While assuring members of Congress that it is their role to make decisions about housing finance reform, Melvin L. Watt, Director of the Federal Housing Finance Agency (FHFA), made it clear that the issue of GSE capital buffers was one decision that cannot wait.  Watt, speaking to members of the House Financial Services Committee on Tuesday, said the statutory obligations of his agency as conservator of the GSEs, Fannie Mae and Freddie Mac, make it essential they maintain investor confidence in their safety and soundness.

The GSEs are currently required, under terms of their Preferred Stock Purchase Agreement (PSPA) with the U.S. Treasury, to pay dividends to Treasury each quarter in the amount of their net profits less a capital reserve.  That reserve or buffer has, as intended, decreased each year and will reach zero at the end of 2017.  The buffer was designed to protect the GSEs against the need to make additional draws of taxpayer support in the event they suffer an operating loss in any given quarter. The need to take such a draw would create uncertainty and could adversely impact the housing finance market, the Director said.

He called the challenge significantly greater today than it was when he spoke about it last year.  At that point, the buffer allowed each GSE was $1.2 billion.  After the first of next year neither GSE "will have the ability to weather any loss it experiences in any quarter without drawing further on taxpayer support."  

It is no longer a theoretical concern, he said.  Generally Accepted Accounting Principles (GAAP) regularly result in large fluctuations in GSE gains or losses in the ordinary course of business.  These fluctuations are not related to the credit quality of the GSE portfolios but to non-credit related factors such as interest rate volatility and the accounting treatment of derivatives used to hedge risks. 

There is also reduced income from Freddie and Fannie's declining retained portfolios and reduced revenue from the increasing volume of credit risk transfers which, while supporting FHFA's objective of transferring risk and opportunity to the private sector, also transfer current revenues away from the GSEs.  Regulatory changes, such as the Current Expected Credit Loss (CECL) accounting change, have one-time and ongoing impacts on reported net income.  Watt said there is also the possibility that a short-term consequence of corporate tax reform would be a reduction in the value of the GSEs' deferred tax assets, resulting in short-term, non-credit related losses.  The greater the reduction in the corporate tax rate, the greater the short-term losses to them would be.  

In addition to the regular and on-going prospect of non-credit related losses, Watt said even minor housing market disruptions, natural disasters like hurricanes, or short periods of distress in the economy, could also cause the GSEs to experience credit-related quarterly losses.

Although all businesses need a buffer to guard against short-term operating deficits, Watt said it would be especially irresponsible for the GSEs to lack one.  A loss in any quarter would require them to draw against the fixed dollar commitment the Treasure Department has made under the PSPA.  "We reasonably foresee that this could erode investor confidence.  This could stifle liquidity in the mortgage-backed securities market and could increase the cost of mortgage credit for borrowers."

While his next remark was circumspect, its meaning was clear.  After again stressing the obligation of FHFA to ensure that each GSE "operates in a safe and sound manner" and fosters "liquid, efficient, competitive, and resilient national housing finance markets," Watt said:

To ensure that we meet these obligations, we cannot risk the loss of investor confidence.  It would, therefore, be a serious misconception for members of this Committee, or for anyone else, to consider any actions FHFA may take as conservator to avoid additional draws of taxpayer support either as interference with the prerogatives of Congress, as an effort to influence the outcome of housing finance reform, or as a step toward recap and release.  FHFA's actions would be taken solely to avoid a draw during conservatorship.       

Watt also told members of the committee about actions taken by FHFA and the GSEs to assist borrowers affected by the recent hurricanes and said potential losses to the GSEs are difficult to estimate at this point.  Freddie Mac and Fannie Mae are working with their servicers to understand the extent of the damage and where there may be gaps in flood insurance coverage. 

He reminded the committee of the importance of the National Flood Insurance Program (NFIP) to the GSEs risk management.  Congress is currently working on reauthorizing the NFIP and Watt urged them to preserve the GSEs' contractual requirements that protect against collateral risk and help protect neighborhoods.

FHFA is continuing to make progress on its Alternative Credit Score Project, looking deeply, Watt said, at questions about competition and operational issues. This has raised additional concerns.  One example is how to ensure that competing credit scores would lead to improved accuracy and not to a race to the bottom with score providers competing for more and more customers. Another issue is whether the organizational and ownership structure of companies in the credit score market could impact competition.

The Director said his agency has received "overwhelming feedback" from the industry that it would be a serious mistake to change credit scoring models before the Enterprises implement the Single Security in mid-2019.  Consequently, even if FHFA announced a decision immediately about alternative credit score models, the changes would not go into effect before then. In the interim, the GSEs and FHFA continue to take other steps around credit scores such as allowing evaluation of borrowers without a credit score through automated underwriting systems, rather than sole reliance on manual underwriting.  

Watt also reported on the status of the Federal Home Loan Banks (FHLBanks) which FHFA also regulates.  He said the System had its most profitable year in history in 2016, with net earnings of $3.4 billion.  Earnings in 2016 were increased by private-label securities litigation settlements by some FHLBanks, which contributed $952 million of the total.   

In 2016, FHLBank advances grew by $71.2 billion to $705.2 billion.  The increase in advances pushed System assets past the $1 trillion mark for the first time since 2009.  System-wide retained earnings now constitute more than 1.59 percent of aggregate FHLBank assets and more than 31 percent of regulatory capital, up from 1.25 percent and 19 percent, respectively, from five years ago.  The FHLBanks' 2016 net income generated $392 million in Affordable Housing Program (AHP) funding, driving the average contribution for the last five years to over $300 million per year.