Recently, the Federal Housing Finance Agency (FHFA) published a proposal on the capital standards for the government-sponsored enterprises (GSEs), Fannie Mae and Freddie Mac. A new report by the Urban Institute examined the proposal with the focus on how well the rule aligned risk and capital across the various mortgage attributes and how the capital requirement varied across the business cycle.
"Even though the GSEs are in conservatorship, these capital standards are more than an academic exercise," the analysis authored by Edward Golding, Laurie Goodman, and Jun Zhu of the Urban Institute said. "The expectation is that the standards will be used to govern pricing for the duration of the GSEs’ conservatorship. And given the deep divisions in Congress, conservatorship could last a long time."
For the analysis, the researchers used Fannie Mae's loan-level credit data published as part of its credit risk transfer
(CRT) bond programs. They also used 30-year mortgages only (terms of 241 months or more) since that database includes loan age, loan purpose, loan type, property type, loan amount, performance history, original FICO score, original LTV ratio, original debt-to-income (DTI) ratio, and geographic information at the three-digit zip code level.
After calculating the base credit risk requirement for each loan, the researchers adjusted this number to account for additional characteristics, defined as risk multipliers in the FHFA proposal. To account for credit enhancement through mortgage insurance (MI), they used origination LTV ratio and loan age to determine the credit enhancement, assuming cancellable MI with guide-level coverage.
The analysis focused on the credit risk component of the proposed capital standard as this is the largest single risk ($112 billion before credit risk transfers, $90.5 billion after) according to the FHFA, and, even after CRTs, accounts for about half the capital ($180.9 billion) required of the GSEs as of September 30, 2017.
After examining all these aspects, the researchers found that FHFA's capital proposal aligned capital with risks in many aspects. However, they found that the proposal was overly conservative for certain high-risk mortgages. "In particular, mortgages with low FICO scores, with mortgage insurance (high-LTV mortgages), and with layered risk are likely to result in too high a capital charge. These issues are further exacerbated by the requirement’s procyclical nature," the researchers pointed out.
As a result, the analysis found that for high-risk mortgages, especially products used by first-time homebuyers and for many low- and moderate-income households, the proposal over penalized risk allocating more capital than the data would support. It also concluded that the standard was procyclical, with capital standards either doubling or halving in a two-year period.
Read the full analysis and detailed methodology here.