Last week the Urban Institute released a report blasting the new Federal Housing Finance Agency (FHFA) capital rule as “a step backward.” That conclusion is the polar opposite of mine, which characterized the new FHFA capital rule as a great first step toward financial sanity.

The Urban report, coauthored by Jim Parrott, Bob Ryan and Mark Zandi, notes that the FHFA’s task of developing a capital framework for Fannie Mae and Freddie Mac “is not about picking a single number, but creating a set of requirements and incentives for the GSEs that ultimately leads to a more stable housing finance system.”

Given that each of these authors is on record supporting full government ownership of the secondary mortgage market, it is difficult to take this critique at face value. One of their main complaints with the new FHFA rule makes it even less convincing:

As private institutions, the GSEs would need to hold a bit more capital than they do in  conservatorship to ensure they do not run afoul of their regulatory requirements, and their cost of debt would increase, as they would no longer be able to borrow at close to the low cost of the U.S. Treasury.

This supposed bug is actually a feature – it is exactly why the new FHFA rule is a step in the right direction. No private company should be able to borrow at the same low cost of the U.S. Treasury.

This scheme arises out of special privileges that lead directly to financial instability. It ensures that some investors will gain at the expense of others, leading to more special interests lobbying to preserve their profit streams. It is crony capitalism on steroids.

All the typical American has to show for the GSE system is excessive debt, high housing costs, volatile home prices, overregulation, and a trail of federal bailouts. Meanwhile, the homeownership rate is almost exactly where it was prior to the GSE system; home price appreciation has consistently outpaced income growth, and taxpayers have been forced to shell out hundreds of billions of dollars in bailouts.

It was not a private system that collapsed in 2008. It was a government-backed system that collapsed because of excessive government backing.

Parrott and his coauthors (among many others in Washington, D.C., and Wall Street) want Congress to double down and expand federal involvement in housing finance, securing even more explicit guarantees for investors. But one of their critiques of the FHFA capital rule, above all others, exposes the rich irony that exists on this side of the housing finance debates.

Their report praises the GSEs’ “aggressive use of the credit risk transfer market to off-load their credit risk to private investors,” and then criticizes the FHFA capital rule because it “will change this, reducing significantly the GSEs’ incentive to off-load their credit risk.”

So the authors would have us believe that the private market can’t possibly handle funding the mortgage market, but that the GSEs have spent the last few years transferring most of their credit risk to private investors. That’s rather interesting.

It gets even richer after sorting out some details of the credit risk transfer (CRT) market.

First, CRTs are debt securities. They are structured deals that come with many moving parts, but they still amount to nothing more than bonds. These particular bonds are tied to pools of mortgages and, in theory, the bondholders take losses when the underlying loans default.

In reality, though, many of the CRT bondholders can lose only if there is a catastrophic event along the lines of what happened in 2008. For some CRT bonds, U.S. home prices would have to drop even more than they did in the 2008 crash for the investors to lose.

Regardless, the fact that the GSEs are issuing more debt means that they are taking on more risk. If the companies get into financial trouble, for any reason, they will be on the hook for larger financial obligations than if they had, instead, issued more equity. The situation would only be worse if there is a major crisis and they have a higher debt/equity ratio – it’s no secret that the lack of loss absorbing equity capital was one reason the GSEs were placed in conservatorship in 2008.

So it makes perfect sense that the new FHFA rule would recognize that more debt equals more risk, relative to equity. Throw in the fact that Fannie and Freddie actually own some of these CRT bonds, and it makes even more sense that the FHFA would require some kind of loss-absorbing capital for any risk that the GSEs retain through those CRTs.

Wisely, the new FHFA rule proposes adjustments for both of these reasons, ending up with a minimum risk-weight of 10 percent for any retained CRT exposures. (See pages 39330-39331.)

Under the original (2018) FHFA proposal, some of those retained CRT exposures would have had a risk weight of zero (again, see pages 39330-39331).

Another problem with CRTs is that they have never really been tested, especially in a major downturn. And if the 2008 crash taught the world anything, it is that novel-structured securities don’t always work the way they are supposed to work.

For this reason, among others, the Basel capital framework and U.S. banking regulators use a minimum risk weight for CRTs. It’s impossible to say if they have the number exactly right, but their approach – better safe than sorry – is entirely reasonable. (For a refresher on the unexpected problems with securitizations during the 2008 crash, all of which proved that structured financial products had not transferred as much risk as everyone thought, see page 47142, page 246, and pages 138-139.)

At the very least, it is perfectly rational to expect CRT investors to sue Fannie and Freddie if there is a major downturn and they don’t get their money. There was no shortage of finger pointing over who actually caused the 2008 crash, and it’s a safe bet that the CRT bondholders will blame the GSEs if they don’t pay up during the next crisis.

Still, Parrott and company would have everyone believe that CRTs can safely transfer all the credit risk to the private sector so there’s nothing to worry about.

A cynical veteran of Washington, D.C., might think that they are making this argument to convince Congress that a federal takeover of the secondary mortgage market won’t really put any risk on the federal balance sheet. It’s difficult to know.

Regardless, two things are crystal clear from the past decade of housing finance debates.

First, the last thing the world needs is another set of federally guaranteed securities for Wall Street investors and D.C. lawyers. Second, if Fannie and Freddie are going to exist, it is imperative that they operate with higher loss-absorbing equity capital.

The GSEs’ conservatorship has dragged on for more than a decade because hordes of vested interests can’t agree on how to slice up the profits earned by fleecing regular Americans. The only thing that the hordes seem to agree on is that someone else – anyone but them – should hold all the risk.

The newly proposed FHFA capital rule is a great first step toward making Fannie and Freddie shareholders accept some of the risk.

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