The two government-sponsored enterprises represent a giant moral hazard to taxpayers.
In 2008, the federal government bailed out and took control of Fannie Mae and Freddie Mac, the two flawed government-sponsored enterprises whose practices in the secondary mortgage market contributed to the financial crisis. What was supposed to be a temporary patch during a financial crisis has metastasized into almost 12 years of inaction with taxpayers still on the hook for trillions of dollars worth of risky mortgages. Congress has yet to enact any significant housing overhaul, but a newly-proposed rule could be the first step to putting an end to the government's conservatorship of the troubled GSEs.
The Federal Housing Finance Agency—the GSEs’ regulator—proposed a rule that calls for Fannie and Freddie to hold a certain level of capital once returned to private ownership. It’s a forward looking proposal that doesn’t impact the GSEs’ position today, but does provide important guideposts on what might be required for them to operate in a post-conservatorship housing finance system, whatever exact form Fannie and Freddie might take.
If finalized, the proposed rule requires Fannie and Freddie to hold about $240 billion in capital between them, or 3.85 percent of their assets. This is a significant increase from FHFA’s 2018 capital rule, which set the capital requirement at $180 billion and 2.25 percent of assets. The better leverage ratio and frontline private capital is good news for people worried about mitigating taxpayer risk. In the cyclical housing market, having more capital will enable the GSEs to withstand significant losses and avoid another taxpayer-funded bailout and a repeat of conservatorship.
And as we all know, in the lead-up to the financial crisis Fannie and Freddie were severely undercapitalized. This, coupled with taking on subprime mortgage debt, was a recipe for multiple taxpayer-funded cash infusions.
Despite all these years in conservatorship, the GSEs remain thinly capitalized, back half of all newly created mortgages, and guarantee $6.5 trillion in U.S. mortgages. Up until the end of 2019, the GSEs only held $6 billion in reserve capital, a leverage ratio of 1,000 to 1. In fact, since they held such little capital, they required a cash infusion from the U.S. Treasury in January 2018. Thankfully, under the leadership of Mark Calabria, the GSEs’ capital reserve has grown substantially—now at a combined $23 billion. While not entirely sound, it’s a step in the right direction. On a positive note, that leverage ratio has dropped from 1,000 to 1, to 250 to 1. However, even the latter figure remains 20 times higher than the average bank leverage rate.
GSEs cannot be governed and operated exactly like banks. But when it comes to safety and soundness, Fannie and Freddie ought to at least emulate some banklike capital requirements. And if finalized, Director Calabria’s rule will require them to do so.
Fannie and Freddie continue to represent a giant moral hazard. It’s long past time that they retain enough capital to mitigate this moral hazard to taxpayers and the federal government. Currently inadequate GSE capital levels, combined with recent developments on potentially risky alternative credit scoring models, expansive pilot programs, and questionable oversight, create a significant prospect for a future taxpayer-funded bailout. So, to protect taxpayers, it’s not only important that mortgage rates accurately reflect the level of risk, but also that stronger capital serves to backstop the GSEs’ balance sheet.
Thoughtful people can and should discuss the exact parameters of the rule during public comments, including appropriate levels, timing, and other transition concerns. But it’s precisely because of FHFA’s commendable action that such a discussion can now take place in a constructive way.
Of course, mandating high quantity and quality of capital is not the be-all-end-all in protecting taxpayers. The other half of the solution must come from Congressionally-passed reform to how the GSEs operate, types of mortgages they back, and the dollar amount of loans they’ll guarantee. The prospects of any meaningful reform remain dim given the fact that Congress is divided and it’s an election year but hopefully FHFA’s action will restart the conversation toward a long-term solution that will answer these questions. Until then, imposing stricter capital requirements is a strong step in the right direction.
Actions like the updated capital rule demonstrate a core conviction of the Trump administration: smart, well-balanced regulation is good for the American people, economy, and taxpayers. As Congress fumbles to enact meaningful reform to these two housing behemoths, FHFA has given hope to American taxpayers.
Thomas Aiello is a policy and government affairs manager with the National Taxpayers Union, a nonprofit dedicated to advocating for American taxpayers at all levels of government.