By Andrew A. Turner, J.D.
Are declining capital buffers leading to future bailouts of Fannie Mae and Freddie Mac? That concern and the consequences that it could lead to were the focus when Federal Housing Finance Agency Director Mel Watt discussed the FHFA’s work as regulator and conservator of the government-sponsored enterprises at the Bipartisan Policy Center.
The most serious risk arising from the FHFA’s protracted conservatorships of Fannie Mae and Freddie Mac is the GSEs’ lack of capital, Watt warned. Favoring legislative action before we reach a crisis, Watt expressed concern over the lack of “discussion of housing finance reform in any of the presidential campaigns.”
Fannie and Freddie are unable to build capital under the terms of the Preferred Stock Purchase Agreements (PSPAs) set up to provide financial support from the Treasury Department in 2008 when the GSEs went into conservatorship. As a result, the capital buffer available to absorb potential losses, which reduces the need for the GSEs to draw additional funding from the Treasury, is decreasing each year. Watt said that the GSEs “are now over halfway down a five-year path toward eliminating the buffer completely,” at the beginning of 2018.
Watt feared that a number of non-credit related factors—interest rate volatility; accounting treatment of derivatives; reduced income from the Enterprises’ declining retained portfolios; and the increasing volume of credit risk transfer transactions—could lead to a loss and result in a draw against the remaining Treasury commitments under the PSPAs. A disruption in the housing market or a period of economic distress could also lead to credit-related losses and trigger a draw.
Watt worried over possible ramifications of future draws of funds from the PSPA commitments. “First, and most importantly, future draws that chip away at the backing available by the Treasury Department under the PSPAs could undermine confidence in the housing finance market,” he said. A second concern would be a hasty legislative response. Noting high stakes for the housing finance market and for the economy, Watt cautioned, “conservatorship is not a desirable end state and that Congress needs to tackle the important work of housing finance reform.”
Another challenge posed by a continuing conservatorship, noted Watt, is Fannie Mae and Freddie Mac’s insulation from market forces that would normally dictate operations and business practices.
Planning amidst an uncertain future was the final challenge that he discussed. Commenting on the reinstatement of prior CEO compensation limits by Congress, Watt did not want to “debate the wisdom of the decision that Congress made” although he did point out that “it was an easy political decision.” However, with reliance on a highly specialized and technically skilled workforce, Watt acknowledged that “retaining skilled employees will be an increasing challenge.”
Industry viewpoints. National Community Reinvestment Coalition’s President and CEO John Taylor agreed with Watt that the Fannie and Freddie conservatorship is unsustainable and that action must be taken to recapitalize the GSEs. "With a capital buffer declining to zero and with reduced income from the enterprises’ declining retained portfolios, the mission of the enterprises is in serious jeopardy," Taylor said.
A day before Watt’s speech, three national associations representing small mortgage lenders and community banks urged the FHFA to allow the GSEs to “build a capital buffer and avoid a Treasury draw under the GSEs’ Preferred Stock Purchase Agreements, out of a concern that the capital-deficient GSEs could further constrain credit to home buyers.” In their joint letter to Watt, the Community Home Lenders Association, Community Mortgage Lenders of America, and Independent Community Bankers of America recommended that the FHFA suspend the payment of dividends on the senior preferred stock held by the Treasury to “allow the GSEs to build a capital buffer to deal with potential earnings volatility driven by external economic developments rather than by actions or missteps by the GSEs.”
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