Well, now we know. The Fannie Mae and Freddie Mac capital standards put out for comment last Wednesday by the Federal Housing Finance Agency (FHFA) under Director Mark Calabria openly and unapologetically call for the companies to operate under a capital regime and capital requirements designed for commercial banks—in spite of the fact that the companies are not banks, have no business in common with banks, and have historical mortgage delinquency and credit loss rates one-third those of banks. By imposing these standards, FHFA has made it a condition of Fannie and Freddie’s future emergence from conservatorship that they function at a fraction of their potential efficiency, with severe negative impacts on homebuyers, particularly those with low and moderate incomes.

At one level, this not surprising. Director Calabria has said on numerous occasions that “Fannie and Freddie ought to operate under essentially the same capital rules as other large financial institutions.” That’s clearly what he’s done with this rule. And lest anyone miss the point, throughout the proposal FHFA converts capital percentages into “risk weights,” using the Basel bank convention of 8.00 percent capital being a 100 percent risk weight. So, rather than say that a given loan pool requires 1.2 percent capital, FHFA says it has a “15 percent risk weight,” causing the reader to have to mentally, or literally, multiply that risk weight by 0.08 to get back to the more familiar percent of assets measure. This is a not at all subtle way of saying, “make no mistake, these are bank standards.”

The bank standards of the May 2020 proposal require far more capital than FHFA’s June 2018 capital rule, which was merely “bank-like.” I and others noted in our comments on the earlier rule that it produced results that were unjustifiably and unnecessarily high because of numerous conservative assumptions, the most important being not counting guaranty fee income as an offset to credit losses in the risk-based capital stress test (as the Federal Reserve does in the stress tests it runs on large commercial banks). Not only does the new rule fail to correct this omission, it adds more conservatism, including “capital buffers.” Applied to Fannie and Freddie’s September 30, 2019 books of business, the June 2018 rule would have set their risk-based capital requirements at $136.9 billion, or 2.22 percent of adjusted assets. The new rule increases Fannie and Freddie’s required risk-based capital on the same book of business by over 70 percent, to $233.9 billion, or 3.85 percent of adjusted assets. Moreover, the new rule states that no matter what the risk-based standard requires, the companies must hold a minimum of 4.00 percent in “Tier 1” capital (shareholders’ equity plus retained earnings)—the same as commercial banks for mortgages—to avoid restrictions on their ability to pay dividends to shareholders and bonuses to executives.

I had feared Director Calabria might do something like this. After reading yet another statement by him advocating bank-like capital for Fannie and Freddie, last June I sent him a note, thinking, as I said in a post (Assessing the FHFA Capital Rule) that included the text of this note, that “he might not know the facts about the differences in risk between Fannie and Freddie’s business and that of commercial banks.” I summarized my message this way: “Capital must be related to risk, and if FHFA engineers its risk-based capital standard for Fannie and Freddie’s credit guarantees to produce an average capital percentage equal or even close to banks’ Basel III risk-weighted capital percentage for residential mortgages of 4.5 percent, the companies’ capital standard would be far more stringent than banks’, because: (a) the delinquency and default rates of single-family mortgages owned or guaranteed by Fannie and Freddie have been less than one-third those of residential mortgages held by banks, and (b) bank capital also must cover the interest rate risk of funding mortgages in portfolio, whereas Fannie and Freddie’s capital standards treat credit and interest rate risks separately, and additively.”

Calabria and other senior FHFA officials clearly read this note, and in the new proposal FHFA attempted to refute both the relative credit risk and funding risk arguments. Its responses were unsatisfactory, and in the case of the relative risk point, revealing. Here, FHFA did not address the historical delinquency and loss data, but instead justified its proposed capital requirements by linking them to a concept it called Fannie and Freddie’s “peak cumulative capital losses” during the financial crisis, which it defined as “cumulative losses, net of revenues earned, between 2008 and the respective date at which an Enterprise no longer required draws under the PSPA [the Preferred Stock Purchase Agreement].” For Fannie these totaled $167 billion, and for Freddie $98 billion.

