Capital Requirements

H.R. 1427 gives the regulator new authority to adjust the existing minimum capital leverage ratios for the both the GSEs and the FHLBs.

Our Position

As in the early 1990s, we are at a transition time. The recent downturn in the housing market has led to a drop in home values in many markets across the U.S., has sliced a percentage point from annualized GDP growth over the last three quarters, and will slow expansion during the first part of the year as well. Mortgage delinquency rates are up at banks and savings institutions, and subprime servicers have experienced a sharp deterioration in loan performance over the past year. The latest Federal Reserve survey of senior loan officers at major banks found that, on net, home mortgage credit underwriting had tightened over the last quarter of 2006.

One reason Freddie Mac and Fannie Mae were created was to mitigate the impacts on the housing finance system of a transition like the one we are experiencing right now. Freddie Mac and Fannie Mae perform this role through every recession and each downturn in the residential housing market.

We can only serve this function if we have the capital (and operational flexibility) to respond quickly to market transitions. For example, if regulators require us to hold capital in excess of our actual risks, we may not have the financial base that allows us to inject liquidity into the marketplace by buying and holding mortgages. We should be careful not to damage GSE business model, especially at a time when GSEs may be needed to sustain the world's most liquid and successful housing finance system.

Background

Freddie Mac has always been more than adequately capitalized under both the risk-based and minimum capital ratios – for us, the more stringent of the two – established under current law. As the graph below clearly illustrates, before OFHEO's imposition of the current 30 percent add-on for operational risk, we held a surplus over regulatory minimums, and as of September 30, 2006 held a $3 billion cushion over the OFHEO mandatory target surplus.

This is real, permanent, at-risk capital that provides the first line of defense in the unlikely event of a financial catastrophe at Freddie Mac. Since shareholders are the ones providing the capital, they – and not the taxpayers – will be the ones to bear the losses. Shareholders expect an adequate return on their investments in exchange for putting their money on the line, but like any other investor, they buy our stock at their own risk.

Regulatory capital adequacy
1 OFHEO will determine if minimum capital resubmissions are required. Source: Freddie Mac and OFHEO.

As a mortgage guarantor, it goes without saying that being adequately capitalized is a sine qua non of our business. But we fundamentally believe that our mission as a GSE depends on capital requirements that are tied to the actual risks of our business. Under our charter, we can deal solely in mortgages. This business gives rise to three basic risks: mortgage credit risk, interest-rate and other market risks, and operational risks. We should be required to hold capital against those risks to ensure that we can weather unexpected losses without requiring so much capital that we become inefficient and uncompetitive.

Some critics would like us to have much higher capital. For example, some argue our capital should mirror bank capital. As a general matter, all financial institutions should hold comparable capital against comparable assets, but as institutions, banks hold a wider array of assets and have very different risk profiles than the GSEs. Others want us to hold capital against a doomsday scenario, based on the view that we present a unique systemic risk to the global financial system. Either would create a capital regime divorced from risks we actually present, and are thus inherently arbitrary and speculative. Most importantly, raising GSE capital apart from their actual risks would make it much harder for us to meet our mission of ensuring liquidity, stability and affordability without adding meaningfully to our financial safety and soundness.

Requiring capital above and beyond actual risks also can have very real and very serious market effects. Consider the painful effects that can ensue in a market in transition, for example, during the early 1990s credit crunch that particularly affected New England. As Richard Syron, Freddie Mac's Chairman and CEO, and former president of the Federal Reserve Bank of Boston, noted in his testimony before a House Subcommittee at the time, the drop in real estate prices triggered a substantial rise in nonperforming assets among lenders.¹¹

Ultimately, this led to a "capital crunch" that curtailed credit availability for all types of real estate lending save one: conforming residential loans. In contrast to the rising costs and declining availability of construction and development loans, commercial-property loans, jumbo mortgages and small business loans, the conforming home-mortgage market remained robust with conforming mortgage rates remaining on par with those in other markets.¹² The reason is because Freddie Mac and Fannie Mae were doing the job that Congress had set out for them: providing liquidity and responding appropriately to capital market trauma so as to mitigate economic shocks and, hence support a recovery.

As in the early 1990s, we are at one of these transition times right now. The recent downturn in the housing market has led to a drop in home values in many markets across the U.S. has sliced a percentage point from annualized GDP growth over the last three quarters, and will slow expansion during the first part of this year as well.¹³ Mortgage delinquency rates are up at banks and savings institutions, and subprime servicers have experienced a sharp deterioration in loan performance over the past year.¹⁴ Furthermore, the latest Federal Reserve survey of senior loan officers at major banks found that, on net, home mortgage credit underwriting had tightened over the last quarter of 2006.¹⁵

Freddie Mac and Fannie Mae perform this role through every recession and each downturn in the residential housing market. We provide stability to the housing sector by providing funds counter-cyclically to lenders. That means that at the point in the business cycle when economic activity is contracting, Freddie Mac and Fannie Mae increase their relative provision of funds to the mortgage market, and vice versa. In contrast, other mortgage investors make credit available pro-cyclically, such that fewer funds are available during a housing downturn. By acting counter to the business cycle, Freddie Mac and Fannie Mae reduce the depth of a housing recession and support credit flows during an expansion in an "as needed" basis.¹⁶

We can only serve this function if we have the capital (and operational flexibility) to respond quickly to market transitions.

¹¹ Richard F. Syron, Statement before the Subcommittee on Domestic Monetary policy of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, May 8, 1991, reprinted in "Are We Experiencing a Credit Crunch?", New England Economic Review, July/August 1991, pp. 3-10.

¹²Mortgage rate data compiled by HSH Associates show that mortgage rates on jumbo fixed-rate loans in the Boston metropolitan area averaged 0.2 percentage points above the national average jumbo rate during the fourth quarter of 1990, after a full year of falling real-estate values. In contrast, conforming rates in Boston averaged up to 0.1 percentage points below the national average each quarter of the recession.

¹³ Bureau of Economic Analysis News Release BEA 07-06, February 28, 2007, "Gross Domestic Product: Fourth Quarter 2006 (Preliminary)," Table 2, shows that the fall in residential fixed investment subtracted an average of 1 percentage point from real GDP growth over the second to fourth quarters of 2006.

¹⁴ The Federal Reserve Board's Charge-Off and Delinquency Rates on Loans and Leases at Commercial Banks shows that the 30-day delinquency rate on residential loans had risen to its highest level in nearly four years as of December 31, 2006, and charge-off rates to the highest level in nearly three years. Moody's Special Report, "Early Defaults Rise in Mortgage Securitizations," reports a large increase in subprime and Alt-A early-payment default rates during 2006 (January 18, 2007).

¹⁵ Federal Reserve Board, The January 2007 Senior Loan Officer Opinion Survey on Bank Lending Practices, reported that "On balance, about 15 percent of domestic banks reported that they had tightened credit standards on residential mortgage loans over the past three months, the highest net fraction posted since the early 1990s."

¹⁶ See two papers by Joe Peek and James A. Wilcox: "Secondary Mortgage Markets, GSEs, and the Changing Cyclicality of Mortgage Flows," ed. Andrew H. Chen, Research in Finance Volume 20, pp. 61-80, 2003; and "Housing, Credit Constraints, and Macro Stability: The Seconday Mortgage Market and Reduced Cyclicality of Residential Investment," American Economic Review, May 2006, pp. 135-140.