No matter who wins the presidential election, proposals to significantly reform the nation’s mortgage finance system to replace Fannie Mae and Freddie Mac will still struggle to find consensus in Congress and among industry stakeholders.
By Robert Stowe England
Read the article as it appears in the print edition on pages 44 to 54 at this link.
Action on long-overdue mortgage finance reform is low on the policy priority list for the presidential campaigns of both Democrat Hillary Clinton and Republican Donald Trump.
Yet, it is an important issue that would likely zoom to the political forefront in the next housing downturn when the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac could well post losses and require a new bailout, according to Mark Calabria, director of financial regulation studies at the Cato Institute, Washington, D.C.
Ultimately GSE reform will still depend on reaching a consensus on what elements are in any legislative package. “Congress is not going to pass GSE reform because there is not a broad-based consensus,” Calabria says. The lack of consensus will still be there regardless of who wins the White House.
“The most likely outcome is that two years from now, Fannie and Freddie will still be in conservatorship,” Calabria says.
The political impasse in Congress is strong and entrenched, according Ed Mills, financial policy analyst at FBR Capital, Arlington, Virginia.
Republicans do not want a federal backstop. This means a new mortgage finance system would have higher-quality loans and less credit availability, according to Mills. “So Democrats are not going to be excited about making credit less available through a system that doesn’t have a government backup,” he says.
Democrats want to be sure a new system has more credit availability for more people. “That requires a government backstop. Republicans are opposed to that,” says Mills.
With the two sides diametrically opposed on seemingly irreconcilable points, there seems to be no way forward. “To solve any problem is to get the other side opposed to you. All of which means GSE reform is the catch-22 of Capitol Hill,” Mills says.
The phrase catch-22 was made famous by Joseph Heller’s 1961 novel of the same name, in which airmen feign madness to avoid deadly combat missions, but must fly them anyhow because their rational desire for safety shows they are sane.
Mills argues that Congress is more likely to move toward reform in incremental steps, and then “only after significant changes are made to the way Fannie and Freddie operate today, some of which is being implemented by the Federal Housing Finance Agency [FHFA], as we speak,” says Mills. The FHFA regulates the GSEs and oversees their conservatorship.
Those significant changes Mills talks about include efforts by the FHFA to create a common securitization platform. It also includes efforts to set up and expand credit risk transfer transactions to move more of the credit risk to the private sector. And it includes programs to develop standardized datasets and standardized technology that can provide loan-level detail to investors.
These ongoing efforts at FHFA and the GSEs “are developing the market underpinnings” for a future mortgage finance system with less systemic risk, according to Ed DeMarco, former acting director of FHFA and current senior fellow in residence at the Milken Institute’s Center for Financial Markets in Washington, D.C. They also bring to bear the disciplines of the market by paving the way for the entry of securitization competitors, he adds.
New ideas abound
Whatever the considerable challenges for GSE reform, “I think we’re going to see a lot of good proposals,” says James Lockhart, vice chairman of WL Ross & Co. LLC, a New York-based subsidiary of Atlanta-based Invesco Ltd., and former FHFA director. Lockhart placed Fannie Mae and Freddie Mac in conservatorship in 2008.
“Hopefully, come January with a new president and a new Congress, we may have people paying attention to the issue,” Lockhart says.
The former FHFA director hopes that Congress can build on the successful bipartisan efforts that have advanced GSE reform in the Senate to find a practical, workable approach that ultimately achieves the necessary consensus.
“The issue is not that complicated. It’s just very political,” Lockhart says.
Presidential leadership could help push GSE reform over the finish line, according to Lockhart. He sees some promise in the fact that both Clinton and Trump have expressed concern about the decline in the share of the population that owns a home since the financial crisis.
The U.S. Census Bureau reported in July that homeownership for the second quarter of 2016 fell to 62.9 percent, the lowest level since 1962. It is significantly lower than the peak rate of 69.1 percent in 2004.
A resolution of the uncertain future of the GSEs is vitally important in view of the fact they still dominate the U.S. mortgage finance system. Together, Fannie and Freddie guarantee or hold $4.585 trillion in mortgages outstanding, according to Inside Mortgage Finance. That represents 48.5 percent of the $10.009 trillion outstanding in single-family mortgages.
