When details of the Crapo-Johnson proposal for reforming Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) were first released, one of the surprises was that it would set capital requirements for any bank participating in the new program at 10% of risk weighted assets. At that level (and with a reinsurance policy on top), it’s hard to argue that Fannie Mae and Freddie Mac would be vulnerable to another housing crisis, but the additional financing costs would likely push lower income prospective homeowners out of the market.

This same tension between wanting to both shield taxpayers from risk and ensure that affordable mortgages are available is on display in a recent paper from the Federal Housing Finance Agency’s Office of Capital Policy Countercyclical Capital Regime Revisited: Tests of Robustness, written by Scott Smith, Debra Fuller, Alex Bogin, Nataliya Polkovnichenko, and Jesse Weiher.

Fannie Mae, Freddie Mac: Static capital requirements imagine that the past is a guide for future crises

The paper argues that the problem with capital requirements in the past is that they tend to be pro-cyclical (something that Basell III attempts to address) and static, based on the evaluation of previous crises.

“The biggest limitation of the 1992 Act was the requirement to base the capital charge on a stress test based on a worst-case historical experience,” they write. “The observable worst case experience at the time the rule was written proved to be not nearly as severe, in terms of a shock to HPI, as would occur during the 2008-2011 time period.”

It’s hard to imagine facing a worse housing crisis than the one we are still recovering from, but that doesn’t mean it won’t happen.

A potential fix, which Smith et al are back-testing in this paper, is to scale the severity of the stress test (and in turn scale capital requirements) with the growth in the house price index (HPI) so that as the market goes through a housing cycle, lending becomes more expensive and banks are less likely to extend mortgages. When prices start to fall capital requirements on newly originated mortgages would also come down, making it easier for lending to pick up again.

“Any firm adhering to the countercyclical capital requirements leading up to that period would have been confronted with excessive capital requirements for, and hence likely would not have acquired, many of the loans that would later fail,” they write.

simulated cap requirements 0514 Fannie Mae Freddie Mac

Fannie Mae, Freddie Mac’s proposed plan would mostly eliminate capital requirement judgment calls

The idea is that not only are banks protected from a shock, the shock itself should be less severe because the market top isn’t as high. The trough used to measure stress test severity is reevaluated once per housing cycle, but beyond that there isn’t a lot of room in the proposed model for regulators to make judgment calls. Whether that’s a good or bad thing probably says a lot about your view of regulators.

The paper claims this approach would have saved Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC), and that’s probably true, but it completely ignores the other goal – giving people access to affordable home financing. If the only goal were to shield taxpayers, the government could just exit the secondary mortgage market (as some conservatives would like it to do). Otherwise, there has to be a balance between the two goals.