Last week, the Financial Stability Oversight Council formally acknowledged that Fannie Mae and Freddie Mac, the two housing finance giants that imploded in 2008, pose a risk to the financial system and even to the broader economy. The announcement is much more than a revelation of the world’s worst kept secret because the council consists of all the major U.S. financial regulators and has the power to designate financial firms for extra stringent regulations.
The significance was not lost on Mark Calabria, director of the Federal Housing Finance Agency (FHFA), who commended the council for “its historic acknowledgement.”
The council’s announcement is historic because federal officials regularly pretended that the two GSEs were perfectly safe for decades prior to Fannie and Freddie’s 2008 implosion. This fiction allowed the GSEs to grow unencumbered by many of the costs faced by similar firms, parlaying their special relationship with the U.S. Treasury into above-average returns on equity.
From 1990 to 2004, Fannie Mae shareholders’ average annual return on equity was 24.5 percent, with relatively little variation from year to year. This rate is nearly double the typical return for banks, even though both banks and GSEs were—and to a lesser degree still are—in the business of funding home mortgages.
Regardless, it’s all official now—the next time the GSEs blow up, it won’t be so easy for federal regulators to say they were unaware of the risks.
Another important aspect of the council’s statement is its display of broad support among regulators for the FHFA’s new capital rule proposal. According to the statement:
The proposed Enterprise capital rule represents a significant step by FHFA to address the Council’s recommendation in its 2019 Annual Report that FHFA continue to develop capital and other prudential requirements for the Enterprises.
Capital is a core component of the regulatory framework because capital absorbs unexpected losses and helps promote market discipline by aligning incentives and curtailing excessive risk taking. Moreover, significant private capital is the foundation for resilient national housing finance markets.
In simple terms, federal regulators are supporting the effort to fund the GSEs with more equity capital, thus reducing the chances that taxpayers will foot the bill for a future bailout of Fannie and Freddie. This support is critical, because many housing finance trade groups have criticized the FHFA proposal and are seeking to either delay or water down the requirements.
Historically, though, the lack of meaningful capital rules fueled the GSEs’ abnormal growth and, therefore, the outsized risk that they posed to the housing finance system, borrowers, and taxpayers.
The weak rules that did exist also provided Fannie and Freddie with a funding advantage relative to banks, even though there is no objective reason to let the GSEs operate with dramatically higher leverage than large U.S. banks.
Combined, Fannie and Freddie have total assets of almost $6 trillion, roughly half the total assets of all eight U.S.-based global systemically important banks (G-SIBs). Unlike the G-SIBs, though, nearly all of Fannie’s and Freddie’s assets are concentrated in just one type of asset (home mortgages). Arguably, this concentration makes them even riskier than the banks.
The new proposal will move the GSEs’ capital framework closer to the type of capital rules imposed on large U.S. banks, and the council formally agrees that this move is a step in the right direction. According to the announcement:
The proposed rule, by relying on definitions of regulatory capital that are similar to that of the U.S. banking framework, would ensure that high-quality capital is the predominant form of regulatory capital.
Of course, the proposal would not require the GSEs to have the same equity levels as large banks, so Fannie and Freddie would still maintain some of their funding advantage. This fact is one of the reasons I’ve argued that the FHFA’s capital rule proposal is a good first step.
It makes little sense to build this sort of advantage into the system. It is no surprise that this arrangement produced a higher concentration of risk in the more highly levered firms.
The council came down on the right side of this issue as well. The statement explicitly endorses the proposed leverage ratio as a “credible backstop to the risk-based requirements,” and also suggests that the FHFA consider requiring even higher equity capital:
The proposed rule requires a meaningful amount of capital for the Enterprises, and is a significant step towards ensuring that the Enterprises would be able to provide liquidity to the secondary mortgage market and satisfy their obligations during and after a period of severe stress. However, the Council’s analysis using benchmark comparisons suggests that risk-based capital requirements and leverage ratio requirements that are materially less than those contemplated by the proposed rule would likely not adequately mitigate the potential stability risk posed by the Enterprises. Moreover, it is possible that additional capital could be required for the Enterprises to remain viable concerns in the event of a severely adverse stress, particularly if the Enterprises’ asset quality were ever to deteriorate to levels comparable to the experience leading up to the 2008 financial crisis.
In other words, the proposal is a great first step—the minimum capital requirements should be no lower and it’s plausible that they should be higher.
Just in case there was any doubt, the council also made clear that, if the FHFA is unable to adequately mitigate the GSEs’ risk, they will take action on their own:
If the Council determines that such risks to financial stability are not adequately addressed by FHFA’s capital and other regulatory requirements or other risk mitigants, the Council may consider more formal recommendations or other actions, consistent with the December 2019 guidance.
If the council believes that the new capital rule fails to adequately mitigate the risk that Fannie and Freddie pose, they will likely designate the GSEs for special regulations. In laymen’s terms, the council will label Fannie and Freddie systemically important financial institutions (SIFIs).
It would be much better—for borrowers and taxpayers—if the council never has to issue such a designation. Given that all the federal financial regulators recognize that the FHFA’s new capital rule proposal is a good first step toward mitigating the GSEs’ risk, things look to be on the right track. For now.
This piece originally appeared in Forbes