The two GSEs also continue to dominate new mortgage origination activity. During the first half of 2016, Fannie and Freddie together funded 42.8 percent of all new mortgages, according to Inside Mortgage Finance.
Mortgage industry leaders are hopeful there will be a better political climate in Washington for GSE reform after the November Presidential and Congressional elections.
“Clearly the fact that we have a new administration and a new Congress in January 2017 gives us an opportunity to move this whole discussion forward,” says Rodrigo Lopez, chairman of NorthMarq Capital Finance LLC of New York, chairman-elect of the Mortgage Bankers Association and chair of MBA’s Task Force for a Future Secondary Mortgage Market. (See Side bar on Task Force.)
Clinton and GSE reform
Should Clinton win the presidency and the Democrats retake control of the Senate, the Republicans are likely to retain the House, according to Calabria, complicating any effort by a Clinton administration to tackle GSE reform.
“The odds are that [Rep.] Jeb Hensarling [R-Texas] is again going to be chairing the House Committee on Financial Services next year, and he’s not going to roll over for just any deal,” Calabria says.
The Democratic Party’s platform lacks specifics about how GSE reform might be approached if it becomes a priority. The platform defends the regulatory framework created by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, including the creation of the Consumer Financial Protection Bureau (CFPB), and vows to fight any efforts to roll back any of the provisions in Dodd-Frank.
Both Lockhart and Calabria say that a Clinton administration is likely to develop an approach to GSE reform that builds on the strengths of the current system and the progress made in building elements of a new system at the FHFA and the GSEs.
Indeed, the 2016 Democratic Party platform has little to say about mortgage finance except to call for the preservation of the 30-year fixed-rate mortgage.
Clinton provided some detail on her housing agenda in February when she laid out some of the policy details in a briefing paper titled Hillary Clinton’s “Breaking Every Barrier Agenda”: Revitalizing the Economy in Communities Left Behind.
In one proposal, Clinton called for a program that would provide up to $10,000 to match an equivalent amount of savings by households to help accumulate a down payment for a home purchase.
One template for what might emerge in a Clinton administration is a March 2016 proposal titled A More Promising Road to GSE Reform, put forward by Jim Parrott, Mark Zandi and others. Parrott is senior fellow at the Urban Institute, Washington, D.C., and owner of Falling Creek Advisors LLC, a consulting company based in Chapel Hill, North Carolina; and Zandi is chief economist at Moody’s Analytics, West Chester, Pennsylvania.
The proposal is also co-authored by mortgage securities pioneer Lewis Ranieri, founding partner and chairman of Ranieri Partners Management LLC, Uniondale, New York; Gene Sperling, former director of the National Economic Council under both President Bill Clinton and President Barack Obama; as well as Barry Zigas, director of housing at the Consumer Federation of America, Washington, D.C.
“It’s essentially a government model with broad-based guarantees of mortgage-backed securities [MBS]. It is also going to be geared toward wide credit availability,” Calabria says.
More details about the plan from Parrot et al can be found in a June 2016 paper by the same five co-authors titled: (A More Promising Road to GSE Reform: Governance and Capital. The paper fleshed out more of the details of how a new government corporation, the National Mortgage Reinsurance Corporation (NMRC), would be governed and how the mortgage finance system would be protected by a capital buffer of 8.5 percent.
The June paper is the first of what will be more papers providing more details. “Most proposals stop after the first step and leave a lot of questions unanswered. It struck us as more helpful to play this idea out as far as we can play it out,” says Parrott.
Trump and GSE reform
Trump has provided very little guidance about what approach a Republican administration might take with GSE reform if it becomes a priority. The 2016 GOP platform lambastes the “corrupt business model [of the GSEs that] lets shareholders and executives reap huge profits while taxpayers cover all the losses.” Yet, it does not specifically call for winding them down, as did the platform in 2012.
Instead, the platform recommends reconsidering the utility of Fannie and Freddie and calls for clearing away “the jumble of subsidies and controls that complicate and distort home buying.”
