On April 28, Freddie Mac filed its 10Q for the first quarter of 2022 with the Securities and Exchange Commission, while Fannie Mae filed its first quarter 2022 10Q on May 3. These were the first times either company reported on their actual and required capital under the Enterprise Regulatory Capital Requirement (or ERCF) made final by former FHFA director Mark Calabria in December of 2020 and amended by acting director Sandra Thompson in March of this year.

I had been looking forward to the filings. Having read the text and reviewed the tables of former director Calabria’s final capital rule—and taken note of how much capital it would have required Fannie and Freddie to hold as of June 30, 2020—I was eager to learn what each company’s binding capital requirement was as of the end of the first quarter of this year, how much progress they had made in reducing their capital shortfalls, and what they would say about how they intended to ultimately come into full capital compliance.

I might have expected how they would treat this topic. Both said very little about it. Each reported on their capital requirements using similar (but not identical) formats, very likely designed and approved by FHFA, leaving it to the reader to determine what most of the data meant. Freddie’s 10K did not even identify which of its two capital amounts (risk-based or leverage) were binding, nor state what that capital amount was or how far the company was from meeting it. Fannie, at least, did that, saying, “as of March 31, 2022, we had a $272 billion shortfall of our available capital (deficit) to the adjusted total capital requirement (including buffers) of $190 billion under the standardized approach to the rule,” after earlier having said, “the amount of capital we will be required to hold under the amended enterprise regulatory capital framework remains substantially higher than the previously applicable statutory minimum capital requirement.” But Fannie said nothing further, and Freddie said nothing at all, about the new standard.

Fannie, Freddie and FHFA all can try to ignore or obfuscate the real-world impact of having former director Calabria’s grossly excessive and unjustified new capital requirement now be binding on the companies, but that won’t make this issue go away. Yet before discussing the implications of the Calabria capital requirements, I first need to give some facts and figures about them, since the companies (and FHFA) did not.

The March 31, 2022 capital numbers. Because of the way the ERCF has been constructed, its risk-based standard, and not the leverage standard, is currently the binding one on the companies (and, as I note below, will be for the foreseeable future).

The presentation of the capital numbers in both companies’ first quarter 2022 10Qs was a construction, with no explanation. The total required risk-based capital number was shown as the sum of three components: a (misleadingly named) “total capital” amount, derived by multiplying each company’s “risk-weighted assets” by 8 percent, and two buffer amounts—a “stress capital buffer” equal to 0.75 percent of each company’s “adjusted total assets,” and a “stability capital buffer” linked to FHFA’s definition of each company’s market share. The two buffer amounts are arbitrary but at least straightforward, and together make up the “Prescribed Capital Conservation Buffer Amount,” or PCCBA. “Risk-weighted assets” is a concept drawn from the Basel bank regulatory capital scheme, and FHFA’s version mixes credit risk, other risks, capital minimums and cushions in a way that makes it impossible to untangle analytically. Neither Fannie nor Freddie gave any indication as to how their risk-weighted assets were derived; they just presented a number, which, multiplied by .08 and rounded to the nearest whole digit, is labeled the total capital requirement (before buffers). 

At March 31, 2022, Fannie’s total required risk-based capital was $190 billion, made up of $111 billion in risk-weighted asset capital, a $34 billion stress capital buffer, and a $45 billion stability capital buffer. While the percentage was not published anywhere, Fannie’s total required risk-based capital at March 31, 2022 was 4.20 percent of its adjusted total assets. To get the comparable numbers for Freddie, you have to hunt through its capital table. Doing so, at March 31, 2022 its total required risk-based capital was $122 billion, made up of $73 billion in risk-weighted asset capital, a $26 billion stress capital buffer, and a $23 billion stability capital buffer. Since Freddie and Fannie are in the same business and have very similar credit risk profiles, one might have expected Freddie’s required ERCF risk-based capital percentage to be very close to Fannie’s. It was not. Freddie’s required capital was 3.38 percent of its adjusted total assets, 82 basis points lower than Fannie’s.

