Fannie Mae and Freddie Mac have been hanging in the balance for years, and the capital rule that was proposed almost a year ago just made matters worse. Now former Fannie Mae CFO Tim Howard is calling into question calling for the Biden administration to release the government-sponsored enterprises from their conservatorships and reissue a new capital rule that would enable their release.
Q2 2021 hedge fund letters, conferences and more
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
Calculating The Capital Rule For Fannie Mae And Freddie Mac
In a blog post on his website dedicated to Fannie Mae and Freddie Mac, Howard explained how the capital rule for the GSEs should have been calculated. He also accused former Federal Housing Finance Agency Director Mark Calabria of concocting the current rule.
Howard wrote about the two ways to calculate the amount of stress capital the GSEs would need, using the liquidating book and on a going-concern basis. The liquidating book tracks credit losses on the 2007 book over its entire life and uses only guaranty fee income net administrative expenses to offset credit losses. On the other hand, the going-concern method uses income and losses from new business and "runs only until annual total net guaranty fees, from both existing and new business, exceed annual total credit losses, and profitability is restored."
Howard calculated that Fannie Mae and Freddie Mac would have been able to survive another 25% plunge in nationwide home prices like the one that occurred during the Global Financial Crisis without any initial capital. He added that the FHFA confirmed that calculation last month when, "with virtually no publicity, it released the results of the 2020 and 2021 Dodd-Frank' severely adverse' stress tests, run on Fannie's business for the end of 2019 and 2020." The GSE didn't need any initial capital to survive those stress tests either.
How Calabria Came Up With The Capital Rule
Despite that fact, Calabria decided to set the capital rule for Fannie Mae at 4.55% of its $3.76 trillion in total assets, which amounted to $171 billion. Howard questions how Calabria came up with that percentage and concluded that he "concocted it."
He noted that Calabria ignored the directive in the Housing and Economic Recovery Act (HERA) that required Fannie Mae's and Freddie Mac's capital to be based on risk. Instead, Calabria started with a requirement that the GSEs hold at least 4% of their assets as capital, which is how much banks must hold for their on-balance sheet residential mortgages. However, banks take interest rate and credit risk on their mortgages, unlike Fannie and Freddie.
According to Howard, after starting with the 4% capital requirement that banks have, Calabria used four "contrivances" to calculate the rest: "not counting guaranty fees in the risk-based capital stress test; subjecting low-risk loans to a minimum risk weight; misapplying the going-concern buffer and adding a capital penalty for doing more than a small amount of credit guaranty business."
How To Create The New Capital Rule
Tim Pagliara of CapWealth Group agrees that the Biden administration must reissue the capital rule.
"The revelation that FHFA ignored the stress test in formulating capital rules should be troubling to anyone concerned about affordable housing," Pagliara told ValueWalk in an email. "We are in the middle of a housing crisis amid the miscalculation of our regulator. Too much capital will hamper the GSE's mission of providing affordable mortgage liquidity for underserved markets. The Biden administration can rectify this by calling on acting director Sandra Thompson to re-propose the capital rule immediately."
Howard also laid out a framework to help the FHFA create a "rigorous and highly effective capital regime for Fannie and Freddie." He said only three elements are needed to create the rule: "a true risk-based capital requirement based on a stress test run on each company's book of business every quarter, with no cushions or add-ons; a single 'all-purpose' capital cushion, calculated as a percentage of this true risk-based requirement and a minimum capital percentage."
Howard explained that the GSEs' required capital would be the higher number of the risk-based amount plus the capital cushion and the minimum percentage. He added that to implement such a plan, the FHFA would only need to decide two numbers, the multiple to be applied to the stress test results that determine the size of the risk-based capital cushion and the minimum capital percentage.
Where Fannie Mae And Freddie Mac's Capital Requirement Should Be
Howard suggested that the multiple should be large enough to provide "meaningful protection" against the unexpected or error in the model of the stress test but not so big that it overrides the true risk-based element and distorts the GSEs' credit pricing. He believes a multiple of 1.3 is about as big it could be without violating the second principle.
Another factor the FHFA should consider when determining the size of the cushion is the fact that the amount of capital Fannie and Freddie will actually hold will be more than the bigger of the minimum or the risk-based standard.
Howard suggests that Fannie Mae's and Freddie Mac's minimum capital requirement should be at 2.5% instead of the 4.55% set by Calabria, and he gave three reasons for his argument. The first is that HERA already contains a 2.5% capital requirement for the GSEs' on-balance-sheet assets with a 45-basis-point requirement for their off-balance-sheet guarantees, which they only take credit risk on.
Second, he pointed out that the FHFA's June 2018 capital proposal stated that the conservative of the two alternatives for the GSEs' minimum capital was 2.5% of on-balance-sheet assets and off-balance-sheet guarantees. Finally, Howard said 2.5% is also the minimum in the capital rule set by Calabria if excluding the "prescribed leverage buffer amount," which is 1.5%.