The GOP platform also faults the Federal Housing Administration (FHA) for going beyond its mission by lending to higher-income borrowers and recommends setting lower limits on loan amounts eligible for an FHA-insured mortgage.
If Trump is elected president, GSE reform could be “a little bit more of a wild card,” says Calabria. Trump will likely appoint a Treasury secretary who will give deference to Congressman Hensarling as chairman of the House Committee on Financial Services.
“However, Trump is a real estate guy--and real estate guys tend to like subsidies for real estate,” Calabria adds. That would fly in the face of the Republican Party platform’s call for reducing the role of the government in the housing market.
"I don't think he shares a lot of the hostility to Fannie and Freddie that a lot of the GOP [has],” Calabria notes.
Whatever direction Trump decides to go, he will face a divided Congress even if the GOP retains control of both houses. That is the case because the Republican House and Republican Senate disagree on GSE reform. The Senate GOP is willing to have a government backstop in a new system.
“More gridlock and stalemate on GSE reform is probably what we’re looking at in the future” even if the GOP has the presidency, the House and the Senate, predicts Calabria.
Mills also sees Trump as a wild card. “Where people could get excited or nervous, depending on your perspective, is that he is also viewed as a dealmaker. And, as a dealmaker, would be more sympathetic to establishing a GSE reform package or a new senior preferred stock purchase agreement that allows them to return to their former selves,” Mills says.
Treasury’s senior preferred stock purchase agreement of Sept. 7, 2008, establishes the conditions of the government’s bailout and conservatorship of the GSEs. Under this agreement, Treasury received 1 million senior preferred shares from each of the GSEs and a warrant until 2028 to purchase 79.9 percent of common stock at a nominal cost.
Among the 14 people Trump named as his economic advisers in August, a number of them are billionaire investors in real estate and finance, including some who have invested in the securities of Fannie and Freddie, notes Lockhart.
“So there might be a little more support for recap and release” of Fannie and Freddie, which would allow them to emerge from conservatorship, Lockhart says. “Who knows at this point where he will come out?”
The list of Trump economic advisers includes Thomas Barrack, founder, chairman and chief executive officer of Colony Capital Inc., a Los Angeles private-equity and real estate firm; and John Paulson, president and chief executive of investment firm Paulson & Co., New York. Paulson and his firm enjoyed significant returns on the bet against subprime mortgages prior to the financial crisis. The firm has also invested in GSE securities.
Trump’s economic team also includes Steven Roth, founder and chairman of Vornado Realty Trust, the largest owner of commercial real estate in New York City; and Steve Feinberg, co-founder and chief executive officer of Cerberus Capital Management LP, a private-equity firm based in New York.
Role of Congress
In the past, Congress as a body has sidelined determined efforts by some of its members to advance GSE reform legislation. When Democrats had control of both houses in 2009-2010, they did not assign priority to GSE reform at a time when they also controlled the White House and would have been better positioned to enact the kind of reform the party would prefer.
The GOP took over the House in 2010 and has maintained control since then. The GOP-controlled House’s approach to reform--winding down Fannie and Freddie and reinvigorating the private sector without a government guarantee--has been at odds with bipartisan proposals in the Senate.
The bipartisan Senate proposals have retained a government role in guaranteeing mortgage-backed securities (MBS), albeit one that would be diminished from the current system.
Efforts to reach consensus in the Senate under Democratic control from 2009 through 2014 and under Republican control in the current session have foundered because of determined resistance from various stakeholders in the mortgage finance system.
A bipartisan proposal was sponsored in 2013 by Sen. Bob Corker (R-Tennessee) and Sen. Mark Warner (D-Virginia). The bill, the Housing Finance Reform and Taxpayer Protection Act, would wind down Fannie and Freddie and the FHFA and replace them with a new government agency, the Federal Mortgage Insurance Corporation (FMIC).
Under Corker-Warner, the new system would be dominated by the private sector. Instead of Fannie and Freddie issuing mortgage-backed securities, government-approved private firms would issue them. The private sector issuers could purchase insurance for the timely payment of principal and interest on those securities from government-approved private sector insurers, which would cover the first 10 percent of losses. Issuers of securities could also purchase reinsurance for a fee from FMIC for all losses above 10 percent for securities backed by qualified mortgages.
