Congress directed the Federal Housing Finance Agency (FHFA) how to set the g-fees Fannie Mae and Freddie Mac charge for guaranteeing mortgage-backed securities, but the FHFA didn’t follow the directions. The statutory instructions are little known, but they are clearly spelled out in the Temporary Payroll Tax Cut Continuation Act of 2011 (TPTCC). That doesn’t sound like a law about housing finance, but Title IV of the act, “Mortgage Fees and Premiums,” is specifically devoted to Fannie and Freddie’s g-fees.
If the FHFA followed the provisions of Title IV, it would have to significantly increase the g-fees.
In April, the FHFA completed and published a review of Fannie and Freddie’s g-fees and left them nearly the same. The FHFA does not wish to raise the g-fees — that is apparent. Consequently, it appears, the FHFA does not wish to address the statutory requirements. Indeed, it seems to be hoping that everybody will forget about them. The FHFA’s “Results of Fannie Mae and Freddie Mac Guarantee Fee Review” memo makes no mention at all of the TPTCC or its requirements.
The US Treasury Department asserted in a letter last fall that setting Fannie and Freddie’s g-fees is “subject to the sole discretion of the Director of the FHFA.” This is obviously wrong, given the requirements of the TPTCC. But how do you make a federal regulatory bureaucracy obey the law? The FHFA says in its “Review” that it thinks there is “no compelling economic reason to change the general level of fees.” How about a statutory reason? Congress has already made the economic judgment.
What the TPTCC requires is that Fannie and Freddie’s g-fees must include not only the risk of credit losses, but also “the cost of capital allocated to similar assets held by other fully private regulated financial institutions.” The FHFA director is instructed to make this calculation and increase the g-fees accordingly. This is unambiguous. The g-fees must be increased to cover the amount of capital that a private, regulated financial institution would have to hold and the return it would have to earn on that capital.
The FHFA says it has “established guarantee fee levels consistent with the amount of capital the Enterprises [Fannie and Freddie] would need to support their guarantee business.” However, the amount of capital that must go into the g-fee calculation is not the amount of capital Fannie and Freddie have (they don’t have any to speak of), nor is it the amount of capital the FHFA thinks Fannie and Freddie should have. Instead, it is how much regulated banks have to hold. This is the essential idea of the statutory provision.
The economic logic behind this provision is clear. Everybody wants more private capital operating in the secondary mortgage market. But Fannie and Freddie drive out private capital because their enormous government advantages make it impossible for any private entities to compete with them unless these advantages are offset.
So Congress — wisely, in my view — enacted the TPTCC provisions to provide the requisite offset. They result in raising the g-fees to the level where private financial institutions, using their actual capital requirements and required return on capital, can fairly compete. The result will be a more private, economically more efficient, and competitively more robust mortgage market, with much-reduced taxpayer risk. But even if you don’t agree with Congress and me that this is wise, there it is: the statutory requirement.
There is a notable precedent for this directive. In the Monetary Control Act of 1980, Congress required the Federal Reserve to price all its operating services with just the same logic, using the return on the capital required of a private-sector competitor. This is called the Private Sector Adjustment Factor (PSAF). The TPTCC simply creates a PSAF for Fannie and Freddie. Unlike the FHFA, the Federal Reserve followed and continues to follow, 35 years later, the statutory instructions.
Because the TPTCC sets the benchmark based on private, regulated financial institutions, we know what the absolute minimum required amount of capital for the required calculation is. It is leverage capital equal to 5 percent of assets. This is the regulatory floor for a bank holding company of Fannie and Freddie’s size. The financial institution subsidiaries of such holding companies, however, have a minimum of 6 percent. So, this means 5 percent at the minimum and arguably 6 percent.
The FHFA already has a simple and sensible model for setting g-fees, published in its 2014 “Request for Input” on g-fees. The model’s parameters already include the cost of capital and the amount of capital required. In calculations published in the “Request for Input,” the FHFA used 9 percent after tax as a cost of capital. This is moderate and not far from the current average return on equity of all banks — it’s reasonable to use it.
Now we merely have to plug into the FHFA’s own formula the amount of capital required for a private regulated financial institution: 5 or 6 percent. Here are the resulting required g-fees:
- At 5 percent, 90 basis points per year
- At 6 percent, 104 basis points per year
Fannie and Freddie’s average g-fees in 2014 were 63 and 57 basis points, respectively — nowhere near the requirement. Under the calculation the TPTCC directs, they have to go up a lot.
The FHFA needs to try again.
Alex J. Pollock is a resident fellow at the American Enterprise Institute in Washington, DC. He was president and CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004.
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