How Much Capital Is Enough? in Housing

BPC Action believes that while housing is one of the major drivers of the U.S. economy, current federal housing policy is ill-equipped to respond to the many housing challenges facing the U.S. today. We support reforming our broken housing finance system and creating a healthy, stable, and affordable housing market in order to ensure a strong economy and a globally competitive country.  The following information is from BPC, our 501 (c) (3) affiliate. 

If there is one principle uniting the at-times competing Democratic and Republican visions for housing finance reform, it is that the private sector should assume the vast majority of credit risk and be compensated for it. This compensation necessarily requires “pricing in” the cost to hold capital, which is needed to buffer losses in a severe economic downturn.

As the Federal Housing Finance Agency (FHFA) has demonstrated, of the three components of the GSEs’ guaranty fee, the capital cost portion is by far the largest.1 The other two components price in expected credit losses in normal economic times and general and administrative expenses. According to the FHFA, while the combined cost to the GSEs of the latter two components is 11 basis points, the cost of holding capital against unexpected credit losses ranges from 28 to 115 basis points, depending upon assumptions about the required level of capital and the after-tax return on capital.2

Because the cost of capital has real impacts on the price of mortgage credit and access to homeownership, one of the most important policy questions that lawmakers must answer is: “How much capital is enough?”

Planting a Stake in the Ground

A reasonable way to tackle the capital issue is determining what it would have taken for the GSEs to have survived the recent financial crisis. One analysis from the Urban Institute demonstrates that using the GSEs’ 2007 experience, a 4-to-5 percent capital buffer would have been sufficient to enable them to avoid conservatorship. In a 2013 paper, the Center for Responsible Lending (CRL) also found that Fannie Mae and Freddie Mac would have needed approximately 4 percent capital to withstand the 2008 financial crisis, a level more than eight times higher than their statutory minimum requirements. While Senators Bob Corker (R-TN) and Mark Warner (D-VA), and later Senators Tim Johnson (D-SD) and Mike Crapo (R-ID), started from the same data point in their housing finance reform legislation, they doubled down on taxpayer protection by setting minimum capital requirements at ten percent, which they recognized was “more than twice the amount Fannie and Freddie lost during the crisis.”

Independent analysts were quick to point out the extreme caution that a ten percent capital requirement represented, as well as the potential impact such a high requirement could have on the cost of a mortgage. A Goldman Sachs report noted, “More than 1 in 5 borrowers across the country would need to default at a severity of 50 percent in order for a first loss layer of ten percent to be penetrated.”3 They said this scenario was way beyond the GSEs’ actual loss experiences in the recent crisis, even factoring in the performance of non-traditional mortgages such as negative amortization and Alt-A loans.

The minimum ten percent top-line capital requirement quickly became non-negotiable, and attention shifted to the issue of how broadly capital should be defined. Drafters appropriately identified the need for some flexibility, recognizing that if capital were too narrowly defined, mortgage credit would be priced out of the reach of ordinary families. Drafters settled on a broad definition which included in the numerator not just common equity but also “instruments and contracts that will absorb losses before the Mortgage Insurance Fund [such as] reinsurance, letters of credit, and future guarantee fees to be earned by the guarantor after accounting for the stress scenario.”

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