Fannie Mae-No Politics (FNMA)

[mhill_fin]

"assertion ignores fundamental difference in business models"

https://howardonmortgagefinance.com/2016/09/07/a-solution-in-search-of-a-problem/

FHFA is in a perfect position to take the lead on this initiative, by running an honest stress test of the companies’ business by risk category. But to date Treasury has not permitted FHFA to do that, I believe because it knows that if Fannie and Freddie were given an updated and legitimate risk-based capital standard, Treasury and others would lose the ability to pretend that the companies need so much capital to operate safely that it is in everyone’s best interest to replace them.

This issue is so important to opponents of Fannie and Freddie that new attempts to muddle their capital situation continue to crop up. Most recent is the claim that because banks with more than $50 billion in assets must hold capital equal to 5 percent of their risk-weighted assets (about 3.5 percent of their total assets) after having absorbed losses from their Dodd-Frank stress test, Fannie and Freddie should be required to hold an equally large capital cushion after their stress tests have been run. But this assertion ignores a fundamental difference in the business models of banks versus Fannie and Freddie, as well as the experience of both sets of parties during the financial crisis.

What caused the near-failure of the banking system in 2008 was not that banks’ credit losses exceeded the amount of capital they had; it was the fact that at some banks—particularly the larger ones—losses rose so much so quickly that borrowers withdrew non-insured deposits and many investors refused to roll over short-term funds placed in those banks. Without the trillions of dollars made available by the Fed and the Treasury (on very favorable terms), the affected banks would have been forced to sell large amounts of assets at depressed prices, and that would have wiped out their capital. Banks are highly leveraged institutions, and in addition to non-insured deposits a typical bank has between 10 and 15 percent of its assets in short-term purchased funds. Both can flee quickly in times of stress. It is precisely to retain the confidence of non-insured depositors and investors who provide “hot” money that the Fed requires the banks it subjects to the Dodd-Frank stress tests to pass them with such a considerable margin of safety.

Credit guarantors such as Fannie or Freddie are in a completely different position. They have neither deposits nor hot money on their balance sheets subject to runs. (The short-term debt Fannie and Freddie have is associated with their portfolio businesses, which have had and should continue to have capital requirements different and separate from the credit guaranty business). And when large numbers of their mortgages do fail, it happens relatively slowly. Unlike a bank, if a credit guarantor has enough capital to cover its losses during a stress environment, it can stay in business. We saw that during the financial crisis, when Fannie and Freddie were able to remain profitable on an operating basis (that is, excluding the non-cash expenses added by FHFA) even after the spikes in their credit losses.

In contrast to the arguments for excessive Fannie and Freddie capital requirements, the problems with the credit box are real. They are based on economics, and their resolution will depend on politics. Advocates for replacing Fannie and Freddie with mechanisms they favor will continue to cite stress tests padded with non-cash expenses, and liquidity cushions with no rationale in practice, as the basis for capital requirements that make the companies’ credit guarantees noncompetitive. Yet if policymakers fall prey to these ploys—and either replace Fannie and Freddie with a less efficient secondary market mechanism or force them to hold capital unrelated to the risks of mortgages they guarantee—we won’t solve our credit box problem. Instead, we’ll end up with a “reformed” mortgage system in which some financial institutions are more profitable, but large segments of the home-buying population remain underserved, and all segments pay more for their loans than they should. It’s a simple choice: we can solve the real mortgage problem, or one that’s been made up.