Another bipartisan Senate bill known as Johnson-Crapo had much in common with Corker-Warner. It garnered enough support to be passed by the Senate Banking Committee in May 2014 on a bipartisan vote of 13 to 9.
Under Johnson-Crapo, FHFA would become a separate agency within FMIC. Like its predecessor, in this bill FMIC would cover 90 percent of losses. If there were a national crisis, however, the agency could cover 100 percent of losses.
Reform equals uncertainty
Many of the proposals for mortgage finance reform that have surfaced over the years may have been too ambitious, according to Parrott. For one thing, “the proposals tended to start from scratch and come up with what was perceived to be an ideal new system to replace the current one,” he says.
“Even if the system proposed were ideal on paper, the fact it started from scratch meant that it created a great deal of uncertainty on how the proposed model would function when you turn the lights on,” Parrott explains.
The earlier GSE proposals generated economic uncertainty and political uncertainty, and with it opposition, according to Parrott. “A lot of stakeholders are more comfortable with the devil they know rather they the devil they didn’t know,” he explains.
Opposition came from consumer groups that fear proposed reforms will not serve the needs of lower-income and minority homebuyers. There was also resistance to reform proposal from community banks and smaller mortgage lenders who fear that the new system might favor large banks in a way that would put them at a disadvantage when compared to the current system, according Parrott.
Thus, Parrott concludes, proposals that keep what works in the current system and change or reform what does not work today are more likely to gain the support from all stakeholders and, thus, the consensus in Congress to achieve GSE reform.
January 2018 deadline
There’s also a bit of a hard deadline facing the next administration and Congress that would turn even modest quarterly losses at the GSEs into a new bailout situation beginning as soon as the first quarter of 2018.
A new bailout of two financial giants that have already been bailed out is likely to create political fireworks and increase public fury already aimed at the political class in Washington. Public outrage is likely to swiftly move mortgage finance reform to the forefront.
The financial vulnerability of the GSEs rests on the fact that their already very thin capital reserve amount, set at $3 billion in 2013, is slated to fall to zero by Jan. 1, 2018. It currently sits at $1.2 billion.
The planned elimination of the capital reserve was part of a 2012 amendment by Treasury of the senior preferred stock purchase agreement under which Treasury eventually advanced $187.5 billion in funds to the GSEs to cover losses.
Under existing regulations and agreements, a bailout can proceed without any involvement from Congress or new administration initiative.
That is the case because the GSEs, under the terms of 2008 senior preferred stock purchase agreement, still have a combined $258.1 billion in credit available from the Treasury should they suffer losses, according to a tally by the FHFA. For Fannie Mae, the remaining credit line is $117.6 billion and for Freddie Mac it is $140.5 billion.
Recessions are inevitable, and with them losses--and so the disappearing capital buffer at the GSEs can only lead to one conclusion, according to Calabria. “Another bailout is in the cards. It’s a matter of when, not if,” he says.
Community bankers are worried that the mortgage finance system, now working well, more or less, could deteriorate when the GSEs run out of capital and face a second bailout.
“We think the current system needs to be stabilized and shored up. It needs to have capital behind it,” says Ron Haynie, senior vice president of mortgage finance policy at the Independent Community Bankers of America (ICBA), Washington, D.C.
“What we don’t need is an event that will cause a draw on the Treasury and what might come with that,” says Haynie, referring to the likely headlines and political reaction to another bailout of Fannie and Freddie.
There is a risk that there could be “some type of interruption of credit, something that would cause liquidity problems with the GSEs,” says Haynie. “I just think that would not end well at all.”
Net worth sweep
The GSEs would have been able to build capital under the original senior preferred stock purchase agreement with Treasury made at the time of their bailout. That agreement required Fannie and Freddie each to advance a 10 percent dividend to Treasury every quarter.
In August 2012, Treasury threw out the 10 percent dividend and adopted a third amendment to the stock purchase agreement that required the GSEs to forward virtually all their profits henceforth, except for a small capital cushion. This has come to be known as the sweeps amendment or the net worth sweeps amendment, because it sweeps out nearly all the profits from the GSEs.