Before addressing why the Calabria capital standard produced such significantly different required capital percentages for two companies with essentially the same credit risk profiles (at March 31, 2022, Fannie’s actually was a little better), I first should note that measuring both companies’ required capital as a percentage of their “adjusted total assets” understates the burden this capital places on their business. Adjusted total assets is a concept introduced by Calabria. His final capital rule detailed the types of exposures FHFA can add to Fannie and Freddie’s total assets to create their adjusted total assets. It runs for eight pages (174 to 182), and has nine categories, most of which relate to exposures to derivatives or repurchase agreements (which in my experience posed little financial risk). At March 31, 2022 Fannie’s adjusted total assets were 5.7 percent greater than its total assets, while on the same date Freddie’s adjusted total assets were 16.1 percent greater. I have seen no explanation from either FHFA or the companies as to what specific exposures lead to such a large difference in adjusted total asset add-ons.

There are two more straightforward, and understandable, ways to calculate capital ratios: as a percentage of published total assets, and (for a credit guarantor) as a percentage of average mortgage assets. The difference between adjusted total assets and published total assets is mostly non-earning “exposures,” while the difference between mortgage assets and published total assets is mostly cash and liquidity, on which the companies lose money (because the cost of their debt is greater than the yield on the cash or liquid assets). Fannie and Freddie have to earn a market return on the capital they are required to hold against their liquid assets and their adjusted asset exposures, and their primary way of doing that is through the fees they charge for their credit guarantees. At March 31, 2022, Fannie’s $190 billion in required risk-based capital was 4.20 percent of its adjusted total assets, 4.43 percent of its published total assets, and 4.74 percent of its average mortgage assets. Freddie’s same capital percentages were 3.38 percent, 3.92 percent, and 4.25 percent. Expressing the Calabria standard’s required capital as a percentage of adjusted total assets obscures the important facts that at March 31, 2022 Fannie was having to price to almost 4 ¾ percent capital, while Freddie was having to price to almost 4 ¼ percent capital.

Fannie versus Freddie required capital. Why, though, was Freddie’s required capital as a percentage of mortgage assets at the end of the last quarter so much lower than Fannie’s? There are two reasons—one simple and one not. The simple reason is how the “stability capital buffer” is determined. FHFA computes Fannie and Freddie’s credit guarantees as a percentage of estimated residential mortgage debt (single- and multifamily) outstanding each quarter, and assesses them a charge of 5 basis points of capital for each percentage point their “share of market” exceeds 5 percent. Since Fannie is larger than Freddie, it got a larger capital charge in the first quarter—107 basis points compared with Freddie’s 74 basis points. The only way Fannie could lower this capital charge is by doing less of the one business—mortgage credit guarantees—its charter and regulator now permit it to do.

The second reason for Freddie’s lower risk-based capital requirement at March 31, 2022 has to do with “risk-weighted assets.” The only other date for which FHFA has published risk-weighted asset percentages for the companies is June 30, 2020, as part of its revised capital proposal. Then, Freddie’s risk-weighted assets were 33.3 percent, while Fannie’s actually were somewhat lower, at 32.4 percent. At March 31, 2022, however, Freddie’s risk-weighted assets had fallen to only 25.5 percent of its adjusted total assets, while Fannie’s were 30.7 percent. Had Fannie’s also been 25.5 percent, its first quarter 2022 required risk-based capital would have been 44 basis points less. But since the risk-weighted asset numbers for both companies come from an FHFA “black box,” there is no way to know why Freddie’s risk-weighted assets fell so much more than Fannie’s. (Freddie’s greater use of credit risk transfers can only be a partial explanation, given that Freddie—which always has used more CRTs than Fannie—had higher risk-weighted assets at June 30, 2020.) The lack of transparency in both companies’ risk-weighted asset numbers is highly problematic.

