FHFA's focus in reforming GSEs: Capital, capital, capital

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Even though Fannie Mae and Freddie Mac are still controlled by the government, 2019 saw some of the first signs of progress in efforts to end the mortgage giants' federal conservatorships.

The Federal Housing Finance Agency, which regulates the government-sponsored enterprises, gained a new Trump-appointed director with his sights set on releasing Fannie and Freddie from the government's clutches. Mark Calabria took initial steps to prepare Fannie and Freddie for the private sector, making it a priority to improve the companies' capital position.

Capitalizing the GSEs is expected to stay in the focus in 2020, particularly as the agency retools a risk-based capital rule Calabria inherited from his predecessor.

"The capital rule is one of the most important rules I will issue as director," Calabria said in November. "This rule will be re-proposed and finalized within a timeline fully consistent with ending the conservatorships."


Two months earlier, in September, the GSEs were permitted to retain billions of dollars more in earnings to build up their capital cushions, and in the same month, the Trump administration published a report detailing its principles for an overhaul of the housing finance system.

Although many expected FHFA Director Mark Calabria to finalize a post-conservatorship capital framework for the GSEs that was originally proposed by former Director Mel Watt in June 2018, Calabria spent months deliberating the direction he wanted to take with the proposed rule before ultimately deciding in November to re-propose the framework.

The original proposal under Watt called for assessing the GSEs' credit risk for different mortgage categories, and would have included market and operational risk components in measuring the firms' capital strength.

While it remains to be seen what exact details of the rule Calabria might change or keep intact, he said Dec. 10 that his goal is to be able to issue his own iteration of the capital framework "sometime early in the first quarter."

The FHFA is also in the process of hiring a financial adviser to help the GSEs raise capital. After the agency hires its financial adviser, Fannie and Freddie will also hire their own financial advisers, Calabria has said.

Calabria has also said that he hopes to formalize various private directives issued to the GSEs during conservatorship as rules sometime next year and plans to enhance the FHFA's own capability as a regulator. This will include launching a macro forecasting unit that would be able to evaluate Fannie and Freddie's house price forecasts. He also hopes to be able to lift the $45 billion retained earnings cap, he said in October.

But heading into the new year, mortgage policy watchers are zeroing in on how the FHFA will approach risk-based capital requirements.

"The final capital rule is going to be about what are the appropriate levels to protect taxpayers when they emerge from conservatorship," said Scott Olson, the executive director of the Community Home Lenders Association.

And that determination will be "very significant," said Mark Goldhaber, a principal at Goldhaber Policy Services who also serves on the board of the Center for Responsible Lending.

"The capital rules lead to pricing, and in this case, it's going to lead to what loans go to [the Federal Housing Administration] versus what loans really are going to go to the conventional market," he said.

One of the major concerns about the original proposed capital framework that various groups expressed in comment letters to the FHFA was that the rules were too procyclical and could leave the mortgage giants severely weakened in a crisis.

"It requires additional capital at exactly the wrong time — once stress has already occurred," said Tom Parrent, a principal at Quantilytic LLC, a financial and biostatistics research consulting practice. "It would not only be very difficult to raise capital under stress and would probably shut down large segments of the market, but it would also mean that the fees charged to the homeowners would increase at that time, reducing demand for new loans."

A degree of regulatory forbearance is an essential tool in an economic downturn, Olson agreed.

"That's the way things have been done historically and that's the way it should be here, as opposed to having too strict of an adherence to very high levels of capital all the time and you freak out if your capital gets depleted in a down cycle," he said.

Calabria himself acknowledged the concerns that the original proposal was too procyclical in a December speech at the Federalist Society.

"The very purpose of Fannie and Freddie and the Federal Home Loan banks is to be countercyclical, and my belief is that they have been a little too procyclical in the past," he said. "I think it's critical as we repropose the capital rule that how do we make sure that we’re having a capital rule that is countercyclical rather than procyclical?"

To combat procyclicality, Parrent suggested that the rule incorporate a contingency reserve that could be built up over time, a device used by some insurance companies. For it to work at Fannie and Freddie, a portion of guarantee fees could be set aside in a reserve that would only be used to pay claims during periods of financial stress.

"Once the reserve dollars have been held for 10 years, they can be released and replaced with fees generated on new loans," Parrent said.

In fact, the FHFA should contemplate a capital regime by looking at the GSEs through the lens of insurance companies and not banks at all, Goldhaber said.

"You've got to start with a baseline that says nobody wants to see them in an undercapitalized state as they were before the crisis," he said. "The question really becomes using the right capital framework to achieve the appropriate level of capital, and the reality is, these entities look a lot more like insurance companies than they do banks."

The GSEs' capital framework could also be a hybrid of a bank and insurance company capital framework, said Pete Mills, senior vice president of residential policy at the Mortgage Bankers Association.

"That's where I think there will be differences as a guarantor versus a holder of risk. Banks lay off risk as well, but they retain capital against the risks that they lay off," he said. "So it won't look exactly like bank capital either, but in terms of overall levels of capital for various mortgage exposures, they're going to try and get some rough equivalency is my guess."

Olson said it's critical that the capital framework take into account the development of the credit risk transfer programs at the GSEs and the two companies' risk-sharing activities.

"Particularly if it's a utility model that's being used — which we think is the right way — they're more of an insurance company type of operation, as opposed to a risk-based operation," he said. "It's a pretty vanilla product. It's not that it's not risky at all, it's just that bank capital standards seem inappropriate, because they're not doing commercial loans. They're doing more of an insurance."

If the FHFA developed a capital framework that either required the GSEs to hold too much or too little capital, there could be serious consequences, Parrent warned.

"If you had a capital structure that was too liberal, as the market feels that stress is approaching, the reinsurance and transfer trades would stop, and the GSEs would end up holding all of that risk because they would have a beneficial capital position relative to the reinsurers," he said.

But at the same time, "you don't want the GSEs to have to hold a punitive amount of capital where the reinsurers are basically arbitraging that," Parrent said.

In that kind of a regime, not only could people be pushed out of the housing market, but they could be forced into the less-regulated mortgage spaces, like the subprime and nonqualified mortgage markets, he added.

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