Under the amended stock purchase agreement, the GSEs have paid Treasury $250.2 billion in dividends as of June 30, 2016. That is $62.7 billion more than the draws taken on their credit lines.
“The reason they did the sweep in the beginning was they never wanted to get into a situation where the GSEs get the remaining $248 billion on the credit lines they are eligible for,” says FBR Capital’s Mills. Ironically, the lack of GSE reform could guarantee those draws.
The financial outlook is not promising for the GSEs. “There are real questions about their solvency going forward,” says Mills. Even so, politically “it is easier to maintain the status quo rather than the alternative of trying to tackle wholesale GSE reform,” he says.
The inability to find a solution to the future of the GSEs and the pending financial crisis that maintaining the status quo represents should be laid firmly at the feet of Congress, according to Ed Pinto, resident fellow and co-director of the International Center on Housing Risk at the American Enterprise Institute, Washington, D.C.
“Congress years ago abdicated its responsibility to make decisions” on critical policies affecting Fannie and Freddie, says Pinto.
For example, Pinto says, Congress was derelict when it made the charters for Fannie and Freddie perpetual when they were granted the charters in legislation decades ago.
“Not only are they perpetual; they can’t be killed,” Pinto says. The Housing and Economic Recovery Act (HERA) of 2008 contains a provision that “if one or both of the agencies is liquidated, that FHFA has to establish stand-up new ones to replace them. They can’t go away,” says Pinto.
Fannie and Freddie were supposed to be subject to the requirements of the Qualified Residential Mortgage (QRM) definition, as well as the Qualified Mortgage (QM) definition authorized in Dodd-Frank, Pinto points out.
CFPB provided a seven-year agency patch to Fannie and Freddie, beginning in 2014 through 2021. Under the so-called patch, the GSEs do not have to comply with debt-to-income (DTI) requirements in QM rules that specify that lenders must determine whether borrowers are able to repay a mortgage.
“That can be extended by the stroke of a pen by the director of CFPB,” says Pinto. Congress gave the CFPB the authority to make such decisions, he notes.
Further, Pinto notes, Fannie and Freddie are supposed to be subject to QRM. “Yet FHFA has said as long as they are in conservatorship, they are not subject to QRM. And even if they came out of conservatorship, they have a patch from CFPB,” he says.
The most egregious abdication of responsibility by Congress in the Housing and Economic Recovery Act was to grant Treasury sufficient authority to allow for the terms contained in the stock purchase agreement that set up the GSEs for another failure and bailout should Congress fail to enact GSE reform, Pinto maintains.
Under existing agreements, Treasury will be obliged to advance as much as $248 billion to the GSEs--a far greater amount than the prior $187.5 billion bailout. “That obligation continues regardless of whether they are in conservatorship,” says Pinto.
“Every time they sell new mortgage-backed securities or agency debt, investors in those debt instruments are beneficiaries of that agreement,” says Pinto.
In short, “Congress has put in place a series of provisions that allow the status quo even though everyone says it is bad and shouldn’t continue,” says Pinto. “The status quo has been legislated by Congress.”
Recapitalize and release?
There is a growing political effort to convince Treasury to allow the GSEs to keep more of their profits by revising the third amendment that sweeps virtually all profits into Treasury.
The calls to end the dividend sweep have been made for years by community lenders, affordable-housing advocates such as the National Community Reinvestment Coalition (NCRA), civil rights groups such as the NAACP, and distressed-asset investors who have purchased junior preferred and common shares.
Concern about declining capital levels at the GSEs gained a powerful new voice on Feb. 18, when FHFA Director Mel Watt stated in a speech at the Bipartisan Policy Center in Washington, D.C., that the declining capital buffers at Fannie Mae and Freddie Mac constitutes “the most serious risk” facing the GSEs--“one that has the most potential for escalating in the future,” he said.
In May, conservative organizations such as the National Taxpayers Union and the Competitive Enterprise Institute embraced recap and release for the GSEs by throwing their support behind the Housing Finance Restructuring Act of 2016, introduced in April by Rep. Mick Mulvaney (R-South Carolina).