Progress in closing capital gaps. Fannie and Freddie’s first quarter 2022 capital tables also enable us to calculate their recent progress in closing their ERCF capital gaps. We’ll start with Fannie. When FHFA published its final capital rule, it said that at June 30, 2020, Fannie’s total required risk-based capital was $171 billion, its adjusted total capital was a negative $118 billion, and its shortfall to full capitalization was $289 billion. At March 31, 2022, Fannie’s total required risk-based capital was $190 billion, its adjusted total capital was a negative $82 billion, and its capital shortfall was $272 billion. During this seven-quarter interval, therefore, Fannie’s required capital increased by $19 billion, its adjusted total capital rose by $36 billion, and it reduced its capital gap by $17 billion, or 5.9 percent, leaving 94.1 percent of its June 30, 2020 capital shortfall still to be covered in the future.

Freddie’s progress was similar. At June 30, 2020, Freddie’s total required risk-based capital was $112 billion, its adjusted total capital was a negative $68 billion, and its shortfall to adequate capitalization was $180 billion. At March 31, 2022, Freddie’s total required risk-based capital was $122 billion, its adjusted total capital was a negative $47 billion, and its capital shortfall was $169 billion. So over the last seven quarters, Freddie’s required capital increased by $10 billion, its adjusted total capital rose by $21 billion, and it was able to trim $11 billion, or 6.1 percent, from its capital shortfall, with 93.9 percent still to go.

The ERCF allows both companies to begin paying partial dividends and some executive compensation before they are fully capitalized. They can pay out up to 20 percent of their after-tax net income in dividends (common and preferred) and executive compensation once they have capital equal to their risk-weighted capital requirement plus 25 percent of their total PCCBA buffer amounts, and they can pay out 40 percent when they’ve covered 50 percent of their PCCBA. Neither company, however, is anywhere near either threshold. Fannie must cut its capital gap by $213 billion before it can pay out 20 percent of its net income, and to pay out 40 percent it needs to cut that gap by $233 billion. The comparable capital gap reductions for Freddie are $132 billion and $145 billion, respectively.

At the end of this month, Fannie and Freddie are required to file the first of their annual capital plans—described in FHFA’s December 2021 ”Notice of Proposed Rulemaking on Enterprise Capital Planning”—in which they are supposed to detail their “plan to rebuild capital to come into compliance with the ERCF.” These plans will not be made public, but they will contain each company’s proprietary estimates of how much they might further reduce their capital shortfalls over the five-year projection horizon. I obviously don’t know what those internal projections will look like, but I’m certain that during this period both companies will be projecting significantly slower asset growth because of higher interest rates, fewer refinances, and attempts to increase guaranty fees, and also a return to more “normalized” (and lower) earnings compared with the last seven quarters, because of slower amortization of upfront guaranty fees, a shift from loss provision income to loss provision expense, and higher interest costs for credit risk transfers. When Fannie and Freddie run these numbers and give them to FHFA, therefore, I doubt if Fannie projects that it can cut its capital gap by more than around $50 billion by the end of 2026—leaving about $220 billion unaddressed—and I wouldn’t expect Freddie to project a capital gap reduction of more than around $30 billion, leaving about $140 billion still to go.

FHFA and Treasury are likely to be very surprised, and disappointed, by what they will perceive as Fannie and Freddie’s lack of progress in meeting the requirements of the ERCF, because neither understands how little ability the companies truly have to eliminate on their own the huge capital deficits imposed upon them by former director Calabria. For this reason, I believe the executives at Fannie and Freddie must use the opportunity presented by the close sequencing of the initial publication of the ERCF capital data in in their first quarter 2022 10Qs and the subsequent submission of their initial capital plans to FHFA to break their silence about the impossible position FHFA and Treasury have put them in, and, whether publicly or privately, state in no uncertain terms the stark realities of their current capital dilemma, which are neither of their own making nor within their power to remedy:

• The huge difference between the positive book net worth of Fannie ($52 billion) and Freddie ($32 billion) at March 31, 2022 and their negative “adjusted total capital” on the same date (minus $82 billion and $47 billion, respectively) arises from Treasury’s refusal to consider any net worth sweep payments made by the companies over the last ten years as repayments of its senior preferred stock, even though financially they clearly were. Treasury senior preferred stock is not included in “adjusted total capital”.

