The term "systemic risk" has come a long way. Several years ago it was the "s-word" in congressional hearings. Today, it is de rigueur. Back then, I testified that Fannie Mae and Freddie Mac posed serious systemic risks to the U.S. and global economy. This observation was not popular.
I also stated that, as the safety and soundness regulator of those institutions, my agency had a responsibility to reduce the systemic risk that Fannie Mae and Freddie Mac posed to the financial markets but that we needed more tools to do so. In particular, as I testified repeatedly, they did not have enough capital — not nearly enough.
One year ago, Congress agreed and passed the Housing and Economic Recovery Act, or HERA, signed by President Bush July 30, 2008. Unfortunately, the creation of the Federal Housing Finance Agency, or FHFA, in 2008 came too late.
The outmoded capital standards of the pre-HERA law allowed mortgage credit risk leverage of more than 200-to-1 and market risk leverage of almost 50-to-1. Under that standard, Fannie Mae and Freddie Mac were considered "adequately capitalized." Even with our additional 30% capital requirement resulting from the companies' accounting misdeeds, the past year has demonstrated how grossly inadequate were the old capital rules. The combination of weak capital rules and large, subsidized market shares was a systemic event waiting to happen.
Fannie Mae and Freddie Mac did not create the housing price bubble (they lost significant market share as the bubble grew), but their actions were procyclical, further inflating the bubble despite our regulatory efforts to pull them back. In pursuit of market share, higher profits and fulfillment of affordable housing goals, Fannie Mae and Freddie Mac reduced their mortgage credit standards and invested heavily in AAA-rated securities backed by subprime and alt-A mortgages.
As the market began to seize up last summer, Fannie and Freddie's key mission of bringing stability to the mortgage market was endangered. I believe mortgage market stability can best be achieved if automatic stabilizers are built into the system by developing countercyclical practices. Since it is difficult to convince people during a bubble that they are facing significant systemic risk, we need to hard-wire into our regulatory framework mechanisms to dampen those risks.
Three primary reasons exist to shift our regulatory framework toward countercyclical policies: First, to curb asset price bubbles and dampen credit cycles; second, to improve the odds that an institution can survive a crisis, and third, to reduce actions by distressed financial institutions that hurt the broader economy. Often, a financial institution in distress will seek to sell off assets and reduce risk exposures. These actions can become "fire sales" that compound credit crunches and reduce the availability of credit to sound borrowers, choking off economic activity. We need policies that strengthen the ability of financial institutions to withstand distress by encouraging or requiring them to build up capital reserves in good times instead of having to rebuild capital in bad times.
At FHFA, under our new regulatory powers, we are exploring countercyclical policies that could strengthen the institutions we regulate — including the Federal Home Loan banks — reduce systemic risk and help them better withstand stressful times. Such policies include cyclically-varying minimum capital requirements, provisions for loan losses, retained earnings levels, liquidity requirements and pricing for credit guarantees.
For example, the accompanying chart shows that house prices were below the long-run (1975-2002) trend for much of the 1990s but then moved rapidly above the trend beginning in 2002. Increasing capital requirements as house prices exceeded trend would have helped financial institutions withstand the dramatic fall in house prices that began in 2006; institutions would have built up capital to withstand losses. Potentially, these losses may have been smaller if higher capital requirements had reduced risky lending.
Other policies could automatically recapitalize financial institutions. One possibility would be to require firms to issue contingent capital notes — a form of debt that would automatically be converted to common equity when a specified capital level is breached. Another possibility would be to require firms to buy insurance against catastrophic losses. The GSEs, for instance, could have helped prefund their extraordinary losses if a government catastrophic insurance fund were available. Such countercyclical capital approaches could improve the ability of individual financial institutions to survive credit losses associated with falling house prices, could limit the formation of house price bubbles and could lessen the contraction of mortgage credit as house prices fall.
Though the institutions that FHFA regulates — Fannie Mae, Freddie Mac and the Federal Home Loan banks — hold $6.7 trillion of assets, such policies must be developed and carried out in conjunction with other regulators in order to really improve financial stability. Adopting the Obama administration's proposal to create a Financial Services Oversight Council to monitor systemic risk would be a good step in that direction.
Finally, though the financial regulatory community can do much to promote sound financial institutions, boards of directors and executives must understand that their most important fiduciary responsibility is ensuring the institution's long-term viability and stability, not short-term profitability. To head off systemic risks, they, too, need to think countercyclically.