The Mulvaney bill proposes to end the dividend sweep and allow the GSEs to retain profits to build up risk-weighted capital. The bill provides that when each of the GSEs accumulates a 5 percent capital buffer, they would be released from conservatorship.
A group of 32 House Democrats in June requested that FHFA director Watt and Treasury Secretary Jack Lew make sure the GSEs retain sufficient capital. The Democrats argued in a letter to the two officials that FHFA is required to make sure the GSEs operate in a safe and sound manner under provisions in HERA.
Despite the groundswell of concern about capital levels at the GSEs, Congress seems unlikely to get behind recapitalization and release, according to Lopez at MBA.
“Recapitalizing the existing entities and releasing from conservatorship is not a viable option,” Lopez says.
“Those in Congress who have spent time studying the issue all recognize there are a lot of good things about the secondary housing finance system in the United States but there are certain things that need to be improved,” he adds.
The high-water mark to date for GSE reform happened more than two years ago on May 15, 2014, when the Senate Banking Committee approved the Johnson-Crapo bill in a bipartisan vote, according to Ed De Marco.
The Johnson-Crapo bill and other legislative proposals that have come out of Congress have all shared three important goals, according to DeMarco. Each proposes to wind down Fannie and Freddie, create a common securitization platform and transfer credit risk from the GSEs to investors.
While legislation is stalled in Congress, progress has continued since 2014 at FHFA and the GSEs toward those goals, DeMarco says.
The hard work of reform
Whatever GSE reform might eventually emerge from Congress, the FHFA continues to develop the market underpinnings for GSE reform begun by DeMarco and that have continued under Watt. This is a good thing, according to Mills. “The hard work is being done by the regulators and entities themselves, and this makes it easier for Congress to tackle reform at the end of the day,” he says.
The notion that a significant reform effort would emerge from a government bureaucracy is a bit of a surprise, according to Mills. “Incrementalism is traditionally what you get from a bureaucrat. There is not a lot of desire to stick your neck out there and do the bold call,” he says.
In the case of the FHFA, DeMarco and Watt have listened to what Congress had to say, what the Obama administration had to say and what the mortgage finance industry had to say. “They took all that in and came up with a vision,” says Mills.
The progress being made by FHFA might save the day. It sets the stage for a new President to finish the job by forging a consensus in Congress to enact streamlined GSE reform. But don’t hold your breath. MB
DeMarco: Keep It Simple
In June, the Milken Institute, Washington, D.C., posted a paper titled Why Housing Reform Still Matters, by Ed DeMarco, former acting director of the Federal Housing Finance Agency (FHFA) and current senior fellow in residence at the Milken Institute’s Center for Financial Markets; and Michael Bright, director of the Center for Financial Markets and a former trader in mortgage-backed securities (MBS) and interest-rate derivatives at Wachovia Bank, a Charlotte, North Carolina-based bank acquired by Wells Fargo in 2008.
The purpose of the paper was to provide a context for the next phase of housing reform efforts, according to DeMarco.
Government-sponsored enterprise (GSE) reform is important unfinished business, DeMarco says. “We had this debacle [in 2008] and we dealt with a lot of things in the financial system. But we didn’t deal with the epicenter of the crisis. We didn’t deal with the housing finance system,” he says.
The DeMarco-Bright paper acknowledges, for starters, that since 2008 there has been broad agreement on a number of elements of reform.
“We have agreement that we have to wind down Fannie [Mae] and Freddie [Mac]. We have agreement on getting taxpayers out of bearing most of the mortgage credit risk. We have broad agreement on having a standardized common securitization platform that doesn’t put the country’s housing system at risk that way it was in 2008,” says DeMarco.
All of the major proposals in Congress so far contained those three elements. “And yet, there remains a lot of disagreement beyond the area of consensus,” according to DeMarco.
In order to make progress toward a broader agreement, the next phase of GSE reform “needs to focus more on throwing out the dirty bathwater but keeping the baby,” says DeMarco.
“Reform has to get simpler, and it’s really got to focus on what is it we’re trying to preserve and what is it we’re trying to fix,” says DeMarco.
