You may not have heard much about Freddie Mac and Fannie Mae since the financial crisis of 2008. Back then, the taxpayer bailed out the institutions after they became insolvent and put them into federal conservatorship, where they’ve remained since. Deficiencies in the capital framework of Government Sponsored-Entities (GSEs) were front and center in the financial crisis: Financial institutions like Fannie and Freddie were overleveraged, and when the value of their mortgage assets declined amid the housing downturn, their equity evaporated. In the aftermath of the financial crisis, many Americans, especially those below the median income, lost their jobs.
The conservatorship of Fannie and Freddie does not mean that taxpayers cannot suffer further losses and that the GSEs don’t still pose a systemic threat to the financial system. In fact, any losses that Fannie and Freddie now incur will be directly passed onto the taxpayer. You may be surprised to hear that they’ve also maintained high debt levels since the financial crisis. Dodd-Frank capital rules meant to limit financial-institution leverage did not apply to GSEs but only to private banks (with a particular emphasis on global systemically important banks or “G-SIBs”).
At the outset of the Trump Administration, when Mark Calabria became the new FHFA director, Fannie and Freddie had the ability to own $1,000 in assets for every dollar of equity on their balance sheets (only holding $6 billion in equity with $6 trillion of liabilities), implying a 0.1 percent capital ratio. By comparison, private U.S. banks have been required to meet an 8 percent capital ratio — and that’s before Dodd-Frank’s additional capital buffers. One could argue that the risk for Fannie and Freddie is further exacerbated by their undiversified sector risk (all of $6 trillion of their assets are in the mortgage space), notwithstanding the fact that they’re no longer invested in the risky off-label mortgages as they were before the financial crisis.
Fortunately, the Federal Housing Finance Authority (FHFA), which since 2008 has overseen GSEs, recently proposed a new rule that requires a capital ratio of 8 percent for GSEs, as well as a minimum leverage ratio of 2.5 percent and additional buffers.
Unsurprisingly, there are many opponents to the Fannie and Freddie capital rule in the mortgage-finance industry, whose members stand to have their profitability potentially crimped by the move. Scores of trade groups, including The American Bankers Association, the Center for Responsible Lending, the Mortgage Bankers Association, the Housing Policy Council, and the National Association of Realtors, are all seeking to delay the new rule with the hope of a different policy from a potential Biden administration.These are all organizations that benefit in different ways from the lower mortgage rates that GSE guarantees provide.
Thankfully, the Financial Stability Oversight Council (FSOC) — after being set up ten years ago — is acknowledging for the first time that Fannie and Freddie pose risks to the stability of the financial system, lending additional support to the capital rule from the rest of the regulatory community. In effect, the FSOC will label Fannie and Freddie systemically important financial institutions (SIFIs), something which they’ve done in the past for non-bank private institutions such as AIG and Prudential (designations which FSOC has since rescinded).
While it’s unclear that Fannie and Freddie will leave conservatorship anytime soon, a tighter capital framework would certainly be a precondition to becoming fully private entities.
Some of those opposed to exiting conservatorship at present — including authors of a recent Urban Institute report — have criticized the FHFA capital plan for being procyclical and for discouraging the use of Credit Risk Transfer (CRT) securities, which shift the risk of borrower defaults on Freddie and Fannie to private investors. But these are relatively minor issues which could be fixed in an update to the rule (several fund managers holding CRTs have in fact shielded taxpayers to from mortgage losses during the COVID crisis).
Regardless of whether they exit conservatorship, the new capital framework is a welcome step to protecting taxpayers from incurring further losses.