In a recent report to Congress, the Federal Housing Finance Agency once again failed to satisfy a fundamental legal requirement. This is a requirement that the FHFA keeps ignoring apparently, perhaps because it doesn’t like it. But, to state the obvious, the preferences of a regulatory agency do not excuse it from complying with the law.

The law requires that when the FHFA sets guarantee fees for Fannie Mae and Freddie Mac, the fees must be high enough to cover not only the risk of credit losses, but also the cost of capital that private-sector banks would have to hold against the same risk. This is explicitly not the amount of capital that Fannie and Freddie or the FHFA might think would be right for themselves, but the cost of the capital requirement for regulated private banks.

This requirement created by the Temporary Payroll Tax Cut Continuation Act of 2011 was clear and unambiguous. The law mandated a radical new approach to setting, increasing and analyzing Fannie and Freddie’s g-fees, based on a reference to the private market. In setting “the amount of the increase,” the law said, the FHFA director should consider what will “appropriately reflect the risk of loss, as well as the cost of capital allocated to similar assets held by other fully private regulated financial institutions.”

FHFA Director Mel Watt.
A 2011 law mandated a new approach for the Federal Housing Finance Agency, led by Director Mel Watt, to setting Fannie and Freddie’s guarantee fees, based on a reference to the private market. But the FHFA is not fulfilling the mandate. Bloomberg News

In other words, the director of the FHFA is instructed to calculate how much capital fully private regulated financial institutions have to hold against mortgage credit risk, the required return on that capital for such private banks, and therefore the cost of capital for private banks engaging in the same risk as Fannie and Freddie. This includes the credit losses from taking this risk and operating costs, both of which must be added the private cost of capital. The net sum is the level of Fannie and Freddie’s guarantee fees that the FHFA is required to establish.

The law also further requires the FHFA to report to Congress on how Fannie and Freddie’s g-fees “met the requirements” of the statute, that is, how they included the cost of capital of regulated private banks.

However, if you read the FHFA’s October 2017 report on guarantee fees, nowhere in it will you find any discussion — not a single word — about private banks’ cost of capital for mortgage credit risk. There is the same amount of discussion — zero — about how that private cost of capital enters the analysis and calculation of Fannie and Freddie’s required g-fees. Yet this is the information and annual analysis that Congress demanded of the FHFA.

Why has the agency failed to fulfill its legal obligation?

A reasonable hypothesis is that the FHFA doesn’t like the answer that results when this analysis and calculation are performed, so it is tap-dancing instead of answering the question and implementing the answer. In short, the calculation required by the law results in much a higher level of g-fees than at present. This reflects the whole point of the statutory provision — to make the private sector competitive and to take away Fannie and Freddie’s subsidized cost of capital and the distortions it creates.

The FHFA certainly understands the importance of this issue. Its report clearly sets out the components of the calculation of g-fees, saying, “Of these components, the cost of holding capital is by far the most significant.” That would be the perfect section to add the required analysis of the cost of capital for regulated private financial institutions and to use that to calculate the legally required g-fees.

But instead, the report treats us to a discussion of how “each [government-sponsored enterprise] uses a proprietary model to estimate … the amount of capital it needs.” The mortgage companies use “models to estimate the amount of capital and … [subject] that estimate to a target rate of return” to “calculate a model guarantee fee.”

That’s nice, but here are the two questions that must be answered:

  • What is the cost of capital for a private regulated financial institution to bear the same credit risk as Fannie and Freddie?
  • What is the g-fee calculation based on that cost of capital for private institutions?

The FHFA has not answered these questions. Instead, the agency said it had “found no compelling economic reason to change the overall level of fees.” How about complying with the law?

Alex J. Pollock

Alex J. Pollock

Alex J. Pollock is a distinguished senior fellow at the R Street Institute.