One of the most consequential flaws in the GSE model of mortgage finance--as it worked pre-crisis and now--is that it concentrates $5 trillion in credit risk for mortgages on the books of the GSEs, according to DeMarco and Bright in their paper. A new system should greatly diminish that concentrated systemic risk, the authors state.
A new system, however, should preserve the liquidity and capacity of an active, global finance, mortgage-backed securities (MBS) market that the GSEs made possible “to ensure lower mortgage rates and stable access to credit,” DeMarco and Bright note.
The authors examined the role of the credit-risk market and the interest-rate market in the existing GSE system and how they might work in an improved system. The credit market was “entirely housed at Fannie and Freddie,” DeMarco says. Ultimately the risk also fell on the taxpayer when the GSEs were placed into conservatorship.
The GSEs made it possible for private investors to assume the interest-rate risk and enjoy the guarantee on monthly payments of principal and interest on the notes issued by Fannie and Freddie.
DeMarco, when he was acting director at FHFA, sought to reduce the exposure of the GSEs to concentrated credit risk by spearheading the credit-risk transfer transactions that transfers some of the credit risk to private investors. “In this huge market there really are investors who are willing to price, underwrite and take credit risk,” says DeMarco.
A separate and different investor base, DeMarco notes, “is willing to hold mortgage-backed securities and bear the interest rate risk of it--but they don’t want to hold credit risk.”
The design of a future secondary market has to find a way to attract more private capital to take on the credit risk and make the market competitive, liquid and competitive. At the same time, DeMarco explains, the new system must also be attractive to interest-rate investors.
DeMarco and Bright examined the government model represented by Ginnie Mae insuring securities and credit insured by government agencies (the Federal Housing Administration [FHA], Department of Veterans Affairs [VA] and U.S. Department of Agriculture [USDA] Rural Housing Service) for possible guidance on a new reform proposal.
DeMarco and Bright liked the fact that Ginnie Mae has a single common security and there are 450 issuers of that common security. “Very little credit risk touches Ginnie Mae because Ginnie Mae is there basically as a backstop if one of these 450 issuers fails,” DeMarco says.
The authors like the idea of adapting the Ginnie Mae model to replace Fannie and Freddie, and bring in the private-sector investors to take on the role of FHA, VA and USDA, DeMarco explains.
“Rather than create a new government guarantor or a new government corporation, we’ve already got one [with Ginnie Mae],” DeMarco says. “It’s a global brand. It’s backed by the full faith and credit of the federal government. It’s known by the investor community around the world,” he adds.
Using Ginnie Mae as the framework for a new system would allow a common security and multiple issuers “rather than having everything funneled through a Fannie Mae security or a Freddie Mac security,” DeMarco explains.
Data and technology standardization can help develop the broad and deep market of investors needed for such a new mortgage finance system.
“It’s all about getting a modernized digital way of doing this business with standardized data definitions and standardized technology for data to be imported,” DeMarco says. It also allows for more reliable loan-level disclosures.
Better loan-level disclosures in turn help support FHFA’s effort to do credit-risk transfer deals, DeMarco explains.
Dataset standardization began in May 2010 with the announcement of the Uniform Mortgage Data Program® (UMDP). It began with the Uniform Appraisal Dataset (UAD), which has been in use for many years, DeMarco notes.
FHFA also developed the Uniform Closing Dataset (UCD) program.
While FHFA has developed standard data definitions, technology standardization has taken place through the Mortgage Industry Standards Maintenance Organization (MISMO®), which is run out of the Mortgage Bankers Association (MBA).
Standardized data also paves the way for hundreds of securitizers to issue new securities in the future because it removes an important barrier to entry: creation of a proprietary data and technology system to compete with proprietary systems at Fannie and Freddie, DeMarco explains.
Starting from scratch three years ago, the breadth and depth of the credit-risk transfer transaction market at Fannie and Freddie have expanded significantly.
In a June report, FHFA stated that since the program began in 2013, there have been credit-risk transfers on portions of a total of $838 billion of unpaid principal mortgage balances through the end of 2015.
The amount of risk transferred (the value of the notes issued by the GSEs) is $30.6 billion, or about 3.6 percent of the unpaid principal balance on those mortgages, according to FHFA.
