As legislators evaluate the Johnson-Crapo proposal to reform Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), one of the main questions they will need to answer is whether it adequately protects taxpayers from having to bail out the mortgage markets in the event of another deep recession.

The proposal would create a new federal agency, the Federal Mortgage Insurance Corporation (FMIC), partly modeled on the FDIC, to provide explicit guarantees for the securitized mortgages, but it also has a 10% first loss layer of protection.

10% is higher than AAA jumbo prime securitization

“The probability of losses exceeding this level, while not zero, should be low, assuming that mortgage underwriting remains appropriately careful,” write Goldman Sachs analysts Marty Young and Charlie Himmelberg in a March 20 report.

For comparison, Young and Himmelberg point out that subordination levels for AAA jumbo prime securitizations have stayed well below the 10% mark, and they are usually geographically concentrated, which makes them riskier assets than mortgage securities that are issued on a national basis. Anyone who followed the crisis knows that assuming underwriting remains robust in perpetuity is optimistic, but it looks like Senators Johnson and Crapo took this into account when they set the bar so high.

AAA jumbo prime subordination 0314 Fannie Mae

Under Basel III capital requirements, banks are required to retain capital worth 8% of risk-weighted assets. If a prime mortgage is generally given a weight of 50%, the capital requirement would be 4% of the total portfolio, far below the level set by Johnson-Crapo. Even sub-prime mortgages with weak underwriting standards would require 8% RWA under Basel III, so Johnson-Crapo seems quite conservative.

Fannie Mae, Freddie Mac historical losses lower than 10%

Young and Himmelberg also look at the historical losses of Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) to see if a 10% buffer would have been sufficient, and find that it is actually enough to cover a multi-decade recession.

“The largest annual loss experienced by the Fannie Mae single family portfolio was 0.77% (77 bp), in 2010. Thus, a 10% buffer could provide a buffer against over ten years of peak realized losses,” they write.

peak fannie mae loss 0314

Similarly, the Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) received a $187 billion capital injection from Treasury on top of roughly 0.5% capitalization at the start of the recession. On a $4.7 trillion portfolio, this works out to roughly 4.5% capital needed for the Fannie Mae and Freddie Mac to survive the financial crisis, so a 10% capital requirement would have left plenty of buffer intact. On top of that, the FMIC would maintain insurance equal to 2.5% of capital, built up over the first decade of operations, giving taxpayers further protection if the first loss provisions fail and the private companies working with the FMIC go under.