Claiming that peak cumulative capital losses were a valid measure of Fannie and Freddie’s riskiness was a giveaway: it was an unmistakable indication that FHFA had rejected the reality-based realm of economics and finance for the fabulist realm of ideology and politics. Prior to the day the new capital proposal was released, I had been unsure how FHFA would square the fact-based approach required to devise and implement a balanced capital rule with the fictional versions of the financial crisis and the Fannie and Freddie takeovers it and Treasury had adopted in defending the lawsuits against the net worth sweep. Again, now we know: the current FHFA leadership has aligned itself with the fiction. Rather than acknowledge the demonstrable reality that Fannie and Freddie were by far the strongest providers of mortgage finance leading up to the crisis—which, as FHFA ignores, was caused by the collapse of underwriting standards following the rise to dominance in 2005 of undisciplined and unregulated private-label securities financing—FHFA in the text of its capital rule repeats the fable that the companies were not victims but causes of the crisis, claiming, “The Enterprises’ imprudent risk-taking and inadequate capitalization led to their near collapse and were among the proximate causes of the 2008 financial crisis.”

Discovery in the lawsuits has helped bring the facts about Fannie and Freddie’s pre- and post-crisis financial condition into focus. As I discussed in the July 2015 amicus curiae brief I wrote for the Perry Capital case, Fannie and Freddie’s placement into conservatorship by FHFA (at Treasury’s direction) was not a rescue, it was a takeover, and the reason the companies incurred such a large capital deficit between 2008 and 2012 was that “well over $300 billion in non-cash charges [were] booked to their income statements after they were put in conservatorship and placed into the hands of FHFA.” The large majority of these non-cash book entries were discretionary or based on inflated estimates of future losses, and were made to force the companies to take nonrepayable draws of senior preferred stock from Treasury they neither needed nor wanted, whose purpose, as I’ve noted elsewhere, was “to transform massive, temporary and artificial book expenses created for them into massive, perpetual and real cash revenues for [Treasury].” Had there been any doubt that these losses were artificial, it should have been dispelled when in just 18 months, from the fourth quarter of 2012 through the first quarter of 2014, the two companies somehow came up with enough income to make net worth sweep payments to Treasury of $158 billion—half again what they had earned in their entire existence as private companies.

FHFA leadership, however, is pretending that Fannie and Freddie’s “peak cumulative capital losses” were real, and that they are a better basis for calibrating the companies’ capital standards than are several dozen years of incontrovertible relative credit loss and delinquency data. FHFA also isn’t admitting that funding risk argues for a higher capital requirement for the banks who take this risk than for Fannie and Freddie who don’t. FHFA does concede that “the Basel and U.S. banking frameworks generally do not contemplate an explicit capital requirement for interest rate risk on banking book exposures” [except not “generally;” they don’t at all], but argues that “differences in the interest rate and funding risk profiles…should not preclude comparisons to the U.S. banking framework’s leverage ratio requirements” [not “comparisons to;” equivalence of.] The two reasons it gives are at best weak: that “the monoline nature of the Enterprises’ mortgage-focused businesses suggests that the concentration risk of an Enterprise is greater than that of a diversified banking organization with a similar amount of mortgage credit risk,” and that bank capital standards leave “interest rate risk capital requirements to bank-specific tailoring through the supervisory process” [while citing no instance of any such “tailoring” ever taking place].

Here too, FHFA forsakes economics and finance for ideology and politics. Fannie and Freddie would be able to deploy their proposed 4 percent minimum capital only to make credit guarantees on residential mortgages, for which in 2019 they earned an average fee of a little over 40 basis points. A bank can take its 4 percent minimum capital and buy mortgages with the same credit risk as Fannie and Freddie are taking, but then fund them with short-term, maturity-mismatched consumer deposits and purchased funds and earn a spread of over 300 basis points. It is axiomatic in finance that return is related to risk. A business that supports a margin of 300 basis points is in the judgment of the market far riskier than one that supports a margin of 40 basis points. Yet FHFA would have us believe that the capital for these two businesses should be identical.

Personally, I think the arguments FHFA makes to justify its imposition of bank capital standards on Fannie and Freddie are pretextual, and even its leadership doesn’t believe them. Rather, Director Calabria has determined, against any objection, to use the most powerful tool he has—the authority to set capital requirements—to reshape Fannie and Freddie’s business according to his view of how they should operate in the mortgage market. I first learned of this view in an essay Calabria did in July 2016 for the Urban Institute’s “Housing Finance Reform Incubator” (for which I also wrote an essay). There he claimed, “Securitization is often defended as an important provider of ‘liquidity’… [but] securitization’s ‘liquidity effect’ is procyclical, providing too much liquidity in good times and not enough in bad times.”