“I do think it’s good progress. It shows that the market is open to taking this on,” says DeMarco.
The risk transferred is an addition to any credit enhancement by primary mortgage insurance as well as the borrowers’ equity, according to FHFA.
DeMarco would like to see the amount of risk transferred rise to 500 basis points so that it is comparable to the amount of capital that community banks have to hold against mortgages they hold on their books.
Some portion of credit-risk transfer is now occurring on about “90 percent of the 30-year fixed mortgages being sold to Fannie and Freddie,” says DeMarco.
The market for credit-risk transfers has been boosted further by a change in policy on representations and warranties that loan originators have to make about the loans they sell to the GSEs.
“Investors have more confidence now that Fannie and Freddie are doing loan-quality reviews upfront rather than the pre-crisis model where they just waved the stuff in and they only looked at a loan if a borrower went delinquent,” says DeMarco.
“While it’s been painful for everybody, the changes in the way the reps and warrants system works is another development that allows the credit investor to have greater confidence in participating in this market,” says DeMarco.
DeMarco identifies mortgage real estate investment trusts (REITs) as a natural investor in credit-risk transfers that could expand the investor base.
However, mortgage REITs have not participated because these assets are not eligible for REITs to purchase under the Investment Company Act of 1940, DeMarco explains.
DeMarco suggests that Congress could remedy the inability of mortgage REITs to invest in credit-risk transfers by amending the 1940 act.
In the end, the steps taken by the FHFA make GSE reform more likely and now GSE reform legislation needs to be advanced to complete the process, according to DeMarco.
To do that, GSE reform should be kept simple and minimize the amount of changes made from what works in the current system to win a wider consensus among stakeholders.
Keeping it simple can ultimately change the game and make GSE reform “in fact quite achievable,” DeMarco says.
SIDEBAR # 2
MBA Task Force Focuses on Affordability
A key focus on the Mortgage Bankers Association (MBA) is work toward GSE reform that includes a concerted and broad-based effort to address the challenge of meeting the affordability needs of the American public and in expect 1.4 million to 1.6 million new households to be formed in the coming years.
To address the concern, the MBA formed a Task Force for a Future Secondary Market last February and appointed as its Rodrigo Lopez, chairman of NorthMarq Capital Finance LLC of New York, chairman-elect of the Mortgage Bankers Association.
The 25 members of the task force include people from single family and multifamily lenders of all sizes and business model types for both owner-occupied and rental housing, according to Lopez. “We are looking not only at how the future secondary market would operate but in particular make sure that we look at end state models that can fulfill an affordable housing mission while reducing taxpayer risk,” Lopez says.
The lack of an affordable housing component in GSE reform proposals is a key reason the proposals failed to advance in Congress, according to Lopez.
“On the single family side, we want to be sure we preserve a deep and robust and effective TBA market for 30-year fixed rate pre-payable single-family mortgage,” Lopez says. “On the multifamily side of housing finance we want to maintain what is now a well functioning long-term mortgage finance market,” he says. “The work that Fannie and Freddie do in multifamily is extremely successful and has been for decades and we want to preserve that.”
The MBA task force would like to see a GSE reform model where the explicit government guarantee is limited to mortgage-backed security level and not at the entity level.
Another guiding principle for GSE reform within the task force will be to be sure that proposals put private capital at risk before the backstop guarantee from the government “would come into play,” Lopez says. “That of course would help us attract global capital.”
The task force is trying to be sure that there is enough affordable housing, whether owner-occupied or rented, to meet the needs of the American public, including an expected new 1.4 million to 1.5 million households that are to be formed annually in the coming years.
Affordable housing should be approached “holistically,” says Lopez. That means it should include improved government programs and subsidies for for rental housing in addition to strong and stable mortgage finance system financed through the secondary market from private investors with a government guarantee to back securities.
Lopez co-authored a paper in June for the Urban Institute titled “Affordable Housing and Access to Credit: Critical Objectives for a New Secondary Market.” The paper outlines the principles that should guide reform efforts that include affordability provisions. It is co-authored Debra Still, president and chief executive officer of Pulte Financial Services, and chair of affordable housing subgroup of the MBA’s task force.
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