• For as long as their Treasury senior preferred remains outstanding—and Treasury’s $173 billion liquidation preference in Fannie and $104 billion in Freddie exists, and keeps growing—the companies will have no access to the capital markets; their sole means of closing their gaps to adequate capitalization will be through retained earnings.

• The Calabria “risk-based” standard contains so many arbitrary buffers, cushions, and capital minimums that there is very little scope for Fannie or Freddie to reduce their required risk-based capital through changes in the risk of their books of business. For this reason, and those below, the companies’ risk-based standard will be binding for the foreseeable future, and their (lower) leverage requirements irrelevant.

• The final Calabria standard was artificially calibrated to produce 4+ percent required risk-based capital at a time when Fannie and Freddie’s books of credit guarantees were near all-time highs in credit quality. It is a virtual certainly that with slowing home price growth, rising interest rates, and fewer refinances, the credit quality of these books will move back closer to normal (then at some point be below normal), and as this occurs the companies’ “risk-based” capital requirements will rise, no matter what they do.  

• The guidance from acting director Thompson to attempt to earn a market return on FHFA’s (hugely excessive) amount of required capital by increasing fees on lower-risk business will drive more of these loans to banks and private-label securitization, and inevitably leave the companies with a larger proportion of higher-risk business, and as a consequence an even higher required risk-based capital percentage in the future.  

The senior executives at Fannie and Freddie know all this. That, I think, is why they had so little to say about the ERCF in their first quarter 2022 10Qs. But the data released in those 10Qs tell the story without words. At March 31, 2022, Fannie and Freddie had the highest-quality books of credit guarantees in their histories—with an average current loan-to-value ratio of 53 percent, and an average credit score of 752—yet together the companies found themselves $441 billion below their new “risk-based” capital requirement of $312 billion, or 4.5 percent of their average mortgage assets, with no way to reduce that gap other than to continue to retain their earnings at the expense of an ever-rising Treasury liquidation preference, and even then it would take decades to eliminate their capital gaps completely. What else can FHFA or Treasury possibly be expecting them to do to come into compliance with the ERCF as it’s now structured and specified?  

Treasury and FHFA are the ones that created Fannie and Freddie’s capital quandary, and they are the ones that can and must get them out of it. It won’t be difficult to do.

First, Treasury and FHFA must agree to cancel the net worth sweep, and eliminate Treasury’s liquidation preference. Fannie and Freddie already have repaid their senior preferred stock, with 10 percent interest. And Treasury should not require that the companies’ senior preferred be converted to common. To do so would be to require them to repay their indebtedness to Treasury twice, which is unjustifiable, and blatantly unfair. Without the senior preferred, Fannie and Freddie’s combined March 31, 2022 capital shortfall of $441 billion would be cut to $248 billion, or by 44 percent.

Then, FHFA must scrap the Calabria capital standard, and either go back to its June 2018 standard, or propose a new one. Calabria’s “risk-based” standard was cynically designed not to be risk-based, but instead to require Fannie and Freddie to hold a bank-like amount of capital no matter how little risk they took on their credit guarantees, with a “stability buffer” that penalized them for doing more than a token amount of business. There is no reason for the top economic officials in the Biden administration to keep former director Calabria’s punitive capital standard in place, particularly when a Fannie and Freddie with a properly designed capital standard, based on real data and economics, could be of such great value to a key Biden administration constituency—affordable housing borrowers.

This should not be a hard call.