The new FHFA proposed capital rule seems structured precisely to remedy this perceived problem. Fannie and Freddie have base capital requirements of 2.5 percent—either exactly (minimum) or approximately (risk-based)—but also must hold capital buffers of another 1.5 percent—exactly (minimum) or approximately (risk-based)—to avoid restrictions on their dividends and bonuses. The combined base and buffer capital of roughly 4.0 percent is designed to restrain or reduce the companies’ business in “good times” by making the pricing of their credit guarantees uncompetitive. Then, in “bad times”—when banks and other providers of mortgage credit move to the sidelines because of worsening credit conditions—Fannie and Freddie’s envisioned role is to finance the mortgages the banks and others won’t. And if losses from those loans cause their capital to fall below the level required by the capital buffers, FHFA will not put them into conservatorship, but instead “only” require them to forego shareholder dividends and executive bonuses, until in good times they can restore their capital to the fully compliant percentages.

If this interpretation of what Calabria is doing with the capital rule is correct, as I believe it is, FHFA will resist making any significant changes to it following the comment period. It will try to keep minimum capital at a 50 percent risk weight of the base 8.00 percent Basel bank capital requirement, no matter what the commenters say. And because the risk-based standard has been engineered to produce a result very close to the minimum requirement, FHFA also will resist removing any of the new elements of conservatism it has added to the June 2018 rule, including the minimum 15 percent risk weight (or 1.2 percent capital requirement) on any loan no matter how low its risk, the nearly doubled capital charge for operations risk, or the so-called “stability buffer.”

The stability buffer is nothing more than a capital incentive for Fannie and Freddie to reduce their volume of business. FHFA sets this buffer to kick in whenever either company exceeds a 5 percent market share, as defined by FHFA. But by its definition, a mortgage guaranteed by Fannie or Freddie and held in a bank portfolio is deemed to be financed by the companies, not the bank. That’s a gross inaccuracy. The mortgage business consists of several linked activities, the main ones being origination, servicing, credit risk-taking, and funding. Fannie and Freddie have a market share of zero in origination, zero in servicing, a share of less than the stated 44 percent in credit risk-taking—because private mortgage insurers do supplemental risk-taking and their share isn’t counted anywhere—and as of the end of 2019 about a 3 percent market share in funding (which is dominated by banks). Weighting these mortgage-market activities by the revenues available to be earned in them, Fannie and Freddie’s true combined share of the mortgage market is only about 2 percent—well below the 5 percent threshold for FHFA’s punitive capital surcharge. FHFA, however, undoubtedly would dismiss this analysis were it presented in a comment letter.

The only potentially successful opposition to FHFA’s strategy of using excessive capital requirements to reshape Fannie and Freddie’s role in the market to the liking of its Director will need to come from the investment community, whose support FHFA is counting on for a successful recapitalization of the companies. With 4 percent minimum capital, Fannie and Freddie’s normalized earnings (that is, earnings without the recent benefits for credit losses, which are about to end) would produce returns on equity (ROEs) for each of around 8 percent, far below the 12 percent average ROE in the banking industry last year and even further below the ROE of a typical Standard & Poor’s 500 company. Both companies could potentially increase their ROEs by raising guaranty fees, but this would reduce the amount of business they can do in normal times—which indeed is what FHFA intends.

The large institutional investment firms know Fannie and Freddie quite well, understand they don’t need anywhere near 4 percent capital to operate safely and soundly, and also know that requiring so much unneeded capital will make them considerably less valuable to homebuyers and thus considerably less valuable as investments. The question is, will Calabria be willing to give on this, or will he say, essentially, “This is what the companies will have to look like to exit conservatorship, so tell me what they’re worth?” There almost certainly will be discussions about the impact of excessive capital on business value, but we won’t learn about them from the comment letters; the discussions will take place privately, between the investment firms and FHFA’s, Fannie’s and Freddie’s financial advisors.

I haven’t yet determined whether to make a formal comment on the proposal, but I’m leaning against it. For the 2018 capital rule my comments were intended to help FHFA find the right balance between safety and soundness and allowing Fannie and Freddie to do business in a way that provided the maximum support to the widest array of borrower types, throughout the business cycle. The current FHFA leadership has made clear that this is neither their goal nor their interest. Yet I do believe it’s important for affordable housing groups and others interested in economics-based housing policy to comment on the FHFA proposal, if for no other reason than to get their views on the record. At some point there will be a FHFA Director who will look at his or her capital-setting authority not from Calabria’s ideological perspective but as a means of safely restoring Fannie and Freddie to their traditional roles of channeling large amounts of low-cost funds from the international capital markets to U.S. mortgages, to help a wider segment of the American population afford a home. This final step, which Director Calabria so adamantly refuses to take with the current proposed capital rule, will complete the companies’ full release from their 2008 conservatorships.