A High Standard for Mortgage Agencies

By a vote of 412 to 8, the House of Representatives on Sept. 25 passed H.R. 2900, a bill that establishes a tough risk-based capital standard for the Federal National Mortgage Corp. and the Federal Home Loan Mortgage Corp.

On Oct. 7 in this space, Rep. Jim Leach, R-Iowa, one of the eight congressmen who voted against the bill and the only banking committee member to vote against it in committee, repeated assertions he made in opposing the legislation.

I wish to respond to those assertions and show that H.R. 2900 is a well-conceived approach to setting capital standards.

Fannie's Leverage Declined

Before discussing the capital requirements, I must correct some misconceptions.

First, Fannie Mae and Freddie Mac have not grown since 1985 by becoming highly leveraged. In fact, Fannie Mae's leverage declined by more than a third in that period, while assets and obligations tripled. Also, the company more than tripled its loss reserve; this was a self-imposed decision.

Second, Fannie Mae and Freddie Mac do not control "90% of the market." The two companies together purchased or securitized about 55% of the conventional, conforming loans originated in 1990.

Finally, Fannie Mae and Freddie Mac do not receive "the equivalent of $2 billion to $4 billion in annual taxpayer subsidy." Studies by both the Office found that the subsidies in question go to homebuyers in the from of lower interest rates, not to the companies.

The capital requirements in H.R. 2900 have also been misinterpreted. The bill has three capital standards, and the corporations must meet the highest of them to avoid sanctions, many of which are severe. The minimum capital standard and the critical capital standard are both equity-only leverage ratios.

Contrary to Rep. Leach's assertion, no loss reserves can be counted. If either company falls below the critical level, it must be put into conservatorship. If either falls below the minimum, the Department of Housing and Urban Development will virtually run the company.

That's a good definition of minimum capital, not maximum capital. And the ultimate (not transitional) minimum capital level was proposed by the U.S. Treasury, not the enterprises. It is effective 18 months after enactment, not three years, as Mr. Leach states.

But the most innovative feature of H.R. 2900's capital standard is not even mentioned by the congressman - the extremely tough, state-of-the art, risk-based capital standard.

Survival Test

The standard, which the companies must meet within three years, requires that each company hold sufficient capital (including loss reserves) to survive, for a full 10 years, the simultaneous occurrence of:

* The worst credit loss experience in any region for any two or more consecutive mortgage origination years.

* An environment in which interest rates increase or decrease by up to 50% (to a maximum of 600 basis points in each direction) over one year and stay at that level for nine more years.

That's about three to four times the companies' loan-loss experience in the 1980s, combined with an interest rate scenario worse than any that has occurred in the past 100 years.

Since the test is rerun each quarter on the basis of new interest rates, the companies will be required immediately to hold capital to cover rate changes that may well be outside the original 1,200-basis-point band.

We have estimated that H.R. 2900's capital standard would require a company holding fixed-rate single-family mortgages funded in part by long-term debt and currently earning 100 basis points on the portfolio after expenses to hold more than 9% of its assets in capital. This is more than double the level now required of thrifts and banks.

In addition, H.R. 2900's credit risk standards direct the regulator to set capital requirements taking into account whether single-family residential loans are self-amortizing, whether they are fixed rate or adjustables, and their term. Bank and thrift capital requirements do not deal with these issues.

H.R. 2900's standards, far from representing a tilt in favor of Fannie Mae and Freddie Mac in comparison with thrifts and banks, are the toughest in terms of requiring capital commensurate with risk.

Mr. Johnson is chairman of the Federal National Mortgage Association, Washington.

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