Option ARMageddon » Blog Archive » Lowering Capital Requirements for Fan and Fred….

Lowering Capital Requirements for Fan and Fred….

March 20, 2008 – 8:12 am

Can’t say I support this move. Seems a bit short-sighted to add MORE debt to Fannie’s and Freddie’s balance sheets. We’re simply encouraging them to throw more good money after bad in a quixotic attempt to keep house prices from falling any farther. And taxpayers remain on the hook if either or both of these companies–levered 50:1–end up in bankruptcy.

Fan and Fred say they are going to raise additional capital as part of this move. But that shouldn’t inspire confidence. What’s happening here is the companies’ regulator, the Office of Federal Housing Enterprise Oversight, is allowing them to carry less capital RELATIVE to the mortgages they purchase or guarantee.

The plan involves a reduction in capital requirements for the companies and a promise by them that they will each raise several billion dollars of capital this year, likely through a sale of preferred shares, according to several people familiar with the situation. As a result, they are expected to be able to provide additional funding of as much as $200 billion for home mortgages and related securities.

…..

Ofheo for the past several years has required Fannie and Freddie to hold 30% more capital than their usual minimum while they have worked to resolve lapses in their accounting and internal-risk controls, a process now viewed as largely complete. Ofheo is expected to reduce that capital “surcharge” initially to 20%.

…..
The move should reduce Freddie’s capital requirement by about $2.6 billion and Fannie’s by $3.2 billion. The companies have indicated that they are prepared to raise similar amounts in new capital, though the timing and exact size of those transactions depend on market conditions, according to people familiar with the agreement.

Currently, the two have purchased or guaranteed well over $4 trillion of mortgages, including hundreds of billions of subprime/Alt A/high LTV. And they have approx. $80b of capital between them as a backstop against losses. A 15% fall in the value of mortgages in their “high-risk” portfolios would by itself be enough to wipe out their capital. Nevermind that in a world of falling house prices, even “prime” creditors often have an incentive to walk away.

So while we’re waiting for Fan and Fred to “raise new capital” the two behemoths will be allowed to back another $200 billion worth of mortgages, including jumbos up to a price of $729k in bubbly areas like California.

For the moment, this move isn’t costing taxpayers anything. But the more mortgages Fan and Fred are allowed to back, the larger the bill for taxpayers when they fail.

But say they don’t fail. Maybe we get through the present housing crisis without much more damage. My question is: at what cost? The various “emergency” moves meant to prop up house prices are bailouts that simply shift more risk TO taxpayers without any additional regulation to PROTECT taxpayers.

Frankly, I think Fan and Fred should be abolished. The government has no business subsidizing housing for those that can afford it.

But since they do exist, since their quasi-public status means taxpayers share the risk of declining house prices along with Fan/Fred shareholders, then taxpayers should also share in the returns. But they don’t. To start with, Fan’s and Fred’s shareholders own 100% of the companies’ profits. And as AEI’s Peter Wallison points out on the WSJ op-ed page today, the two don’t even act as a stabilizing force for housing. In fact, they are procyclical: shoving more capital into housing when times are good and, because they exist to serve shareholders, withholding capital from housing when times are bad.

The solution here isn’t to lever up and pour more capital into housing. The solution is to reduce the size of their balance sheets as a prelude to outright privatization. Taxpayers have enough to pay for, they shouldn’t be providing insurance to buyers of mortgage-backed securities.

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And while we’re on the subject of taxpayers bearing risk without receiving adequate protections, we have exhibit B….the Fed’s new “Term Securities Lending Facility.”

–In the wake of the Bear Stearns failure, which itself was NOT a bailout, the TSLF allows investment banks to put their toxic mortgage securities onto the Fed’s balance sheet in exchange for treasuries. This is yet another example of public resources protecting private balance sheets.

Some observers even see these loans as pseudo-equity. After all, if the investment banks encounter serious enough trouble that the loans are at risk, does anyone think the Fed will pull the plug by refusing to roll over the loans? Meanwhile, the investment banks haven’t been asked to submit to regulations that would protect the Fed (i.e. taxpayers). But don’t take my word for it: