Regulator Warns Capital Buffers Shrinking at Fannie, Freddie

Lack of capital most serious risk

Melvin Watt (Chris Maddaloni/CQ-Roll Call File Photo)

Federal Housing Finance Agency Director Melvin L. Watt warned that Fannie Mae and Freddie Mac are in danger of losing the capital buffers that enable the two government-sponsored enterprises to absorb financial losses, a development that could put a chokehold on the mortgage market and lead to another taxpayer-funded bailout.

The GSEs will see their capital cushions reduced to zero on Jan. 1, 2018, Watt said in testimony before the House Financial Services Committee Tuesday.

“At that point, neither enterprise will have the ability to weather any loss it experiences in any quarter without drawing further on taxpayer support,” the director said in his opening statement.

Fannie and Freddie “need some kind of buffer” to guard against short-term operating losses, just “like any other business,” he said. Watt called it “really irresponsible to try to run any business without some kind of capital cushion.”

The Federal Housing Finance Agency chief said it was “especially irresponsible” for Fannie and Freddie not to have a “limited buffer” because the need for any additional taxpayer support could “erode investor confidence.” That, in turn, “could stifle liquidity in the mortgage-backed securities market and could increase the cost of mortgage credit for borrowers.”

This is not the first time Watt has warned about the GSEs’ shrinking capital cushions.

In a February 2016 speech at the Bipartisan Policy Center, he said, “The most serious risk and the one that has the most potential for escalating in the future is the enterprises’ lack of capital.”

Republicans in Congress and the administration have said overhauling Fannie and Freddie is a priority, but haven’t enacted legislation.  The two entities hold trillions of dollars of mortgages and lawmakers are wary of disrupting the housing market.

Watt attributed the capital shortfall on provisions in the so-called senior preferred stock purchase agreements, or PSPAs, the Treasury Department used to bail out Fannie and Freddie in 2008 as the enterprises teetered on the brink of collapse.

Since 2008, when the GSEs were placed into FHFA-controlled conservatorship, Fannie and Freddie have taken a total of $187.5 billion in funding from Treasury.

At issue is whether Watt has the authority to stop paying dividends to the Treasury and instead use the funds as capital buffers for Fannie and Freddie.

The enterprises are allowed to retain some income generated by business operations to act as a capital buffer. The buffer is available to Fannie and Freddie to absorb potential losses. It also reduces the need for Fannie and Freddie to go back to the Treasury for additional funding. 

But under the terms of the PSPAs, the capital buffers are shrinking each year.

In 2016, each GSE had a $1.2 billion buffer. That amount was reduced to $600 million apiece at the beginning of this year.

Watt told the committee he is discussing with Treasury Secretary Steven Mnuchin ways for the GSEs to maintain capital cushions beyond the end of 2017. But Watt said he did not need Treasury’s permission and had the statutory authority to withhold payment of GSE dividends to build up capital reserves.

“I don’t absolutely need it,” he said when asked if the Trump administration needed to agree to Watt’s taking such action. “I could do it by myself.”

But he said he did not think that was the “best way to do it” and he planned to continue working with Mnuchin to come to some type of resolution.

The question of Watt’s authority to suspend the dividend payments unilaterally has come up before in Congress.

In May, while testifying before the Senate Banking Committee about the shrinking GSE capital buffers and how to address them, Watt said: “If the two parties can’t dance, I may have to dance by myself. And that’s not a pleasant position to be in and it may not be pretty.″

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