Capital Framework Changes Will Strike Better Balance

Altered credit conversion factor increases liquidity of uniform mortgage-backed securities

Leah Dempsey, Jack Furth, Sohil Khurana and Zach Pfister
Capital Framework

Guarantees on Commingled Securities

The new rule would adjust risk-based leverage and buffer capital requirements on commingled securities by reducing the risk weight from 20% to 5% and the credit conversion factor from 100% to 50% on an Enterprise’s exposure to other Enterprise commingled securities. The purpose is to better align the requirements with the counterparty risk inherent of the resecuritizations that involve underlying collateral from both Fannie Mae and Freddie Mac.

The proposed change also builds on the FHFA’s 2019 rule on UMBS to maintain market confidence that a UMBS of a certain coupon, maturity and loan origination year issued by one Enterprise is equivalent to one from the other. To maintain this equal exchange rate, the Enterprises may issue “Supers,” which are single-class resecuritizations of structured securities that can be backed up by UMBS, but if the security of one Enterprise is backed by one from the other, the original security-owning Enterprise is obligated to cover any shortfall in payments by the security-backing Enterprise. This ensures the investor benefits from both the original guarantee of the underlying collateral and the additional guarantees of the resecuritizing Enterprise.

Overall, the change in risk weight decreases the incentive for Fannie Mae and Freddie Mac to only guarantee Supers with their own UMBS, while the altered credit conversion factor increases the liquidity of UMBS in commingled securities and increases the stability of the secondary mortgage market. These guards against leverage and buffer capital impacts of the guarantees are designed to reduce the total CET1 capital need to balance these risks by $5.1 billion.



Multifamily Mortgage Exposures

The FHFA requires the Enterprises to acquire multifamily loans collateralized by affordable rents based on income. Due to the high demand for affordable units by renters and strong incentives for property owners to maintain affordable buildings to keep government subsidies, the new rules lowered the risk multiplier of these liabilities to 0.6, a 40% reduction.

For a mortgage to qualify for this new multiplier, the property would have to be funded by significant, long-term and continuous subsidies. This includes only those rents that are supported by the Low-Income Housing Tax Credit (LIHTC), Section 8 project-based rental assistance or state and local affordable housing programs that require the provision of affordable housing for the life of the loan. The property where the mortgage is taken must also have at least 20% of its units be affordable, as defined by their income restrictions being less than or equal to 80% of the area’s median income.

This change is estimated to reduce CET1 capital required by $400 million.


Derivatives and Cleared Transactions

In 2020, U.S. banking regulators adopting the standardized approach for counterparty credit risk (SA-CCR) to calculate exposure risks for derivative contracts and decide the asset amounts necessary to hold in the case of default on those contracts. Until this new rule, the Enterprises still relied on the current exposure methodology (CEM) for this purpose. CEM is a system that was created before the 2008 financial crisis and had drawbacks including not differentiating margined and unmargined derivatives, not recognizing the need for a balanced derivative portfolio and outdated supervisory conversion factors.

The new rule would enforce the use of SA-CCR to improve the Enterprises’ ability to capture and reduce the risk of derivative contracts in their portfolios. It would also bring the ERCF more in line with the U.S. banking framework and the international Basel Committee on Banking Supervision. The CET1 required to meet capital requirements would increase by less than $100 million with this change.


Credit Scores

Credit scores are essential for ERCF to determine risk of default, but due to individual borrowers having credit scores from multiple agencies and mortgages sometimes having multiple borrowers, the entities must use a procedure to find a single credit score for each mortgage. The new rule would reduce the number of credit reports necessary to find this score from three to two.

It also alters the method that the score is calculated. The current method first takes the median credit score of each borrower if there are three, or the lowest if there are two, then takes the lowest score (as determined in the first step) of all borrowers. To relieve the downward bias of this method, the new rule would now take the average of the first step as opposed to the median. The FHFA does not believe this alteration will increase the risk of missing high-risk borrowers.

Overall, this change would reduce CET1 capital requirements by less than $100 million.


Other Changes:

The proposed rule also makes a number of more minor changes to the ERCF that will affect the capital requirements of the Enterprises. These alterations are estimated to reduce CET1 capital requirements by $200 million. The new rules will:

•  Require the Enterprises to assign an original credit score of 680 to single-family mortgage exposures without a permissible credit score at origination, rather than 600;

•  Introduce a 20% risk weight for guarantee assets;

•  Expand the definition of mortgage servicing assets to include servicing rights on mortgage loans owned by anyone, including the Enterprise;

•  Delay the first application of the single-family countercyclical adjustment on new originations to coincide with the first update to the property values associated with those single-family mortgage exposures;

•  Explicitly permit eligible time-based call options in the credit risk transfer (CRT) operational criteria;

•  Amend the risk weights for interest-only mortgage-backed securities to 0%, 20% and 100%, conditional on whether the security was issued by the Enterprise, the other Enterprise or a non-Enterprise entity, respectively;

•  Clarify the calculation of the stability capital buffer when an increase and a decrease might be applied concurrently; and

•  Extend the compliance date for the advanced approaches to Jan. 1, 2028.

Leah Dempsey, Jack Furth, Sohil Khurana and Zach Pfister

Leah Dempsey, Sohil Khurana, Zach Pfister and Jack Furth are attorneys with Brownstein Hyatt Farber Schreck in Denver, Colorado. This article originally appeared on JDSupra.

This article was originally published in the Mortgage Banker Magazine May 2023 issue.
Published on
May 01, 2023
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