MBA Letter Offers Recommendations to FHFA Proposed Regulatory Capital Framework

The Mortgage Bankers Association, in a Nov. 23 letter to the Federal Housing Finance Agency, offered a series of recommendations to improve a proposed regulatory capital framework rule for Fannie Mae and Freddie Mac.

The letter comes in response to an amended September FHFA proposed rulemaking on further enhancements to the regulatory capital framework applicable to Fannie Mae and Freddie Mac. In comments to a previous rulemaking, MBA identified significant concerns with the regulatory capital framework proposed at the time, including: 1) the frequency with which the leverage ratio requirements, rather than the risk-based capital requirements, would serve as a binding capital constraint on the Enterprises; and 2) the punitive treatment of credit risk transfer mechanisms that would discourage the Enterprises from transferring credit risk to private investors in a meaningful manner.

In the Nov. 23 letter, MBA President & CEO Robert Broeksmit, CMB, said MBA welcomes FHFA’s efforts to address these concerns through targeted amendments to the Enterprises’ regulatory capital framework. “The changes to this rule, if finalized as proposed, will encourage the Enterprises to operate as prudent managers and distributors of mortgage credit risk while promoting both safety and soundness and broad access to sustainable credit for borrowers,” he wrote.

Here is a summary of key points in the letter:

Prescribed Leverage Buffer Amount

The letter notes the Enterprises must meet a threshold of at least 4 percent to avoid limits on capital distributions and discretionary bonus payments. As such, the effective minimum leverage ratio to which the Enterprises will guide their businesses is 4 percent. MBA said this 4 percent minimum leverage ratio exceeds all three risk-based capital ratio requirements for Freddie Mac and two out of three risk-based capital ratio requirements for Fannie Mae, and is problematic because a binding capital constraint that is risk-insensitive will encourage the Enterprises to seek higher-yielding, riskier assets in order to optimize their operations (from a capital perspective) and reduces incentives to engage in CRT – again encouraging a build-up of risk in the Enterprises’ portfolios.

“An appropriately calibrated leverage ratio, therefore, should serve as a credible backstop to the risk-based capital requirements rather than as the primary means for determining Enterprise capital levels,” MBA said. “The proposed framework appears to generate few scenarios in which the leverage ratio would serve as a binding capital constraint, but MBA recommends that FHFA and the Enterprises provide the historical data needed to affirm this point.”

Credit Risk Transfer

The proposed rule includes amendments to the existing framework that are intended to encourage continued use of CRT mechanisms by the Enterprises. FHFA proposes to reduce the prudential floor on the risk weights assigned to retained CRT exposures from 10 percent to 5 percent and eliminate the overall effectiveness adjustment applicable to retained CRT exposures. MBA said these amendments – in particular the reduction in the risk weight floor – should result in more appropriate treatment of CRT that generates the incentives needed for ongoing use by the Enterprises.

However, MBA said while FHFA correctly notes in the proposed rule that dollar-for-dollar capital relief is not appropriate for CRT due to counterparty, model and structural risks, the existing framework is far too punitive in the capital that is required for retained CRT exposures. Much of this overly conservative treatment is derived from the 10 percent risk weight floor assigned to these exposures.

“This requirement is far higher than necessary and dilutes the benefits that otherwise would encourage greater use of CRT by the Enterprises,” MBA said. “With a 10 percent risk weight floor, the cumulative capital required due to the credit risk associated with the retained CRT exposure often is greater than the cumulative capital required for the credit risk associated with the underlying loans or guarantees. By reducing the risk weight floor to 5 percent, the proposed rule addresses this concern and makes it much less likely that the risk weight floor far exceeds the actual credit risk of a given CRT tranche.”

Proposals to Address Procyclicality

MBA said it appreciates that FHFA continues to express its desire to include a multifamily countercyclical adjustment in the Enterprises’ capital framework and is seeking input on how that adjustment should be constructed. MBA said in addition to this work, FHFA should continue to monitor the performance of the single-family countercyclical adjustment.

MBA said it continues to see the need to include a multifamily countercyclical adjustment in the framework, recognizing that the approach used in the single-family portion of the framework does not translate appropriately to the Enterprises’ multifamily businesses. MBA recommends FHFA consider an approach that limits the capital impact of market declines in values and incomes until they breach the levels associated with the stress scenarios (-35 percent for values and -15 percent for income). Such an approach would operationalize the intent of the capital framework – building capital during market growth and relying on that capital during market declines.

The existing framework includes a countercyclical adjustment to the Enterprises’ single-family businesses that moderates the use of mark-to-market LTV ratios for purposes of minimum capital requirements. This adjustment is triggered when national home prices deviate more than 5 percent from the estimated long-term trend. MBA supports this provision of the framework, as it offsets the procyclicality associated with the use of mark-to-market LTV ratios (by limiting the decrease in minimum required capital during periods of rising home prices and the increase in minimum required capital during periods of falling home prices). But it said FHFA should monitor this development and continue to analyze whether any further fine-tuning is needed with respect to the single-family countercyclical adjustment.

Impact of Senior Preferred Stock Purchase Agreements

In the proposed rule, FHFA notes that the Senior Preferred Stock Purchase Agreements between the Treasury Department and each Enterprise include amended terms as of January 2021 that require the Enterprises to comply with the regulatory capital framework finalized in December 2020, “disregarding any subsequent amendment or other modifications to that rule.” FHFA further elaborates that any changes to this arrangement “will require agreement between the Treasury and FHFA…”

“While many of the January 2021 amendments to the PSPAs proved disruptive for the Enterprises, lenders, borrowers and stakeholders across the housing finance system, perhaps the most baffling provision was the requirement that the Enterprises abide by a point-in-time capital framework,” MBA said. “We are not aware of any other situation in which an agency explicitly has required a regulated entity to comply with a prior version of a rule despite amendments to that rule proposed and finalized by the same agency.”

MBA said any changes to the regulatory capital framework undertaken by FHFA will require a proposed rule, a compelling rationale, data and evidence to support these changes, and an opportunity for public comment. “As such, it is entirely unclear why the PSPAs should require the Enterprises to adhere to what would be an outdated capital  framework,” the letter said. “Indeed, this provision seems to be directed at binding the hands of future FHFA leadership rather than promoting the sound operations of the Enterprises.”

The letter noted in September, FHFA and Treasury suspended several provisions of the PSPAs. MBA said the suspensions of PSPA limitations on the Enterprises’ acquisitions of loans secured by second homes and investment properties, loans with multiple risk factors, and multifamily loans, as well as limitations on the Enterprises’ use of the cash windows, were “critically important to restore the smooth functioning of the housing finance system.” However, the September directive did not alter the PSPA provision requiring adherence to the December 2020 version of the Enterprises’ regulatory capital framework.

“Without any changes to this provision, the problematic nature of the binding leverage ratio and the punitive CRT treatment would continue to serve as constraints on the Enterprises’ operations – regardless of whether the current proposal is finalized by FHFA,” MBA said. “FHFA and Treasury therefore should prioritize the suspension or removal of the point-in-time capital framework from the PSPAs. This action should be taken no later than the effective date of any changes made to the regulatory capital framework, though ideally this action should occur as soon as possible to allow the Enterprises to adjust their businesses accordingly.”