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FSOC leaves mortgage markets uncertain

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The Financial Stability Oversight Council’s recent comments on the Federal Housing Finance Agency’s proposed capital rule for Fannie Mae and Freddie Mac reinforced aspects of the proposed rule but left market participants uncertain about key issues.

For instance, FSOC’s endorsement of FHFA’s use of bank-like regulatory capital definitions and structure suggests that this approach will be retained in the final rule. FSOC also observed that the capital “buffers” in the proposed risk-based framework should be risk-based, as they are in the bank framework (a point made by many market participants).

However, elements of FSOC’s statement raise questions for market participants trying to anticipate a post-conservatorship secondary mortgage market, should the incoming Biden administration’s FHFA go through with the GSEs’ exit from governmental control. Three stand out.

First, market participants are concerned with FHFA’s and FSOC’s intentions with credit risk transfer (CRT), a critical housing finance reform made in conservatorship. By selling credit risk to investors, CRT diversifies the sources of private capital and broadens the universe of investors that absorb credit losses. CRT investors monitor and assess mortgage credit risk so the financial system is not solely reliant upon the risk management judgments of the GSEs. Further, CRT permits pricing transparency previously absent in the GSE market.

CRT should reduce the GSEs’ required risk-based capital since the risk is transferred away, with CRT investors providing the capital backstopping the transferred credit risk. Yet, FHFA’s proposal provides meager capital reduction for CRT. If capital relief is limited, the overall cost of capital — equity plus CRT — would increase, thereby removing the incentive for CRT.

Since FSOC’s duty is identifying and reducing systemic risk, FSOC should be a strong CRT proponent. Indeed, Treasury Secretary Mnuchin and Fed Chairman Jerome Powell repeatedly have supported CRT as an effective means to transfer risk from the GSEs.

Surprisingly, FSOC makes no mention of CRT in its formal statement. Surely this panel of regulators understands that FHFA’s proposed rule would render CRT ineffective and that, without CRT, the market would revert to the previous concentration of risk in and opacity of pricing by the GSEs.

FSOC doesn’t address FHFA’s reservations with CRT, as expressed in the proposed rule, where FHFA notes CRT’s limitations compared to common equity. Yet, Fannie Mae’s and Freddie Mac’s failure in 2008 arose from their underpricing and under-estimating credit risk, combined with insufficient capital. They retained almost all credit risk on nearly $5 trillion of mortgages. CRT, like the reinsurance market, uses market mechanisms to distribute rather than warehouse credit risk.

FHFA has the authority to correct shortcomings it sees with CRT structures used today, if any. If it sees problems with CRT, it should make them clear and work with market participants to find solutions. FHFA’s and FSOC’s goal should be prudent levels of both equity capital and CRT. This would enable the Enterprises to benefit from the unique loss absorbing and risk mitigating features of both while reducing the cost and increasing the efficiency of capital.

In sum, CRT can reduce both systemic risk and the amount of common equity to be raised while expanding the investor base focused on mortgage credit risk. It should also lower the GSEs’ overall cost of capital, thereby lowering mortgage rates for homebuyers.

Second, FSOC’s statements on the leverage requirement sent mixed signals. Consistent with current bank capital policy, FSOC poses that the leverage requirement should be a “credible backstop” to the risk-based requirements. Yet FSOC also noted that the final leverage and risk-based requirements should not be “materially less than those contemplated by the proposed rule.”

The conflict arises because leverage is the binding, not backstop, capital requirement in FHFA’s proposal. Such a result creates adverse incentives for risk-taking. Solutions could include aligning the leverage capital buffer — an add-on component of the requirement — more with the bank framework or allowing CRT to count toward the buffer.

Finally, FSOC notes that the risk-based capital charge for mortgage credit risk in the FHFA proposal is lower than banks face, creating an advantage for the GSEs that “could maintain significant concentration of risk with the enterprises.” This leads FSOC to “encourage FHFA and other regulatory agencies to coordinate and take other appropriate action …”

Should market participants conclude that FHFA, across two very different directors and after extensive modeling of mortgage credit risk, is underestimating mortgage credit risk? Or are the current bank risk-based capital requirements excessive? Does this portend an increase in the GSEs’ risk-based requirements relative to the proposal?

The Treasury’s 2019 report on housing finance reform stressed that “similar credit risks generally should have similar credit risk capital charges across market participants.” The Housing Policy Council agrees, and bank regulators and the FHFA should seek parity in the treatment of mortgage credit risk.

Here again, FSOC’s statement identifies a key uncertainty that needs to be resolved by FHFA and other FSOC members.

Edward DeMarco is president of the Housing Policy Council and former Acting Director of the Federal Housing Finance Agency where he initiated the Credit Risk Transfer program.