New Capital Requirements Threaten To Stick Us With Fannie Mae Forever

Global banking regulators may be close to reaching a deal on bank liquidity requirements that could saddle the U.S. taxpayer with supporting Fannie Mae and Freddie Mac for eternity.

The committee drafting the new Basel III rules will meet in Switzerland next Tuesday. A final set of rules is expected to be agreed on September 12. The leaders of the Group of 20 nations are expected to endorse the rules when they meet in November.

A little noticed change in the proposed rules, however, could throw a monkey wrench into plans to reform Fannie and Freddie, the two mortgage giants that have spent the last two years on government life-support. So far, U.S. taxpayers have been forced to pony up around $150 billion for Fannie and Freddie, and the Congressional Budget Office says that the total cost could amount to three times that much.

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Policy makers who hoped to eventually remove the costly government subsidies and guarantees for Fannie and Freddie will run into a stumbling block, however, if the Basel III rules are implemented. That’s because Basel III includes a liquidity requirement for banks that will encourage them to buy the debt of the Fannie and Freddie as well as the mortgage-backed securities they back.

The new liquidity regulation—sometimes known as “The Bear Stearns Rule”—is intended to make sure that banks have enough “high-quality liquid assets” to survive a temporary credit crunch. Specifically, the banks will be required to have enough high-quality liquid assets to fund 30 days of capital outflows under a stress scenario.

Right from the start, the way the Basel Committee defined “high-quality liquid assets” was problematic. It included cash and central bank reserves, relatively non-controversial highly liquid assets. But it also included sovereign debt, a move that would inevitably encourage banks to hold more sovereign debt than they otherwise would. This is problematic for two reasons—it created an implicit subsidy for spend-thrift governments and it created the danger of over-exposing banks to sovereign defaults.

Recent amendments to the Bear Stearns Rule have extended this subsidy to Fannie and Freddie. The Basel Committee decided to include the debt of “Government Sponsored Entitites”—bureaucratic code for Fannie and Freddie—in the definition of “high quality liquid assets.” What’s more, it also included mortgage-backed securities guaranteed by Fannie and Freddie in the definition.

Up to 40% of a bank’s liquidity reserve can be made up of GSE obligations, under the rules likely to be approved in the next few weeks. And while it is true that these obligations get a 15% haircut under the rules because they are considered “Level 2” liquidity assets, compared with the cash, central bank reserves and sovereign debt that will now be considered Level 1 assets.

This creates a huge subsidy for Fannie and Freddie. Banks will load up on GSE obligations, especially in an era where central bank reserves and Treasury bond yields are being depressed by policy-makers seeking to keep sputtering economies afloat. This artificial demand will scramble market signals about the risk taken on by Fannie and Freddie—all but ensuring that Fannie and Freddie will once again unwittingly take on more risk than they can handle. In short, the very same toxic situation created by the once implicit government subsidy of Fannie and Freddie is being baked right into Basel III.

Perhaps even more troubling, this will create a vicious cycle that will make reform of Fannie and Freddie next to impossible. Once banks have loaded up on Fannie and Freddie obligations, there will be no way for the U.S. government to remove government guarantees without triggering a liquidity crisis in banks around the world.

Imagine a bank that is estimated to require $10 billion in liquidity assets to survive a 30-day credit crunch. Under Basel III, some $6 billion of those assets would be Level 1. Some $4 billion would be Level 2, which includes highly rated non-financial corporate debt and GSE obligations. Let’s say the Level 2 assets are split between corporate and GSE obligations.

If lawmakers on Capitol Hill passed reforms taking Fannie and Freddie out from under the government umbrella, that bank would immediately find itself with a 20% shortfall in its liquidity assets. It would have to sell the GSE debt or other assets worth $2 billion in exchange for cash to make up for the shortfall. But it would be doing this at precisely the moment that every other bank was trying to sell its GSE debt and raise cash.

The domino effect of this would be devastating. It has all the makings of another banking crisis.

Which is why it wouldn’t happen. Any attempt to reform the GSE’s would be met with the certain knowledge that the reform would precipitate a crisis. And so the reform would be put on the back burner.

This is what Basel III threatens—Fannie and Freddie forever out of reach of financial reforms, forever subsidized, and forever unable to manage their own risk because of their immunity to market discipline.