The GSE Reform Debate: How Much Capital
Is Enough?

Abstract

Over the past eight months, a broad consensus has been emerging as to what the future state of housing finance should look like. There are several plans, including the Corker–Warner bill, under which private-sector entities would continue to originate and service mortgages, with other private-sector entities providing credit enhancement for mortgage-backed securities (MBS). A public entity would be the guarantor of last resort, absorbing the catastrophic risk. The public entity would also provide the securitization platform as well as regulatory oversight. In all these plans, the government’s catastrophic coverage is meant to kick in under extraordinary circumstances; thus the amount of capital the private sector is required to invest must be sufficient to cover all but catastrophic conditions. This article demonstrates that collateral composition, house price experience, and diversification significantly affect credit risk, and thus the capital requirement. The authors’ empirical results demonstrate that 4%–5% capital would have covered Fannie Mae and Freddie Mac (the GSEs) using the 2007 experience. With the GSEs’ current book of business, that is too high, as collateral composition has changed in favor of much more pristine loans. The other important aspects of collateral composition are pool size and geographic diversity. Risk increases with smaller or less geographically diverse MBS pools. Investors are likely to be willing to take credit risk in MBS only if pools are large and geographically diverse. This will make loan-level, risk-based pricing more difficult. It is critical to calibrate the capital needs correctly; if capital requirements are too low relative to the credit risk, the catastrophic government guarantee will be invoked far more than should be the case. If capital requirements are too high, banks will respond by holding more high-quality loans in portfolio, shifting the ultimate credit risk of their lower-quality loans to the government.