Last week, we released an in-depth analysis of FHFA’s sweeping proposal to set capital standards for Fannie Mae and Freddie Mac in conservatorship and then in whatever lies ahead.  Capital – or the lack of it – was the reason Fannie and Freddie were among the first systemic financial institutions to collapse in 2008, a particularly remarkable fact given that the GSEs’ implicit guarantee should have made them the most impregnable too-big-to-fail institutions on the planet.  Capital now is key to the reason that the GSEs dominate U.S. housing finance – an effective guarantee combined with no capital constraints means that Fannie and Freddie can always beat all competitors save Ginnie Mae.  FHFA’s proposed approach mandates shadow capital during conservatorship to force more real-world pricing, product development, and risk mitigation.  That’s all to the good, but only because FHFA’s standards look strong in comparison to the total vacuum that proceeded them.  A comparison of the proposal to what it would really take to make resilient, totally-private mortgage guarantors demonstrates that FHFA’s rules may hope for this future, but even prayer for the higher good is unlikely to achieve it.

The nicest thing I can say about the pre-conservatorship regulatory-capital rules is that they were captive to GSE profit-making objectives. A harsher verdict borne out by history is that FHFA’s predecessor, the Office of Federal Housing Enterprise Oversight (OFHEO), took almost a decade to issue more than a thousand pages of rules expressly designed to make no dent in the GSEs’ ability to make seemingly endless amounts of money for their shareholders.  To be fair, OFHEO didn’t have a lot of leeway – the 1992 law that ordered capital regulation was hand-crafted by the GSEs into toothless statutory leverage and risk-based ratios.

But, OFHEO’s rules did more than just allow Fannie and Freddie to become pin-head leveraged.  They also precipitated the entire subprime-mortgage crisis because the GSEs were the world’s largest single-holder of AAA-rated junk paper, creating a ready, deep market for WaMu, Countrywide, giant securities firms, and ultimately the rest of the financial system’s foray into disaster.  Clearly, GSE capital requirements matter – a lot.

In the wake of the crisis spawned by OFHEO’s largesse, Fannie and Freddie in conservatorship have no capital regulation.  Even if they did, it wouldn’t matter as they remit almost all of their earnings to Treasury and, should this fall short, draw funds from the taxpayer to bring their noses back barely above water. In this never-never-land, the conservatorships continue to control single-family mortgage finance.  In recent years, they have also come to dominate multi-family housing, making them still more systemically critical, if still just as unbounded by capital constraint.

A decade later comes FHFA’s effort to rewrite the GSEs’ capital rulebook.  Like OFHEO’s rules, FHFA’s capital standards start with a political objective – the GSEs should dominate mortgage finance – and work backward to a capital rule so complex in detail as to provide ample opportunities for all sorts of regulatory arbitrage.  In conservatorship, this framework might make some sense — even some shadow capital rules will force Fannie and Freddie to operate at least somewhat more in line with the constraints governing a real-world venture.  This curbs their ability to out-compete everyone else – at least a little – and also reduces taxpayer risk – at least a bit.

But, would FHFA’s framework meaningfully govern the limited-life regulated entities (LLREs) that succeed the GSEs in a Treasury-led receivership?  What about the private companies the law requires in short order following these LLREs? 

To accept FHFA’s framework, one has to agree with two fundamental assumptions.  The first is that residential mortgages are so safe when done by Fannie and Freddie that nothing close to the risk-based capital required of banks is warranted.  Given that Fannie and Freddie are in fact buying loans with considerably higher debt-to-income and loan-to-value ratios at lower credit scores than banks now hold, this is at best questionable.  Our in-depth analysis also picks apart FHFA’s “risk-density” analytics, noting that FHFA puts all its faith in capital standards no more than half as stringent as those governing banks even though Fannie and Freddie are under virtually none of the other post-crisis rules governing bank safety and soundness. 

FHFA does address potential GSE liquidity risk, but argues that there isn’t any since the GSEs match their books of assets and liabilities.  True, but a darn sight easier to do with an effective USG guarantee and a TBA market premised on it.  GSE successors would not be so fortunate unless Congress decides to grant them a new taxpayer backstop.

Ideally, FHFA would craft rules for the GSEs’ successors that correct for some of the flaws in the bank-regulatory framework to make risk-based capital a meaningfully binding constraint backed by a well-designed, lower leverage ratio.  However, two companies with a combined $5.6 trillion in assets cannot be made well-capitalized by private market standards without either a magic hat – FHFA’s proposal, or a decades-long transition from public venture to private companies.  Or — my preferred solution – we recognize that we built Fannie and Freddie with huge advantages, we bought Fannie and Freddie in the crisis, and we now cannot simply wish they were small, fully-private, safe, and sound bastions of U.S. housing.  $5.6 trillion has to go somewhere and, given the impossibility of near-term capital resources anywhere close to enough for anything that large, the best path forward is a government utility immune from private-capital regulation under stringent regulation and with a very limited mission.