years (they now hold 37 percent of outstanding residential mortgages, up from 26 percent ten years ago)–I think in large part because guaranty fees are so much higher. Pushing them up even further should cause banks to retain even more mortgages. Second, having guaranty fee pricing distorted by a too-high capital requirement will allow banks to hold down their single-family credit losses by keeping their higher-quality mortgages on their balance sheet, and swapping their risker loans (on which the mismatch between loan risk and guaranty fee won’t be as great) and selling those as MBS to other investors. Banks win in two ways, and homebuyers foot the bill for both.

            Liked by 2 people

      2. Tim the horror (or beauty) of dramatically increasing capital requirements is that it works on both a media, legal, and political front.

        Politically this rule can be imposed via regulation through FHFA. No need for Congress to be involved. Cynically they will never act they can’t be seen as responsible for any problems.

        Legally FHFA can do this. They and treasury can pay lip service to recap and release. Which could neuter many court cases? Even legally we’ve seen judges stretch interpretations of the law.

        And the media is already primed to blame the GSE’s for any sort of housing issues/crisis. And it’s hard for us to win when the narrative is “Fannie and Freddie caused the last crisis. We’re making them safer. Are you against safety and soundness?”. It worked in getting CRT’s created.

        The biggest help will be from housing advocates. But let’s be honest they aren’t Capital Markets or accounting experts. They won’t win against the narrative of safety and soundness. They don’t have the lobbying prowess of the banks. They’re too busy actually helping homeowners.


        1. I agree with you on the housing advocates, although I think it’s important for them to comment (I’m in contact with many of them). But my post also is aimed at the key supporters of the Moelis plan, many of whom I also know, and will be reaching out to. My analysis leads me to believe that the FHFA capital proposal has two sets of impacts–one intentional and one unintentional. The intentional one is pushing Fannie and Freddie’s required capital towards “Basel-like” levels, even though that’s not what a true risk-based approach would do or require. I get that, and also get that the politics make a true risk-based requirement for the companies out of reach–at least for now, in the current environment.

          The unintentional consequences–stemming from FHFA not realizing the interplay of an overly conservative but binding risk-based standard, which moves counter-cyclically, and a prompt corrective action regime that punishes failure to comply with that standard–are a different matter. If sufficient political consensus exists or develops for something like the Moelis plan to go forward, its supporters won’t want to have signed on to a capital scheme that makes it difficult or impossible for the companies to operate successfully. Fixing unintended consequences is easier than trying to change intended ones. I’ll also suggest to FHFA (and some Fannie executives) that it get Fannie’s comments as well. Even though it’s been a long time since I was there, I’m sure they have people in their credit risk analytic group who understand the intricacies and subtleties of how the structure and mechanics of a risk-based capital standard affect guaranty fee pricing and credit risk management, and who could say to FHFA, “This really won’t work the way you think it will, and you need to fix it.”


          1. Thanks for posting this analysis, Tim, greatly appreciate the feedback you’ll provide to FHFA. One question I’m not sure has been addressed is in a capital raise, doesn’t the buck stop with potential investors, who would say this is not a feasible capital standard? If there is a lack of demand from the market, FHFA would be forced back to the drawing board. But most treat the capital raise as definitively possible, regardless of the terms, as long as it’s authorized by FHFA/Treasury.


          2. Yes; if it turns out that I’m right about the FHFA capital standard, and FHFA doesn’t fix it, then it’s highly unlikely investors will put up the capital required to bring the companies out of conservatorship. In my view, that’s all the more reason to bring these problems to the attention of supporters of the Moelis plan now. If the current capital proposal gets adopted as made (and I don’t think it will), it will become harder for FHFA to change it. What would seem more likely to happen is that whoever has the lead on this in the administration will say, “Well, recapitalizing the companies and releasing them from conservatorship won’t to work; let’s try to restructure the secondary mortgage market around mutually owned credit guarantors, with capital supplied by the banks.” For banks, it would make sense to invest in credit guaranty companies, even with burdensome capital requirements that make a stand-alone guarantor a poor investment. Large banks can raise capital at the holding company level, and would view the equity infusion into the credit guarantors as a sensible proposition from the perspective of their overall mortgage business (origination, cross-selling to other products, servicing and portfolio investment)–the poor economics of credit guarantees alone would be more than offset by the associated increases in profitability that guaranty process control would permit in these other areas.


          3. Thanks for your reply.

            If there’s any charting/excel work you think I could assist with in putting together your response to FHFA, please feel free to reach out. My job more or less revolves around putting together presentations for investment committees.


          4. Tim

            in a rational world, fhfa would have “taken the temperature” of the capital markets before putting out a capital proposal, to see what was practical and feasible. but we are in this nevereverland of conservatorship hiatus where fhfa seems to think it can propose capital targets in a vacuum and with no input from the parties who will raise this capital. DC/Wall Street disconnect.



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