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Housing Perspectives

Research, trends, and perspective from the Harvard Joint Center for Housing Studies

The FSOC Secondary Mortgage Market Review: A Grade of “F”

The Financial Stability Oversight Council (FSOC), a committee of federal financial regulators chaired by the Secretary of the Treasury, announced in July that it was going to review the secondary mortgage market. I subsequently wrote a paper about what could and should be included in their review. On September 25, FSOC released the results.

It is, in modern slang, mostly a nothing-burger.

The FSOC review includes nothing about how much servicing should be done by banks versus non-banks. Nothing about how much credit risk transfer could, or could not, reduce the systemic concentration of risk in the two government-sponsored enterprises (GSEs) of Freddie Mac and Fannie Mae. Nothing about why specialized investors in GSE or Ginnie Mae mortgage-backed securities almost failed during the early days of the pandemic. Nothing about how well the new GSE single security performed during the pandemic’s stresses. Nothing about whether mortgage servicing practices and compensation need revision to be more stress-resistant. And nothing about the concentration of risk and capital levels standing behind the mortgage insurance required on GSE loans with over 80% loan-to-value ratios.

The document was astonishingly short at just four pages, and focused only on the two GSEs (the largest but hardly the only significant players in secondary mortgage markets) and then almost exclusively on just the proposed new GSE capital rule from the Federal Housing Finance Agency (FHFA), their regulator. The review’s recommendations, as discussed below, are also just not crisp or specific.

Indeed, a full secondary mortgage market review should have looked like, as but one example, a report about improving financial regulation, published by Treasury in June 2017, which was 147 pages in length, with many clear and specific recommendations. In this case, therefore, a grade of “F” goes to FSOC for a very inadequate and limited set of comments, which are in no way a complete secondary mortgage market review.

A second “F” goes to FSOC for its communications, which either (1) mis-labeled its original announcement of intent to do something so very narrow and specific, or (2) did a U-turn somewhere along the way and, for reasons about which we can only speculate, became something far more limited, while still non-credibly claiming that the four-page result delivered upon the original commitment.

The Contents

I was able to extract five substantive recommendations in the four-page document. These were proceeded by repeating what is already well-known and accepted, i.e. that the GSEs are so large they pose systemic risk to the financial system, and that they need a major revision to their regulatory capital and related requirements, which have not been updated since before 2008.

The substantive recommendations are:

  1. A call for coordination across regulators: FSOC notes that the proposed capital requirements for the GSEs do not match what banks would need (i.e. the former are lower), and calls for there to be regulatory coordination for more consistency. This reasonable conclusion is hollowed out, however, because there is no information about who would see to this coordination or how it would be carried out.
  2. Capital buffer revision: The public comments on the FHFA’s proposed capital rule heavily criticized that its risk-based calculation for capital has large buffers that are not, in fact, risk-based. The FSOC calls for FHFA to “consider” making the buffers risk-based, although with hesitant and non-critical wording.
  3. The role of the leverage ratio: The FHFA proposal considers an accounting-based leverage ratio minimum (i.e. the lowest allowed percentage of assets funded by capital) to be appropriate if it is routinely cyclically binding on the companies. That is, it is expected to require more capital than the risk-based measure at certain points in the economic cycle. The FSOC document, however, calls for the leverage ratio to be a “credible backstop to the risk-based requirements,” which is regulatory lingo meaning that the minimum leverage ratio is not expected to be high enough to be routinely cyclically binding but rather lower so that it only becomes binding if, for some reason, the risk-based measures go awry and do not work as expected. This inconsistency is not addressed in the FSOC review, but does indicate that the FHFA capital proposal deviates from mainstream thinking on this point.
  4. Capital composition: The FHFA’s proposal calls for the definition of what constitutes capital (e.g. would preferred equity count?) to be aligned with what bank regulations employ post-2008, which the FSOC review supports. This is non-controversial and mainly stems from current GSE regulations and legislation that have not been updated since 2008.
  5. Capital amount: The FSOC first says, with convoluted wording, that the proposed level of capital (criticized by most public commenters as too high) should not be reduced too much, i.e. not be “materially less” than what was proposed. It then seems to say almost the opposite: that it is “possible that additional capital could be required” under certain extreme circumstances; as the risk-based calculation should automatically generate such a result, the point isn’t totally clear. In fact, the review’s conclusion is the antithesis of crisp.

It is similarly unclear how useful this very narrowly-focused document will be. The only truly impactful items it contains are (1) the call for FHFA to consider revising its capital buffers to be risk-based, (2) the soft mention that the leverage ratio is inconsistent with mainstream thinking (but strangely with no recommendation to revise it), and (3) that it seems to roughly validate the overall level of capital required by the proposed rule (more on this below).

The Missing Stress Test Results

The FSOC four-pager says, in bold and italicized type, “The Council also encourages FHFA to require the Enterprises to be sufficiently capitalized to remain viable as going concerns during and after a severe economic downturn.” That is excellent advice, and the regulatory process to most directly determine if the GSEs are capitalized to meet that requirement is the annual stress test, reflecting the Federal Reserve’s “severe adverse” economic scenario (which roughly mimics what happened in 2008). This type of stress test is performed annually on large banks and the two GSEs. The idea is to first determine the loss that would be incurred in a severe adverse scenario, and then judge whether the remaining capital would be sufficient to maintain market confidence.

The latest available figures, from December 2018, show that the two GSEs together would lose $43 billion in a severe adverse scenario (including losing the value of the deferred tax asset, though it is questionable if that would happen; without losing the tax asset, the loss would be just $17 billion). This means that the FHFA capital proposal, which calls for $243 billion in capital, would leave a “going concern buffer” (i.e. the remaining capital) of $200 billion to hopefully maintain market confidence in the two companies, or 4.7 times the predicted $43 billion loss. A remaining capital buffer of almost five times the severe adverse loss is clearly enough to maintain market confidence. In fact, it is probably well more than what is needed. (Using the $17 billion figure instead, which reflects the deferred tax asset not being lost, results in the remaining capital buffer in excess of twelve times the predicted loss, which would be incredibly high.)

The severe adverse loss calculated for the GSEs has declined every year since the first calculation was done in 2013. It was expected to do so again and probably be materially less than $43 billion, for the stress test based on December 2019 figures, which should have been disclosed in August of this year, but mysteriously were not. This begs the question: why have the results not been made public? A number materially lower than $43 billion would make the case even stronger that the $243 billion required by the FHFA proposal is simply excessive.

The FSOC paper, after indicating in bold italics to focus on the stress results, incredibly then simply drops the topic. There is no follow-up and no mention of the mysteriously delayed 2019 results. This missing follow-up, conspicuous by its absence, is another reason to give the review an “F” grade.


It is difficult to find much value in the FSOC secondary review results.

It is clear than an opportunity to truly improve the stability of the American financial system by doing a major study of all aspects of the secondary mortgage market has been missed.

It is also clear that the comments on the GSEs in this document, being focused almost entirely on the capital rule, are another missed opportunity.  The review could have holistically examined the GSEs and their business model to recommend changes to improve stability (for example, the wisdom of utilizing, or not, credit risk transfer).

Additionally, the comments on the capital rule seem to me to clearly be compromised. Indeed, how much should we expect FSOC to criticize one of its own members (the Director of the FHFA), when all of its voting members are Trump administration appointees?  The report’s findings are the opposite of crisp and it simply drops identified issues too often.

This is why I have given the FSOC secondary mortgage market review an overall grade of “F”. The housing finance system deserved better.