Will GSEs' record-high capital requirements scare investors away?
WASHINGTON — As soon as the Federal Housing Finance Agency re-proposed a capital framework for Fannie Mae and Freddie Mac, some observers warned that potential investors could be scared off by the high amount of loss protection the companies would have to hold.
But others are suggesting that may be an overreaction.
The proposed target of over $230 billion in combined risk-based capital for the two government-sponsored enterprises is more than 70% higher than the amount proposed in a previous plan under former FHFA Director Mel Watt.
But the reality of the new proposal is much more nuanced. Under the new framework, Fannie and Freddie would be required to hold $135.1 billion in core regulatory capital, plus an additional $98.8 billion in three supplemental capital buffers.
Some experts theorize that the FHFA may deploy options that would allow Fannie and Freddie to technically leave conservatorship before reaching the new capital target. And while the proposal would require the GSEs to hold the additional buffers before paying dividends, the agency could show flexibility on their making capital distributions.
“Whether or not [the GSEs] have to have that capital day one of being out of conservatorship or year three is a question they ultimately need to answer and haven't yet,” said Karen Petrou, a managing partner at Federal Financial Analytics.
Determining the right amount of capital for Fannie Mae and Freddie Mac has always been about striking a balance between a figure low enough to attract investors and maintain access to credit, and high enough to avoid another government bailout.
FHFA Director Mark Calabria has said previously the agency’s capital rule would give investors a clear idea of what will be required once the two companies return to the private market. For a successful offering the agency needs shareholders to invest potentially record-high amounts of money.
“Nobody will invest in anything unless they understand how much capital a company is required to hold because that determines ultimately the return on equity the investor wants to price,” Petrou said.
But some wondered after the FHFA debuted its new proposal on Wednesday whether the high figure would actually ward off investors. Currently, the GSEs have about $24 billion in capital, and Calabria has said it would likely take the companies more than a decade to work up to the capital level needed to exit conservatorship based on retained earnings alone.
“We have earlier argued that higher capital requirements relative to what was required under the 2018 proposed capital rule would make it more challenging for the GSEs to raise external capital,” Bose George, a managing director at Keefe, Bruyette & Woods, said in a research note. The higher capital requirements would reduce an investor’s return on equity to about 8%, George added.
Yet others have noted a number of methods the FHFA could deploy to bridge the gap between conservatorship and the level of capital needed for privatization, including the possibility of the FHFA using consent decrees to allow Fannie and Freddie to technically exit government control, while also implementing additional safeguards to ensure the GSEs raise the capital needed to completely operate in private hands.
And although the proposal importantly would require Fannie and Freddie to hold additional a stress capital buffer, stability buffer and countercyclical capital buffer in order to pay dividends and award bonuses, the FHFA would also have the ability to let the GSEs make capital distributions or pay bonuses upon request if it “would not be contrary … to the safety and soundness of the enterprise.”
“The penalty for being below the buffer thresholds is manageable: a prohibition on capital distributions and unplanned bonuses that can be lifted at the the FHFA’s discretion,” said Isaac Boltansky, a policy analyst at Compass Point.
The proposal includes a chart describing the maximum payout ratio that Fannie and Freddie can make under certain circumstances, and the only scenario in which they would be completely restricted from making payouts would be if they held less than 25% of the amounts required for each of the three supplemental capital buffers.
Still, investors could end up pricing in an additional internal buffer that Fannie and Freddie might deploy themselves to ensure that they would be able to pay dividends and bonuses, no matter what.
“If you're managing one of these enterprises and you know that if you get below the buffer, you get restrictions on ability to pay dividends and restrictions on bonuses, management is going to hold a buffer above those buffers, because they're not going to want those restrictions on their ability to pay their employees or reward their shareholders,” said Mike Fratantoni, chief economist at the Mortgage Bankers Association.
Deeksha Gupta, an assistant professor of finance at Carnegie Mellon University, agreed that a management buffer might be an important consideration for investors.
“I definitely think that investors will price in that possibility,” she said. “It's either they have to have a certain capital buffer or they're going to have restrictions on dividend payments and whatnot.”
However, Petrou said that for years, investors in global systemically important banks have been operating under the same knowledge that capital distributions could be suspended if a bank were to dip below required capital buffers on the Federal Reserve’s annual Comprehensive Capital Analysis and Review stress tests.
“I think we need to look at the G-SIB model, and we see the same thing there where the CCAR stress testing is exactly the same thing,” she said. “We've been doing this since 2009, in which once a year investors know that their dividends and capital distributions are at risk, and they price for that.”
It also remains to be seen whether the Financial Stability Oversight Council might designate Fannie and Freddie as systemically important financial institutions. That label comes with additional Fed scrutiny and higher capital requirements.
Calabria, who is a voting member of the FSOC, has said that it would be appropriate for the council to discuss whether the GSEs should be designated. While the oversight council has shifted to an activities-based designation, which likely would make it more challenging to designate Fannie and Freddie as SIFIs, that approach could change should political power switch hands after the November presidential election.
“I think some of the buildup of the buffers here sure looks like that's in anticipation of whether it's a SIFI designation or just sort of universal recognition that they are SIFIs regardless of whether the designation happens or not," said Fratantoni. “And so that level of going-concern buffer and countercyclical buffer are appropriate, given their place in the markets.”
Whatever the case, most experts agree that the proposed framework would to some extent cut down on regulatory arbitrage and put the GSEs on a more similar playing field in terms of capital requirements.
“Going towards higher capital requirements should help curb the kind of the riskiest lending that we saw, which many people attribute to having partially caused or worsened the 2008 housing collapse,” said Gupta.
Putting Fannie and Freddie on the same capital level as banks capital-wise makes sense, said Fratantoni.
“The one goal would be, from a system perspective, that essentially the same credit risks should require the same capital, whether it's at a bank, at a GSE, elsewhere in the system, so that investors are making decisions about whether to hold that risk based upon sort of their capabilities, not on a regulatory arbitrage,” he said.